Question

In 2001 the US Federal Funds Rate was only around 1-2%. If the negative shock had been larger, the economy might have hit the Zero Lower Bound. If this had happened, what alternative policy would you recommend and why?

Answer 1

The Federal Funds rate is the rate, which commercial banks are charged for taking loans from the Federal Reserve. Whenever, the country is in a recession cycle, the Federal Funds rates are lowered. This is in response to the decreased flow of capital in the economy which causes aggregate demand to decrease. When the aggregate or total demand in a country is low, the resultant is that producers cut back on production and unemployment in the economy rises as they try and control their costs of operations under low demand conditions.

When the interest rates are reduced, the demand for goods and services goes up, as consumers get loans at cheaper rates and producers can avail the facility to expand business. Also, the incentive to save is negligible in these conditions.

Further to this is the fact, that interest rates cannot go beyond a certain limit as the banking sector in itself would collapse under such circumstances. Interest Rates are the total amount of revenue which the banking sector generates for itself over a period of time lowering this any further would mean that the profit rates for banks and their incentive to be a part of the economy would be very less.

To avoid this situation an alternative strategy could be that of open market operations. Through this the Federal Reserve would buy bonds from the market and in return supply those which hold these bonds additional currency. Usually bonds are held by private banks and earn interest on the same. If the Federal Reserve purchases bonds from the market, it supplies money to the banks directly, which then can be extended to consumers as well as producers on competitive interest rates so that on one hand the incentive of banking sector still remains, and on the other hand zero interest rates are not applied to the industry.

Another similar technique, which can help in resolving the issue, is through revision in the cash reserve ratio, which is the minimum amount of capital which commercial banks must hold at all times with the federal reserve. When, the federal reserve reduces the same, it adds cash into the hands of commercial banks directly without revision in the interest rates.

For example, if the Federal Reserve’s minimum cash reserve policy is 5% and is reduced to 2%, the net effect would be that the commercial banks would have an additional availability of 3% reserves with them which can then be used to grant loans.

Please feel free to ask your doubts in the comments section.