According to the Federal Reserve’s Federal Open Market Committee (2011), the Federal Reserve “controls the three tools of monetary policy—open market operations, the discount rate, and the reserve requirements.”
It goes on to say that using these three tools, the Federal Reserve influences the demand for and supply of balances that depository institutions hold at the Federal Reserve Banks, and in this way, it alters the federal funds rate. The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.
Changes in the federal funds rate trigger a chain of events that affect the following:
- Other short-term interest rates
- Foreign exchange rates
- Long-term interest rates
- The amount of money and credit in the system
- Prices of goods and services (i.e., inflation)
Using your understanding of the financial system, the demand for money, banking and the money supply, the stock market, interest and spending, interest and investment, how money moves, and how monetary policy affects aggregate supply and demand and inflation, explain exactly how a change in the federal funds rate can trigger all these reactions. Use at least 4 graphs. Do you think we are in a liquidity trap today? Why or why not?