Question

Firms use long-term interest rates when making investment decisions (for equipment, software and structures). When the Fed lowers its fed funds rate target (in more normal times), can this affect these investment decisions? Briefly explain your answer.

Answer 1

The federal funds rate is one of the most important interest rates in the U.S. economy since it affects monetary and financial conditions, which in turn have a bearing on critical aspects of the broader economy including employment, growth, and inflation. The rate also influences short-term interest rates, indirectly, for everything from home and auto loans to credit cards, as lenders often set their rates based on the prime lending rate. The prime rate is the rate banks charge their most creditworthy borrowers and is influenced by the federal funds rate, as well.

When Fed lowers the interest rate it has a great effect on the economy. With the lowering ofi retest rate the cost of borrowing becomes cheap. It becomes easier for households and business organizations to obtain loans. As a result the aggregate demand and spending increases. This increases investment and this is very helpful in times of recession when economy is stagnant. This helps in stimulating the economy. People investing in stock markets base their decisions on such interest rates.