Federal Reserve: Impact of Fund Rate Changes |
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The Federal Reserve plays a significant role in the stability of the US economy, and has done so since 1913, when it was chartered by President Woodrow Wilson as a response to the decentralized and incomprehensible monetary policy that existed in the United States at that time. President Wilson tasked the Federal Reserve with three major duties; changing the reserve requirement, changing the discount rate, and open market operations. These duties are carried out through the use of fiscal and monetary policy, both of which are aimed at influencing the level of aggregate economic output activity in a beneficial manner.
Recently, the Federal Reserve’s Federal Open Market Committee (FOMC) decided to increase the Federal Funds Rate by 25 basis points to 2¼%. In a related action, the Federal Reserve’s Board of Governors decided to increase the Discount Rate by 25 basis points to 3¼%. This increase was requested by the Board of Directors of the Federal Reserve Banks of Boston, New York, Chicago, Philadelphia, Atlanta, St. Louis, Richmond, Cleveland, San Francisco, Minneapolis, Kansas City, and Dallas. The Federal Reserve believes that adopting this rate increase will result in a tightening of the money supply, as this will make it more expensive for banks to borrow money from the Federal Reserve.
This decision will have an impact on the US macro economy. The Federal Reserve’s contractionary monetary policy will result in an increase in the interest rate, a decrease in investment, and a decrease in income and output. This contractionary monetary policy is aimed at restraining aggregate demand by increasing the Federal Funds Rate. This policy is needed when savings is smaller than the investment and the economy is operating at too high a level of income causing inflationary pressures. This monetary policy tries to restrict the demand for investment and consumer loans. An increase in this rate will ultimately result in lowered income. Since it will be more expensive for banks to borrow money from the Federal Reserve, banks will restrict the amount of money that they request, reducing the amount of money in circulation.
The costs of borrowing will be passed on to corporations. Corporate profits will be negatively affected by the increase in the Federal Funds Rate. This will slow the economy down slightly. Contractionary monetary policy results in a decrease of the money supply. This leads to a higher interest rate, which will mean that there will be a decrease in investment, since less and less people will want to invest money. With decreased investment comes decreased input and output. Consumers and firms will react to higher interest rates by reducing the amount of money they spend, and sales will drop. Faced with an unwanted increase in inventories, firms will cut back production and employment. This will push the unemployment rate up, and lead to a reduction in the rate of wage increases (at least, according to Keynesian economic models). In response, companies will reduce the rate at which they are raising prices. Once inflationary pressure is reduced, the rate can be once again lowered and the economy can be allowed to expand again. However, the increase in the Federal Funds rate is only a quarter of a percentage point, and its ultimate effect will not be a dramatic decrease in the money supply or a sharp increase in interest rates or inflation; rather, it is a staged increase designed to slowly affect the aggregate demand of the economy without dramatically shifting the allocation of corporate and/or individual resources.
The increase in the Federal Funds Rate will also have an effect on the finances of a typical household. The first and most noticeable effect will be a decrease in income, due to increases in borrowing rates. Variable interest rate loans like credit cards, lines of credit, and adjustable rate mortgages will become more expensive to maintain. The ability of a consumer to purchase large consumables like cars and homes will be restricted, since they will be more expensive to finance. The aggregate demand curve will be pushed to the left. When aggregate demand goes down, prices goes down, as does income. When income decreases, savings decrease as well. A decrease in savings ultimately results in a decrease in investment and a slowdown of the economy. Households will have less money to spend and to save; their financial decisions will become more conservative and will force retailers to cut their prices as well. Again, we should note that the increase in the Federal Funds Rate is only a quarter of one percent, and should not have a dramatic effect on households. Nevertheless, the effect this rate increase will have on households will certainly be greater than the effect it will have on corporations, since even minor changes to a household’s finances can result in changes to purchases and financial decision-making.
Clearly, the Federal Reserve plays an important role in sustaining the economic vitality of the United States. Its public/private organizational structure lends itself to addressing the concerns of the private sector while still providing the requisite level of government oversight through its President-nominated Board of Governors. The fiscal and monetary policies that the Federal Reserve adopts have far-reaching consequences not just for Americans, but also for the rest of the world. In the United States, the Federal Reserve has the difficult and often unenviable task of not just regulating the US economy, but also providing oversight to the banking system and providing the banking system much-needed financial services, such as electronic funds transfers between banks. However, irrespective of the different duties that it has, all of the responsibilities of the Federal Reserve can be distilled into one overreaching goal; the maintenance of a high level of confidence in the US economy and banking system. Since 1913, it has done an amazing job.
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