In response to problems in financial markets and a slowing economy, the Federal
ID: 1111442 • Letter: I
Question
In response to problems in financial markets and a slowing economy, the Federal Open Market Committee (FOMC) began lowering its target for the federal funds rate from 5.25 percent in September 2007. Over the next year, the FOMC cut its federal funds rate target in a series of steps. Writing in the New York Times, economist Steven Levitt observed,
"The Fed has been pouring more money into the banking system by cutting the target federal funds rate to 0 to 0.25 percent in December 2008."
Source: Steven D. Levitt, "The Financial Meltdown Now and Then," New York Times, May 12, 2009.
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What is the relationship between the federal funds rate falling and the money supply increasing?
A. Cutting the federal funds rate increases saving, which increases the money supply.
B. Cutting the federal funds rate increases the money supply.
C. To decrease the federal funds rate, the Fed must increase the money supply.
D. Cutting the federal funds rate increases bank reserves, which increases the money supply.
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How does lowering the target for the federal funds rate "pour money" into the banking system?
A. To increase the money supply, the Fed increases government spending, which increases aggregate demand.
B. To increase the money supply, the Fed buys bonds on the open market, which increases bank reserves.
C. To increase the money supply, the Fed sells bonds on the open market, which increases bank reserves.
D. To increase the money supply, the Fed decreases taxes, which increases consumer spending.
Explanation / Answer
Ans:
1) Option C
To decrease the federal funds rate, the Fed must increase the money supply.
In order to decrease the federal fund rate, fed must increase the money supply by selling securities in the open market.This will increase the banks' reserves funds and the quantity of money increases causing a decrease in federal fund rate.
2) Option B
To increase the money supply, the Fed buys bonds on the open market, which increases bank reserves.
The instrument rule of the FED to decrease the federal fund rate is that the Fed buys government securities in open market operations.This will increase the banks' reserves funds.
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