Question

4. Explain the Federal Open Market Committee’s choice to lower the Federal Funds Rate and how it impacts the economy. Describe how this action impacts bank reserves, how this changes the loanable funds market (be sure to mention interest rate and lending levels and use a supply and demand model if its helpful), and business and consumer borrowing and spending. You can assume that leakages are minimal.

Answer 1

The Federal Open market Committee tends to lower the federal fund rate to influence the economy. The lower federal fund rate makes the overnight loans cheaper, Thus it increases the availability of excess reserves with banks and these banks make the loan to the investors and consumers increasingly.

When the money supply rises due to the decline in the federal fund rate, The money supply increase would cause the fall in the interest rate, thus when the interest rate decline in the economy, the investors and consumers find the borrowings relatively cheaper and they go for the massive borrowing, The eventually, there would be a rise in the economic activities and aggregate demand in the economy.

Following is the diagram:

Ms MS-1 1-1 Md M M1

In the above diagram, the decline in the federal fund rate would shift the money supply to right thereby causing the rise in the money quantity and interest rate declines to the i-1.

Thus, the investment and consumption spendings would see the rise.