Question

1. What is the relationship between the federal funds rate and Inflation? 2. if the graph of federal rates is in recession, is the inflation graph in expansion? 3. How about vice versa? Please explain with definitions and examples from the US economy. This can be answered as a paragraph. Thank you.

Answer 1

1. Inflation refers to the rate at which prices for goods and services rise. In the United States, the interest rate, or the amount charged by a lender to a borrower, is based on the federal funds rate that is determined by the Federal Reserve (sometimes called "the Fed").

By setting the target for the federal funds rate, the Fed has at its disposal a powerful tool that it uses to influence the rate of inflation. This tool enables the Fed to expand or contract the money supply as needed to achieve target employment rates, stable prices, and stable economic growth.

Under a system of fractional reserve banking, interest rates and inflation tend to be inversely correlated. This relationship forms one of the central tenets of contemporary monetary policy: Central banks manipulate short-term interest rates to affect the rate of inflation in the economy.

In general, as interest rates are reduced, more people are able to borrow more money. The result is that consumers have more money to spend, causing the economy to grow and inflation to increase.

The opposite holds true for rising interest rates. As interest rates are increased, consumers tend to save as returns from savings are higher. With less disposable income being spent as a result of the increase in the interest rate, the economy slows and inflation decreases.

2. When an economy enters recession, demand for liquidity increases but the supply of credit decreases, which would normally be expected to result in an increase in interest rates.
However, a central bank, such as the Federal Reserve, can use monetary policy to counteract the normal forces of supply and demand to reduce interest rates, and this is why we actually see falling interest rates during recessions.

3. Role of The Central Bank
A central bank, such as the Federal Reserve in the U.S., has the ability to influence interest rates by buying and selling debt instruments and increasing or decreasing the supply of credit in the economy. During a recession, the Fed usually tries to coax rates downward to bailout borrowers, especially banks, and stimulate the economy by increasing the supply of credit available.

The Fed buys bonds, usually (but not always) U.S. Treasury bonds or similarly high quality, low risk bonds. In doing so it injects an equivalent quantity of new reserves into the banking system, which supplies banks with fresh liquidity and directly lowers the federal funds rate or the rate at which banks loan each other money to meet immediate liquidity needs. This in turn (the Fed hopes) leads to an influx in new lending, which lowers interest rates and supplies businesses and individuals with the loans they need to finance purchases and continue normal operations.