Question

Suppose, at a given federal funds rate, there is an excess supply of reserves in the federal funds market. If the Fed wants the federal funds rate to stay at that level, then it should undertake an open market ________ of bonds, everything else held constant. If the Fed does nothing, however, the federal funds rate will ________.a. purchase; increase b. sale; decrease c. purchase; decrease d. sale; increase

Answer 1

Answer:

B) sale; decrease

• If the Fed wants the federal funds rate to stay at that level, then it should undertake an open market SALE of bonds, everything else held constant. If the Fed does nothing, however, the federal funds rate will DECREASE.

Explanation:

The federal funds rate is the rate at which banks make overnight loans to other banks or financial institutions. If the supply of money is too high, then the interest rates will start to decrease.

Money is like any other good, and its price is determined by the supply and demand. The higher the supply, the lower the equilibrium price. The equilibrium price of money is the interest rate.

If the Fed wants to avoid the decrease in the interest rate, it must absorb excess supply of money, and the only way it can do it is by selling bonds.