Unused part

To explain that, let me first begin with role of central banks, such as Fed.

Central banks have the right to control the supply of money in the country by setting interest rate through which they can promote economic growth – this is a monetary policy. As in every other country, “by moving interest rate targets up or down, the Fed attempts to achieve maximum employment, stable prices and stable economic growth” [Folger12]. In the USA, such an interest rate is called Fed Funds Rate (FFR) and it is set by The Federal Open Market Committee[1] (FOMC) of Federal Reserve. This daily interest rate is used by banks to lend money to each other for overnight loans.

Let us now consider for a moment a case when Fed raises target of FFR. In such situation, the borrowing for banks is more expensive and consequently that will lower the supply of available money in the economy. On the one hand, people are encouraged to save due to higher interest; on the other hand, they also spend and consume less. Thus, it reduces a confidence from customers and businesses, as they would not likely “take out risky investments and purchases” [Petti12]. Because people are not likely to spend, it may also lead to stagnation of the economy, later resulting into a recession.

There is also an inverse relationship with inflation – namely higher interest rate lowers inflation. To make the economy not to fall into recession, central bank can lower interest rate.

When Fed lowers interest rate, the cost of borrowing is cheaper. People save less in banks, because the return on savings is low. Thus, they are encouraged to take credit, spend and invest resulting into greater economic activity (buying goods, real estate etc.). Hence, the current target rate of 0.25%[2], which has been set since financial crisis in 2008 to provide liquidity to financial markets, should encourage banks to lend money easily and thus support greater economic activity [Effr14].

Although it may seem that lower interest rate is positive for the economy, it has ‘a side effect’, namely it leads to higher inflation, which affects different people in different ways

Considering negative effects, it is necessary to mention that high inflation is harmful to economy because it may lead to decline in economic activity. This is due to prices of goods that go up and wages of employees that do not adjust (fast enough). As they cannot buy the goods that cost more than previously, the demand for them wanes and subsequently due to lower production, we may see higher unemployment and later (again) a possible recession [Clark08].

To offset the higher inflation, central bank may need to raise interest rate. Such an economic circle is illustrated in Figure 7.

Figure 7 illustrates a relationship between interest rates and inflation in the macroeconomics [Gold07].

Interest rates affects the level of consumption, prices of goods and even trade between countries. Therefore, every central bank needs to consider consequences from raising or lowering the rate from multiple perspectives [Skwirk14].

[1] FOMC “is the most important monetary policymaking body” of the Fed, because it “is responsible for formulation of a policy designed to promote economic growth, full employment, stable prices (…).” The committee “makes key decisions regarding (…) purchases and sales of U.S. government and federal agency securities which affect (…) the cost and availability of money and credit in the U.S. economy” [Fomc11].

[2] Historically, the average rate has been around 5%. Between January 2000 and December 2007 the average has been 3.4% [Fedfunds].

 

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