Suppose that the demand for federal funds curve is such that the quantity of fun

Question

Suppose that the demand for federal funds curve is such that the quantity of funds demanded changes by $160 billion for each 1 percent change in the federal funds interest rate. Also, assume that the current federal funds rate is at the 3 percent rate that is targeted by the Fed. Now suppose that the Fed retargets the rate to 4.5 percent.

Instructions: Enter your answer as a positive value.

a. Assuming no change in demand, will the Fed need to increase or decrease the supply of federal funds?

.

b. By how much will the quantity of federal funds have to change for the equilibrium to occur at the new target rate?

by $ billion.

Explanation / Answer

(a) As Federal Funds rate (FFR) increases (decreases), quantity demanded of federal funds decreases (increases). So, when FFR is raised to 4.5%, quantity demanded of funds will fall, and there will be a market surplus. So Fed has to lower the supply of funds.

(b)

Fall in quantity demanded = $160 billion x Change in FFR = $160 billion x (4.5 - 3)% = $160 billion x 1.5%

= $240 billion

Fed ahs to decrease supply by $240 billion to restore equilibrium.

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