MBA 609
Money, Financial Markets, & Forecasting
Homework #16 Key
- Consider the graph of the daily and monthly effective Fed funds rate reported at FRED (DFF and FEDFUNDS).
- Evaluate the possible effect of the Fed funds rate in causing recessions.
The double dip recession in the early 1980’s was definitely caused by the Fed since the effective federal funds rate reached almost 20%. That cause a very severe recession but also brought down the inflation rate.
The Fed raised rates significantly before the mild 1991 recession but started to taper before the recession hit.
Similarly, the Fed raised rates before the 2001 recession but lowered rates dramatically in conjunction of 9/11 and the recession.
This pattern occurs a third time before the Great Recession. In this case, the Fed probably left rates too low for too long and then raised them too dramatically, only to have to cut them and then keep them low for a decade.
- Evaluate the possible effects of the fed funds rate in helping the economy recover from recessions.
The Fed seems to be very effective in lowering rates, even before the onset of a recession to help in the recovery. This is true after 1990 when the Fed started targeting interest rates. Previous to 1990, it is more difficult to detect if the Fed was effective in promoting economic growth so that the economy could exit recessionary conditions.
- Use the market for reserves workspace to explain what
- the Fed does when the effective rate exceeds the target.
If Initially a growing economy stimulates loan demand, then the demand for reserves might increase. This might cause the effective federal funds to rise above its target as shown. The Open Market Desk in New York could cause the effective federal funds rate to return to the target by making a defensive open market purchase as shown:
- the Fed does when the effective rate drops below the target the target.
Similarly, if loan demand is low because of high loan default risk in a slowing economy, then the demand for reserves might drop which would cause the effective federal funds rate to sink below the target. This means that the supply of reserves exceeds the demand and the Open Market Desk should decrease the supply of reserves through an open market sale.
- What happens when the Fed changes the required reserve ratio, the discount rate, or the deposit rate.
An increase in the required reserve ratio causes the demand for reserves to increase. If the Federal Reserve doesn’t increase the monetary base, then the supply of reserves doesn’t shift and interest rates rise:
Changing the discount rate changes the kink on the supply curve. Changing the deposit rate changes the kink on the demand curve. This changes the channel in which the effective federal funds will remain. The discount rates gives the ceiling and the deposit rate gives the floor.