Question

The Federal Funds target range set by the FOMC is 2- 2.25%. Suppose due to temporary market changes, the Federal Funds rate in the market decreases to 1.70%. The Fed wants to keep the federal fund rate in the target rage.

a. If the banking system has limited reserves, what kind of open market operations (purchases or sales) will the Fed use?

b. Are these open market operations considered dynamic or defensive? Why?

c. If the banking system has ample reserves, how would the Fed implement their current monetary policy stance with interest rate on reserve balances?

Answer 1

a. In order to increase the federal funds target rate from 1.70 per cent to the the range of 2-2.25 per cent, the Fed should sell government securities in the open market because selling of government securities will reduce the level of money supply in the money market and this reduction in money supply will increase the rate of interest in the money market.

b. These open market operations are defensive because they have been targetted because federal funds rate in the economy is below the target range. This makes the open market operations defensive.

c. In order to reduce the level of money supply, the Fed will increase the rate of interest on reserve balances. The increase in the rate of interest on reserve balances will reduce money supply in the money market which will increase rate of interest in the money market.