The impact of changes in the Federal funds rate on inflation rate
Any economic model under a monetary system is susceptible to inflationary pressure. A rise in inflation rate has dire consequences economic variables such as investment spending, consumption and income. This paper intends to discuss the impact of the federal funds rate on rising inflation, the lending ability of the financial institutions, investment spending, aggregate demand and the real interest rate.
The Federal funds rate is the rate of interest that commercial banks and other financial institutions levy on each other on overnight loans derived from their surplus reserves. The Federal Reserve usually uses the federal funds rate to maintain equilibrium between the supply and demand of reserves in the Federal funds market. For instance, to curb a rising inflation rate, the Federal Reserve must adopt a restrictive monetary policy by increasing the Federal funds rate to curtail borrowing and spending. An increase in the Federal funds rate in effect will reduce aggregate demand, investment spending and consequently inflation rate. The open- market operation is the most viable option to increase the Federal funds rate. The Federal bank will offer bonds for sale to financial institutions (commercial banks thrifts) and the public to mop up excess reserves in the market. The impact of such a move is that fewer funds will be available for borrowing hence the ability of financial institution to lend will be limited (economic).
Conclusion
As observed above, the open- market operation is the best option to be used in raising the federal funds rates which absorbs excess reserves in the financial market. In addition, a rise in federal funds rate reduces inflation rate and increases the real interest rates and aggregate demand. Investment spending is also severely compromised (Economics).