3.) Assume in parts (a)-(c) that the Fed has decided that a slow (50 basis point

Question

3.) Assume in parts (a)-(c) that the Fed has decided that a slow (50 basis points per year) rise in the Federal funds rate is likely the correct approach to balancing risks of holding inflation to around 2% per year while maintaining enough growth in GDP and labor markets to achieve and stay at full employment. However, even if this is the correct view, it may not be the view that financial markets, lenders and CEO’s take.

a.) What problems might arise in controlling the Federal Funds rate and other money market short term rates to keep them in the Fed’s target zone as the Fed slowly raises that target zone given the fact that in the aftermath of QE1 through QE3, most banks hold substantial excess reserves?

b.) How will the Fed’s ability to pay interest on bank reserves help it deal with these potential problems?

C.) How will short term repo markets sales of Treasury securities from the Fed’s balance sheet help it keep money market interest rates and yields within the Fed’s fed fund target range as the Fed increases its Fed funds target?   

Reference to topic: material on policy normalization on the federal reserve website under the tab "monetary policy" http://www.federalreserve.gov/monetarypolicy/policy-normalization.htm

Explanation / Answer

(a) There could be a market crash due to rise in rate of interest at highest. There could be an increase in the market to avoid such problems.

(b) The ability of Fed to pay interest on bank reserves help to deal with problems such as decling in the supply and demands of the products in the market.

(c) The short term repo markets sales of Treasury securities from the Fed's balance sheet keeps money market interest rates and yields within the Fed's fund target range. It shows requirement of funds by hte banks to increase the money supply and reduce inflation.

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