Question

Now assume that the Fed is following a policy of targeting the federal funds rate. What will the Fed do in the situation described in Question 1 to keep the federal funds rate unchanged? Illustrate with a diagram.

Short answer

The diagram below illustrates the actions of the Fed to keep the federal fund rate unchanged:

Step-by-step solution

Fed’s action to maintain the interest rates

In the previous question, the quantity demanded of money increases with every interest rate. The demand curve shifted to the right, and a new equilibrium was achieved at a higher interest rate (fixed money supply).

Now, if the Fed wants to keep the interest rate unchanged, it will have to increase the money supply.

The Fed will achieve this target by buying the treasury bills or securities from the commercial. Buying it will make a payment that will put money into the system.

The graph below shows how Fed achieves its target of federal fund rate:

The y-axis depicts the interest rate, and the quantity demanded and supplied of money is depicted through the x-axis. The equilibrium rate is atR₁, where the initial demand MD₁ and supply MS₁ curves collide at point E₁. With changes in demand, the demand curveMD₁ will shift towards the right toMD₂, so the equilibrium will change from E₁ to E₂. If the Fed uses a target rate policy, it will try to keep the interest rate constant. This can be done by increasing the money supply from MS₁ to MS₂.

Consequently, the new equilibrium occurs at E₃. The interest rate returns to R₁.