The visible hand in economics

Has the Fed cut rates without telling anyone

Posted on: September 14, 2007

Greg Mankiw noticed that the Fed target is still 5.25%, however the effective rate in August was only 5.02%.

This is interesting, in NZ you could not do this as the Bank is willing to release any amount of money for a given interest rate (that is what our OCR target implies), the constraint in this case is money demand. In American they have a Federal Funds rate, which acts as there target rate. However, they also target a certain money supply level and use open market operations to get there.

Now you can’t arbitrarily choose the combination of the price (interest rate) and quantity of money in the market place, it depends on money demand. As a result, the Fed can only truly control one of these variables, as if they want to hit their target rate there is only one level of money supply that will allow it (given a strictly downward sloping money demand curve).

According to Mankiw, the Fed is pretty good at choosing the right amount of money supply so as to achieve the Federal Funds rate. By deviating from this they are loosening monetary policy, even if they haven’t said they have. The fact that the Fed has control of money supply as well as money demand allows them to be loosen monetary policy quickly without making the market feel like they are. However, it makes them less transparent, which in the long run is not a good thing.

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