Federal funds rate target question?

Question

Suppose the U.S. economy reveals significant rising inflationary pressures in the coming months and the Fed decides to raise the federal funds rate target later this year. Explain how the FED is able to attain the higher target for the federal funds rate.

Answer 1

Through so called Open Market Operations, the Fed buys and sells Government Securities that are held in reserve by banks. This affects the availability of money and hence, interest rates.

When the Fed buys securities from banks, it is effectively adding to the money supply, since more cash is now available to banks for lending out. This lowers interest rates, that is, short term interest rates. (The Federal Funds interest rate is a short term interest rate.)

When the Fed sells securities, it has the opposite effect. Money is taken from the money supply, and since money is now scarcer, people must pay more for what is scarcer. The principle of supply and demand will apply: when money is in short supply, the cost of it goes up.