Question

How do changes in the fed funds rate impact inflation and unemployment?

Answer 1

When the economy is in recession, the federal reserve pursues expansionary monetary policy that involves increasing money supply in the banking system and pushing federal fund rates lower. The federal fund rate is the rate at which banks lend to one another. When the federal fund rate declines, the banks cost of funds also declines. The bank passes the benefit to consumers and businesses and interest rates in the economy declines.

When interest rate is lowered, businesses are more willing to pursue leveraged investment spending. At the same time consumers are more willing to pursue leveraged consumption spending. Therefore, higher consumption and investment spending at lower cost of money triggers economic growth. Importantly, as investment spending increases, new jobs are created and higher consumption spending pushes prices higher along with rise in wages. Therefore unemployment declines, GDP increases and price level increases.

Similarly, when federal fund rates increase ( fed tightens money supply ), the interest rates in the economy increases. This translates into lower consumption and investment spending in the economy. The unemployment trends to natural rate of unemployment and due to lower consumption and investment spending, the price levels decline in the economy.