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The Fed kept the Federal Funds rate target unchanged at 5.25% from June 2006 to September...

The Fed kept the Federal Funds rate target unchanged at 5.25% from June 2006 to September 2007. However, the effective Federal Funds rate dropped from 5.41% on August 9th 2007 to 4.54% on August 14th 2007. If the Fed did not take any monetary measures from August 9th 2007 to August 14th 2007, graphically show what could have caused the decrease in the Federal Funds rate. If you were the Fed’s chairman, what measures would you take to achieve the 5.25% target. Use the diagram of the reserve market to support your answer.  

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Answer #1

1. Apart from the monetory measures that lead to change in interest rate, there is demand and supply of goods market that affect the rate of interest. We can show this with the help of IS-LM Model.

In the above graph due to fall in government expenditure, aggregate expenditure falls and IS curve shifts to leftward side at IS1. So with the help of this rate of interest falls to r0 from r.

2. Monetory policy that can be adopted is reserve market with the help of changing federal funds rate.

Rs is the supply curve of reserve market and Rd is the demand curve of Reserve market.

At r1 there is excess supply of reserve which will lead to fall in federal funds rate to r0.

At r2 there is excess demand for reserve, which will lead to rise in federal funds rate at r0 and equilibrium is established again at E.

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