2. Suppose that actual inflation is 2% which is target inflation rate, output gr

Question

2. Suppose that actual inflation is 2% which is target inflation rate, output growth is 2% which is 1% below potential (Y*), actual federal funds rate is 5%. (5 points)

a. Use the Taylor rule to predict the Feds target for the federal funds rate.

b. Explain how the Fed should move the actual federal funds rate to the new target. Should the Fed sell or buy government bonds to meet the new target for the federal funds rate?

c. Is the Fed making monetary policy expansionary or contractionay? Explain

d. Refer to your answer in part b. Using the concept of the supply and demand for bonds, explain and illustrate graphically the effect of the Fed action from part b on:

• The supply or demand for bonds

• The price of bonds

• The interest rate associated with these bonds

e. Using the concept of supply and demand for money, explain and illustrate graphically, the effect of the Fed action form part b on:

• The money supply in the economy

• The short-term nominal interest rates

• The real interest rates'

f. Using the concept of AD/AS, explain and illustrate graphically the effect of the Fed action from part b on the following in the short-run:

• Aggregate Demand (AD)

• The Real GDP in the short-run (Y)

• Price level (PL)

• Explain the effect of the Fed action from part b on the Real GDP in the long-run

Explanation / Answer

a. Federal funds are excess reserves of a bank deposited to their regional reserve bank. This can be lent as a borrowing to other banks in case they have insufficient reserves. Federal funds rate is the interest rate charged by one bank to another to borrow fed funds overnight. Taylor rule is the interest rate forecasting model. It assumes that when inflation is at target and output is at potential, the Federal Open Market Committee (FOMC) set the federal funds rate at 2%.

b. FOMC decides to set the target for federal funds interest rate and to meet the target, attempts are done to buy or sell government securities.

c. Fed purchasing government securities refer to as expansionary monetary policy and Fed selling governent securities refer to as contractionary monetary policy.

Low federal funds rate means expansion in monetary policy by the federal reserve. This makes the borrowing easy for the banks. This makes an increase in supply of federal funds as reduction in funds rate encourages commercial banks to take borrowings to meet reserve requirements. High federal funds rate means contraction in monetary policy.

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