In the US, the federal funds rate refers to the interest rate used by depository institutions in trading balances held by the Federal Reserve. The Federal Reserve is known s the federal fund. Institutions with surplus balances lend to those institutions with balance deficits. This paper discusses the issues around federal fund rate adjustments. The effect from the adjustments of the federal funds rate influences the economy’s money supply.
The effect of raising or lowering the federal funds rates
The effect of raising or lowering the federal fund’s rates has effects on other short-term interest rates, foreign exchange rates, long-term interest rates, employment, amount of money or credit in the system, the employment rate in the economy, the output, the price level, and the economy’s investment rate. The Fed determines the direction of short-term interest but has no direct effect on long-term interest rates (Jordà, 2005). The effect comes to the investors of bonds in the bond market first, who then cause effect to the economy and its fluctuations as well as on inflations.
When the economy’s interest rates increase, borrowing becomes expensive while saving becomes attractive. Investors find it hard to borrow funds to boost the level of investment in the economy. The result of this is that the output goes down and ends up pushing most of the labor out of the system. The level of employment goes down. (Jordà, 2005) Since people’s incomes freezes as the level of employment and investment goes down, the aggregate demand also decreases. Since people have to cut down their consumption levels, the effect of this action is a push of the suppliers to cut down the prices for their products and services to restore the market equilibrium.
When interest rates are lowered, the opposite happens to the economy. Decreasing the federal funds interest creates an environment whereby borrowing is cheap and saving is undesirable due to t the insignificant returns obtained. Borrowing becomes cheap and now investors can borrow as many funds as they can in order to invest. The initial effect is an increased money supply since people have reduced their saving but instead turned to borrowing. An effect of cheap borrowing is increased investment that further increases money circulation in the economy. The high investment level in the economy creates employment (Garg, 2008). At this point, people have a lot of money to spend against the lower supply. This aspect leads to an increased aggregate demand. Since the aggregate supply, in the economy, is lower than the aggregate demand, producer or suppliers have to adjust their prices to restore the market to equilibrium. This is done by increasing the price level in the economy. The increased prices for goods and services motivate producer to increase their output level. The increase price level in the economy is what is referred to as inflation.
In the stock and bond markets, investors are attracted to various options concerning investment opportunities. Investors always chose investments that yield highest rate returns. The effect of the federal funds rate influences the way investors invest their money in that increased interest rates makes consumers and businesses cut back their spending causes a fall in earnings and a drop in stock prices (Garg, 2008). A fall in the interest rates increases consumption and business spending causing stock prices to rise. Bond prices increase when interest rates are low and decrease when interest rates are high (Garg, 2008).
Graphically the Fed influence on money supply can be established as follows:
The graph shows that money supply is high when the federal funds rates are high. Federal funds rate influence influences money supply in that when the rates are high, people hardly borrow often but saves more to earn higher returns through interest rates. This makes the money supply curve to be lowest were the rates of interest are high (Garg, 2008). The graph has the federal funds rate as the influencing variable and money supply as the dependent variable.
If money supply were the independent variable, the effect of money supply on interest rates would cause a situation whereby increased money supply lowers interest rates. The effect of money supply goes on to a point any increase in money supply does not affect the interest rates. This brings about the issue of liquidity trap whereby even if the money supply is increased passed a given point, the effect on interest rates in the economy is zero or insignificant. A liquidity trap come in when the short-term nominal interest rates are equal to zero which may be happening the US economy (Jordà, 2005). The economy of the United States could therefore be in a liquidity trap given the fact that application of monetary policy has little or no effect on the economy. The US economy is in its maturity with small economic growth rate. Stimulating the economy may not call for the use of monetary policies. The Fiscal policies could be the best whereby the Fed could use various fiscal policy tools to stimulate its growth. One of the tools that could be used in stimulating the US economy is lowering interest rates to attract borrowing for investment and hence increase employment, output, and aggregate demand (Jordà, 2005). The government could also increase its spending to stimulate aggregate demand. The Fed can as well purchase bonds to provide investment funds to investors thereby stimulating its economic growth.
Garg, K. (2008). The Effect of Changes in the Federal Funds Rate on Stock Markets: A Sector- wise Analysis. Undergraduate Economic Review, Vol. 4, Is. No.1 , 1-36.
Jordà, Ò. (2005, May 20). Can Monetary Policy Influence Long-term Interest Rates? Retrieved March 8, 2013, from FRBSF Economic Letter: http://www.frbsf.org/publications/economics/letter/2005/el2005-09.html
Zaman, E. W. (2012, December 10). Where Would the Federal Funds Rate Be, If It Could Be Negative? Retrieved March 8, 2013, from Economic Commentary: http://www.clevelandfed.org/research/Commentary/2012/2012-15.cfm