Question

The FED no longer tries to control monetary aggregates, rather it targets an interest rate. Explain the ways in which interest rates impact economic growth. Based on this, explain how a change in the FED’s interest rate target will impact the US economy.

Answer 1

The Federal Reserve no longer tries to control monetary aggregates, rather it targets an interest rate because of the reason that the higher interest rates leads to Moderate economic growth. Increase in interest rates directly increases the cost of Borrowing, it reduces disposable income and restrains the growth in consumer spending.

Increased cost of borrowing Reduced InvestmentLower Economic growth.

Higher Mortgage Interest PaymentsReduced ConsumptionLower Economic Growth

Increased Return to SavingsFall in House PricesLower Inflation

Hot Money FlowAppreciation in the exchange rateLower Inflation.

Interest Rates impact on Economic Growth -

1. Increase the cost of Borrowing- When the interest rates are on the higher side Interest payment on credit cards and loans will be more expensive. This fact will restrain the people form borrowing and spending. The person having loan will have less disposable income as he has to pay more for his loans. This will result into less consumption.
2. Increase in Mortgage Interest payments- Higher interest rates will result into increased mortgage payments, having significant impact on spending. Discretionary income will reduce with the fact of increase interest rates.
3. Higher interest rates increase the value of a Currency - A stronger currency makes exports less competitive. This will further increase imports reducing the exports of the country, reducing the aggregate demand in the economy.
4. Rising Interest rates affect both consumers and the Businesses - There will be reduced investments by the Business as the consumption scale is already down because the consumers have less disposable income. The Producers and the consumers are inter-related to each other therefore both of them have to bear the shock of increased interest rate.
5. Government Debt interest payments Increase - Increased interest rates increases the cost of Government Interest payments resulting into Higher Tax rates in Future.
6. Reduced Confidence - Higher interest rates closely impacts the consumer and the businesses. Rising interest rates discourage business Investment, consumers are less willing to spend. All in all both business and consumers don't want risky investments and purchases.
7. Lower economic growth. There can be a position of Recession.
8. Higher Unemployment. The business will tend to produce less therefore less workers are required for the production purpose.
9. Improved current account of the country. Higher Interest rates will tend to reduce import related spending , Lower inflation rates will gradually improve the exports.

Federal Reserve Interest rates impact on US economy -

Recently US Federal Reserve announced to maintain the target range for its Benchmark Interest rate of 2%-2.25% as on November 8, 2018.There has been a rise in the interest rates by 25 basis points.

The recent rise in the interest rates by Federal Reserve will effect on the borrowing cost for the consumers and Business, wants to have credit based on the U.S. Dollar.

1. The Prime Rate - Higher Interest rates will have increase Prime rate.Prime rates are the credit rates that banks extend to their most credit worthy Customers.The higher Prime rate means the Bank will increase the fixed and variable rate of borrowing while assessing risk on less credit-worthy companies and the consumers.
2. Savings - The rates of Money Market and Credit Deposits will increase due the increase in Prime lending rate. This will again boost the savings among the consumers and the businesses as there will higher return on the savings.
3. Credit card rates - The Prime lending rate will determine the Credit worth of the Business and Consumer. Extensive risk profiling of consumers seeking credit to make purchases. This will result into higher rates for the short-term borrowings.
4. U.S. National Debt - There will be boost in the national Debt of the U.S. Government. According to a report in the year 2015 by the Congressional Budget office and Dean Baker, The U.S Government will pay at least $2.9 Trillion over the next decade in the view of increased Interest rate. Whenever there is higher interest rates The country have to pay more for its borrowings.
5. Auto Loan Rates - The Auto loans are long term borrowings had no significant impact of the Federal Reserve Interest rates.
6. Business Profits - Higher Interest rates boost the profitability of the Banking sector. But on the other variable grounds there is an adverse impact on the other businesses as the cost of capital investment required for expansion increases. This again results in market recession.
7. Home Sales - Increased Interest rates and Inflation boosts the demand in Real Estate. As real estate investments are long term and there is an option of Long term capital gains though this factor is taxable in many countries.
8. Consumer Spending - The higher Prime lending rates directly impacts to the borrowings. Higher rate of Credit cards and Higher savings rate results into some how balancing the desirable cash for impulse purchase.
9. U.S. Stock and Bond Market - Higher Interest rates have direct impact on the Bond Prices. If the Interest rates are high Bond prices will fall, there will be rise in Bond price if the Interest rates are low.
10. Mortgage Rates - Rate Hike will tend the Home borrowers to close the deal for fixed loan rate for their new home. Mortgage rates fluctuate according to the market situations and largely affected by inflationary rate.

U.S. Federal Reserve Policy to control the Interest rate is intended with a view so that the economy should be in equilibrium position. The Governments burden should be less. U.S Economy is a Market driven economy so there can be good as well as bad results with the change of Interest Rates. To maintain it into equitable position is a challenge for the Federal Reserve. As it some how impacts the economy of the nations having trade relations with U.S.