Question

Fed is open to changing bond policy

Fed policymakers signaled for the first time that they could increase or decrease stimulation of the economy in the​ future, but not now.

​Source: Los Angeles Times​, May​ 1, 2013

What are the ripple effects and time lags that the Fed must consider in deciding when to increase or decrease stimulation of the​ economy?

Choose the statement that is correct.

A. When the Fed raises the federal funds​ rate, the quantity of money decreases on the same day.

B. When the Fed lowers the federal funds​ rate, the supply of loanable funds increases up to a year later.

C. When the Fed raises the federal funds​ rate, the inflation rate decreases about two years later.

D. When the Fed lowers the federal funds​ rate, the exchange rate falls a few weeks later.

E. When the Fed raises the federal funds​ rate, other​ short-term interest rates rise a few weeks later.

Answer 1

Fed policymakers while deciding the increase or decrease in stimulation of the economy have to take into account the impact of policy on interest rate, quantity of money in the economy, loans to be made by the banking system and the response of inflation rate.

All these elements behave in different manner and take different time period.

Fed can impact interest rates in quick fashion but it may take one year for Fed action to reflect on quantity of money in the economy and may take two years for Fed action to reflect on inflation.

Thus,

When the Fed raises the federal funds rate, the inflation rate decreases about two years later.

Hence, the correct answer is the option (c).