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 $120 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.

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

(Decrease/Increase) the supply of Federal funds.

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

Instructions: Input the amount as a positive value.

(Increase/Decrease)by $ billion

Explanation / Answer

(a) FFR = inflation + equilibrium real interest rate + 0.5( inflation-target inflation) + 0.5(GDP-potential GDP) = 2 + r + 0.5*2 - 0.5*target inflation + 0.5*4 = 5 + r -0.5*target inflation Put Target inflation at 2% and assuming the equilibrium real interest rate is 2% then the Fed should increase the Federal funds rate to 6.00%. So Increase in Fed funds is 6%-4% = 2.00% (b) Assuming no change in demand, will the Fed need to increase or decrease the supply of Federal funds? (Decrease the supply of Federal funds. By how much will the quantity of Federal funds have to change for the equilibrium to occur at the new target rate? Reduction in fed rate = (4.5%-3%) = 1.5%. So Reduction in funds = 1.5*120 = $180B

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