Question

How can effective federal funds rate can affect real GDP? How can real GDP affect effective federal funds rate? if the percentage in real GPD increases will the percentage in effective federal funds rate decrease or increase? Please provide examples.

Answer 1

The Federal Funds rate, is the rate at which the Federal Reserve grants loans to the commercial banks. It has full authority on changing the same, as and when required for the economy of the United States. This has a great impact on the Gross Domestic Product which is the total demand for goods and services in the economy. When this is further adjusted with inflation it is referred to as real gross domestic product, which is the output of goods and services minus the inflation rate.

For example, when an economy grows by 5% in value and the inflation rate is 1%, then the Real Gross Domestic product is 4% only.

Now, if the Federal Funds rate is low, then banks lower the interest rates which they charge from people. This in return creates aggregate demand in the economy and production increases which cause the total goods produced in the economy to increase. Thus, Federal Funds rate has a direct impact on the Real GDP. Similarly, when the Federal Funds rate is increased, the banks increase the interest rates on loans, and consumers find it difficult to buy more goods and services and the real gross domestic product decreases in value.

It is also important to remember that the exact opposite is also true. For example, when the Real Gross Domestic Product in the country is high, the prices of goods and services begin to increase as supply does not increase in the same proportion as demand does. In this case, the Gross Domestic Product increasing decides that the Federal Reserve must hike the interest rates. Then, the market corrects, the demand for goods and services reduce and equilibrium can be achieved.

We can thus conclude by saying that the Real GDP is inversely related to Interest Rates. If the interest rates are low, the GDP increases, and if the GDP is high, the interest rates remain low. the inverse of this is also true.

Please feel free to ask your doubts in the comments section.