Question

Should the U.S. raise or lower federal fund rates based on the current econom? Explain why in detail and give real life reasons and consequences. (Two paragraphs minimum)

Answer 1

Federal Fund rate refers to the rate at which banks lend the Federal Reserve funds to other banks on the basis of credit scores. This rate is an instrument of monetary policy which is directly used to control inflation, unemployment and the exchange rate. During the recession in 2008, USA had kept its Fed Fund rate close to zero. Banks were required to maintain lower reserves and lend out larger amounts of money. This made borrowing among banks easier, and also reduced rates at which banks lent to third parties. An increase in borrowing led to an increase in liquidity and subsequently an increase in purchasing power and demand. This is an example of expansionary monetary policy which gave the economy a push to come out of recession by increasing investments and demand further up.   

However, the bad phase has become history for USA and as the economy went on to the path of recovery, Federal Fund rates were steadily increased. An increase in the Federal Fund Rate also increases other related rates (e.g. prime rate) through spill over effects and the optimal federal fund rate helps in achieving stable prices with maximum employment of resources. A hike in Federal Fund Rates is necessary because, if the expansionary monetary policy goes out of hand and works in periods beyond the recession then there is a chance of inflation above the required level. An increase in Federal Fund Rate also helped in appreciating the US Dollar steadily.

This steady increase in the Federal Fund Rate (and thus other rates) is a sign of a healthy economy. Over the years, jobs have been created and unemployment has reduced significantly. Labour market conditions have improved and simultaneously the purchasing power of citizens has increased. Thus, a tighter and firmer monetary policy is required to come into play and Federal Fund Rates should be increased further to encourage contractionary monetary policy. A check on consumer spending is necessary to avoid demand pull inflation. Currently the US economy is moderately strong but has signs of inflation. Hints should be taken from the current US economic condition to keep the increasing price level under check. This can be done by reducing the amount of money in circulation in the economy. When the Federal Fund Rate increases, then the cost of borrowing for banks increases. Banks find it less profitable to lend out too much money such that their reserves dip below the new higher requirements and they end up borrowing from other banks. Ripple effects are seen in the foreign exchange market where the Dollar’s value has strengthened and the currency has appreciated.

However, this policy of increasing the Federal Fund Rate to tame inflation is an effective monetary policy only when done in the right amount. Fed Fund Rate has been increasing steadily since the end of 2015 and care should be taken to not make this hike very swift or very steep. The rate of growth of Federal Reserve Rate should now be lowered and the gap at which this rate is increased should be increased. If not carefully kept under check, a largely contractionary monetary policy through increasing Federal Fund Rates and tightening money supply would slow the US economy down way too much.