Question

suppose you are a member of the board of governors of the federal reserve system. the economy is experiencing a sharp rise in the inflation rate. what change in the federal funds rate would you recommend? How would your recommended change be accomplished? what impact would the actions have on the lending ability of the bankingsystem, real interest rate, investment spending, aggregate demand and inflation?

Answer 1

When economy is experiencing high inflation, it means that aggregate demand is very high. The objective would be to decrease aggregate demand, which can be accomplished by decreasing the Federal Funds Rate (FFR).

FFR can be lowered if the Fed engages in contractionary open market opeations by selling Federal bonds in open market. As FFR rises, effective inter-bank cost of credit increases, so banks decrease their credit lending. As less credit is available, money supply in the economy falls, which increases real interest rate. Higher real interest rate decreases investment spending (since borrowing becomes costlier for firms), lowers consumption demand funded by borrowing, thereby decreasing aggregate demand. The aggregate demand curve shifts leftward, decreasing price level (i.e. lowering inflation) and lowering real GDP (output).