Question

Please respond to the following in a minimum of 175 words:

The Federal Reserve lowers interest rates in the economy to increase economic activity. Using the capital budget decision tools, discuss how decreasing interest rates can cause firms to make more investments.

Answer 1

Fed uses monetary policy to keep economy stable in severe economic conditions. When the economy is in recession, the fed reduces the interest rate to boost up the economic activity. Lower interest rate will give corporates and individuals no incentives to keep their money in bank and hence they will invest in projects, share markets, alternate markets etc which provides them better returns than keeping in banks. This can significantly boost up money flow in the country and through money multiplier effect, the money circulating in market gets multifold.

A decrease in interest rate also lowers the cost of borrwing for firms, this motivates the firms to borrow more money at cheaper cost and invest in their business activities. Through this many job oppurtunities can be created which eventually reduces the recession in the country, This method was used by US government in 2008 crisis along with quantitative easing.

Only disadvantage for this method is that under normal conditions this decisions can increase the inflation levels.