Question

When the inflation rate increases, what happens to the federal funds rate? Operationally, how does the Fed adjust the federal funds rate?

Short answer

In reaction to rising inflation, the Federal Reserve will raise interest rates. This will put an end to the cycle of rising inflation. To address this issue, the Fed will utilise open market operations to sell bonds in the market, reducing the money supply and raising the Fed fund rate.

Step-by-step solution

Concept introduction

Inflation is defined as an increase in the general price level of an economy. Inflation produces a rise in the price of products and services, reducing an economic agent's purchasing power.

Explanation of solution

A rise in inflation would result in a drop in real interest rates, which would lead to an increase in output, a rise in inflation, and yet another drop in real interest rates, resulting in even higher inflation.

The following equation can be used to compute the real interest rate:

$r=\overline{r}+\lambda \pi$

Where

- r represents the real interest rate.

- component $\overline{r}$is Autonomous

- $\lambda$is the real interest rate's responsiveness to inflation.

- The rate of inflation is $\pi$.

Increases in the federal funds rate in response to rising inflation will put an end to the cycle of rising inflation. The Fed will address this issue through open market operations, which will involve selling bonds in the market to reduce money supply and raise the Fed fund rate.