Question

2. The Fed is raised interest rates this week. This is Janet Yellen’s last FOMC meeting as Chair of the Board of Governors. The FOMC increased the Fed Funds rate by 25 basis points from 1.25% to 1.50%. Use the model we developed of the Federal Funds market to answer the follow questions: a. (10pts) Show how the Fed would increase the Fed Funds rate with open market operations. This question requires a graph and a written explanation that states clearly what changes and what happens to the equilibrium interest rate. b. (10pts)We know that the Fed cannot use open market operations to increase the Fed funds rate because of the massive influx of reserves into the Fed Funds market from 2008-2015. Show how the Fed will actually increase the Fed Funds rate when it raises it from 1.25% to 1.50%.

Answer 1

Answer

Interest rates are indirectly affected by open market operations (OMOs). OMOs are a tool in monetary policy allowing a central bank to control the money supply in an economy. Under contractionary policy, a central bank sells securities on the open market, which reduces the amount of money in circulation. Expansionary monetary policy entails the purchase of securities and an increase in money supply. Changes to the money supply affect the rates at which banks borrow reserves from one another due to the law of supply and demand.