Question

1.Explain how the Federal Reserve’s lowering of interest rates affects the following variables in the short run: household consumption, business investment, real GDP, and the price level. Insert or attach a well-labeled Aggregate Demand/Aggregate Supply graph that would illustrate the effect of a decrease in interest rates when the economy is in a recession in the Keynesian zone.

2.How long does the Fed plan to maintain the new target range for the federal funds rate? What is one macroeconomic problem that could cause the Federal Reserve to become aggressive in raising interest rates? Explain.

Answer 1

Answer 1

Household Consumption

With lowering of interest rates household Consumption will increase. When rates go down, people may no longer wish to save, but instead spend and invest, even taking out loans to consume at low interest rates.

Business Investment

With the lowering of interest rates business investments increase. As the interest rates are lowered cost of borrowing gets cheaper. It becomes easier for business organizations to get loans Thus business investments increase.

Real GDP

As the interest rates are lowered Real GDP increases. If lower interest rates cause a rise in AD, then it will lead to an increase in real GDP (higher rate of economic growth) and an increase in the inflation rate. As the interest rates are lowered aggregate demand and spending is increased thus increasing the real GDP.

Price Level

When interest rates are low, the economy grows and price level or inflation increases. The quantity theory of money states that the supply and demand for money determines inflation. If the money supply grows, prices tend to rise, because each individual piece of paper becomes less valuable.

Lower interest rates cause a rise in AD and it will lead to an increase in real GDP (higher rate of economic growth) and an increase in the inflation rate.As we can see AD1 curve shifts towards right to AD2. The Price level increases from P1 to P2. The Real GDP increase from Y1 to Y2.

Answer 2

Federal funds rate is the target interest rate set by the FOMC at which commercial banks borrow and lend their excess reserves to each other overnight. FOMC sets a target federal funds rate eight times a year, based on prevailing economic conditions. The Federal Open Market Committee (FOMC), the monetary policy-making body of the Federal Reserve System, meets eight times a year to set the federal funds rate. The FOMC makes its decisions about rate adjustments based on key economic indicators that may show signs of inflation, recession, or other issues that can affect sustainable economic growth.

The basic purpose of raising the interest rate is to control inflation and erode the excess purchasing power from the economy by reducing Aggregate Demand and spending. Fed raises Interest rates aggressively to save the economy from problem of Inflation. When there is too much growth, the Fed will raise interest rates. Rate increases are used to slow inflation and return growth to more sustainable levels.