Question

Describe how the Federal Reserve controls the interest rates to stimulate or slow down the economy. In your opinion, is this a productive activity or should the economy be left alone to grow or contract on its own ?

Answer 1

• The Federal Reserve, America's central bank, is responsible for conducting monetary policy and controlling the money supply.
• The primary tools that the Fed uses are interest rate setting and open market operations (OMO).
• The Fed can also change the mandated reserves requirements for commercial banks or rescue failing banks as lender of last resort, among other less common tools.
• When the economy is faltering, the Fed can use these tools to enact expansionary monetary policy. If that fails it can use unconventional policy such as quantitative easing.

Manipulating Interest Rates

The first tool used by the Fed, as well as central banks around the world, is the manipulation of short-term interest rates. Put simply, this practice involves raising/lowering interest rates to slow/spur economic activity and control inflation.

The mechanics are relatively simple. By lowering interest rates, it becomes cheaper to borrow money and less lucrative to save, encouraging individuals and corporations to spend. So, as interest rates are lowered, savings decline, more money is borrowed, and more money is spent. Moreover, as borrowing increases, the total supply of money in the economy increases. So the end result of lowering interest rates is fewer savings, more money supply, more spending, and higher overall economic activity – a good side effect.

On the other hand, lowering interest rates also tend to increase inflation. This is a negative side effect because the total supply of goods and services is essentially finite in the short term – and with more dollars chasing that finite set of products, prices go up. If inflation gets too high, then all sorts of unpleasant things happen to the economy. Therefore, the trick with interest rate manipulation is not to overdo it and inadvertently create spiraling inflation. This is easier said than done, but although this form of monetary policy is imperfect, it's still better than no action at all.