Question

On the evening news you heard that the current fed funds rate is 0.5%. (May 2020) Your friend tells you that this rate is set directly by the Fed, to fight possible inflation. Is he right? Explain your answer in a paragraph.

Answer 1

The federal funds rate is the inter depository interest rate on loans.
Yes, he is correct as FED changes the federal fund rate if the inflation is going out of the ratnge of targetted inflation. For example, suppose inflation is too high, so, to decrease the inflation rate it will increase the federal funds rate which will cause banks to keep excess reserves because if they ran out of the reserves, so, they have to borrow at higher interest rates from other banks. So, thier increased excess reserves decreases the amount of momey they can lend, decreasing the money supply in the country. As money supply has decreased, people will start selling bonds in the market which will decrease the price of the bonds but increase the interest rate. This increase in interest rate will disincentivise the business to take loan for investment and households for consumption, decreasing the aggregate demand for goods and services in the market which at given level of aggregate supply will decrease the price level in the economy, thus, bringing the inflation rate in the desirable range. Similarly, incase of very low inflation rate, the FED will decrease the federal funds rate.

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