Question

Describe how the Federal Reserve’s policies affect/have an impact on the circular flow model. How does the interest rate change the play out in the circular flow?

Answer 1

Federal Reserve policies involve changing interest rate and money supply that affects the behavior of the components of the circular flow model. When Federal reserve increases the money supply, then households can borrow more money and spend that money in the products market. So, demand increases. It makes firms to supply more and create more jobs for the households in factors market . It increases purchasing power of the households and they spend more again in the products market. So, the model starts expanding. The contractionary effect takes place when money supply is sucked out of the market.

Regarding the interest rate change, when Fed reduces the interest rate, then firms borrow funds for the investment expenditure and households borrow funds for consumption expenditure. It makes firms to increase jobs and move into the factors market. They hire more workers and households spend more on products & services market. It increases the circular flow of money and inflation increases as well. When interest rate decreases, then firms and households are discouraged from spending and circular flow gets slowed. It controls the inflation.