Question

1. Explain how the Fed influences the equillibrium fed funds rate to move toward its target rate.
2. Explain why the Fed was generally so ineffective before the late 1980s.
3. Define inflation targeting and explain its importance.

Answer 1

Answer 1 - The fed has the power to influence the federal funds rate and make the changes in the money supply of economy. The fed does so by changing the reserves in the monetary system. This is done by the open market operations. Whenever the fed wants to make a fall in federal funds rate , it purchases the securities from the open market. This leads to the rise in the supply of money and greater funds to lend. Hence the fed funds rate drop down. If the fed wants to raise the federal funds rate , it sells the securities in the open market and thus , keeps more reserves. This leads to lesser lending power and hence the federal funds rate rise. In this way the federal reserve influences the federal funds rate to achieve its targets.