Issues of Interest Rates in Monetary Policy

Abstract

In the recent decades, Federal Reserves has been using the monetary policy of regulating the interest rates to ensure economic stability. Governments must regulate the economy during economic recovery or transition reform periods to ensure continued growth. This paper evaluates the role of US Federal Reserve’s monetary policy in economic regulation and determines the impact of such policies on key macroeconomics factors which include productivity, unemployment rates, inflation and aggregate demand of the produced products. This is achieved through analyzing current events on the basis of macroeconomics principles. The paper concludes by highlighting that interests rates directly impacts a variety of economic factors like unemployment, demand and inflation. It also identifies the aspect that some industries may benefit from increased interest rates while other may be affected adversely.

Introduction

After the global financial crises, monetary policy has been proposed by economist as a regulatory tool to manage the economy. Monetary policy involves the measures a Federal Reserve, Central Banks or other monetary authorities take to control the supply of money, interest rates and the availability of money in the economy.  For instance in a state of economic recession, consumers shy away from spending much money as they previously used to. This alternatively leads to reduced production which causes the firms to lay off employees and stop any new investments. Such a move demonstrates a decline in then overall aggregate demand. In such a condition, the government may rectify the economic situation through a monetary policy such as reducing the interest rate to increase aggregate demand through boosted investment and consumption. Therefore, the monetary policy is regularly used as a countercyclical tool as it has the ability to seek acceleration of economic growth (Expansionary monetary policy) or slow aggregate demand growth (restrictive monetary policy) thus leading to the anticipated level of output.

To start with, expansionary policy is a mechanism used by the Federal Reserve to promote growth in aggregate demand. Aggregate demand implies to a sum of several economic factors; investment, government spending, private consumption and imports. Monetary policy primarily focused on investment and consumption. The Federal Reserve increases the amount of supply in the economy to encourage private consumption. Reduced interest rates is one of the mechanism applied by the Federal Reserve increases the lending and investment capacity. The Federal Reserve can enact the expansionary policy through several mechanisms. The open market operations is the main mechanism used to expand the aggregate demand. The Reserve usually exerts downward pressure on interest rates through the purchase of government bonds. Through reducing the interest rates, investment and consumption is promoted.

Fig 1: The effect of expansionary policy and shifs in aggregate demand: investment, government spending, private consumption and imports (Friedman & Woodford, 2010).

From the graph, expansionary monetary policies leads to shift of the agregate demand to the right to achive the new demand. Expansionary policies leads to a growth in demand as demonstrated ini the graph. An increase in money supply increases private consumption. According to the law of demand, an increase in demand leads to an increase in production. Therefore, as the demands increases due to increased consumption, the economy market responds by increasing the level of production (real output). Simillary, an increase in prices leads to an increase in production rate. In this case, expasionary leads to a positive shift in the equilibrium price and production which is determinied by the aggregate demand.

The restrictive monetary policy primarily aims at controlling inflation levels through policies such as increasing the interest rates and reducing money supply in the economy. It therefore aims at creating slow economic growth and controlling inflation levels to protect economic depression through asset values deterioration. These measure slows the growth in aggregate demand. For instance, an increase in the interest rates encourages high savings which alternatively discourages private consumption. These aspects cumulatively leads to a reduction in the aggregate demand. Therefore, the level the aggregate demand shifts to the left changing the equilibrium. This is attributed by the aspect that the demand for goods reduces as the consumers saves more and invest less. Based on the law of demand, reduced demand leads to reduced supply hence the need to reduce productivity.

Application of Interest Rates as a Monetary Policy

The US Federal Reserve is the financial regulatory body that establishes the monetary policy. Interest rates policies is one of the most used tool in monetary policy used in the U.S. over the past few years, the Federal Reserve has frequently changed the interest rates to regulate and stabilize the economy. The Federal Reserve short-term interest rate has been rising for quite some time now. It’s been building since 2015, and in 2018 alone it was raised four times (Davidson, 2018). According to the Federal Reserve, the trend is aimed at maintaining the already achieved strong economy and maintain the growth rate at a sustainable level. From an economic view, the change in federal funds rate is passed on to the banks that charge each other as well as consumers for short-term interest rates. The changes in these interests rate directly impacts the cost of borrowing for both the households and the firms. In addition, a change in the short term interest rates influences also the long-term interest rates offered by the banking sector such as the residential mortgage rates and the corporate bond rates. This is because normally, the short-term rates reflects both the current and expected long-term values of these rates. Therefore, a shift in the short-term interest rates leads to a shift in the long-term interest rates. A shift in the long-term rates directly impacts other asset prices. For instance, foreign exchange value of the dollar and equity prices in this case are reduced as the higher interest rates tend to reduce the equity prices.

Based on these facts, the increasing Federal Reserve rates have a direct impact on the real U.S economy. First, domestic aggregate demand of the produced products with decline. This is based on the fact that the banking sector also increased their interest rates thus tightening the borrowing capacity for both the households and firms. As a result of increasing lending costs, money supply will be reduced in the economy. At this economic situation, consumers are more likely to spend less and consume less. Similarly, businesses are less likely to invest through purchase of new items and equipment thus overall reducing the aggregate demand. In addition, the high rates are likely to appreciate the dollar as foreign investors seek to gain higher returns. This results in reduced exports for the U.S products since they are more expensive to the importing nations. This may have far reaching consequences on the production sector. For instance, the auto industry has recently experienced a decline in sales as a result of declining demand. In the first quarter of 2019, the industry had a 2% decrease in total sales (Krisher, 2019). In addition, analysts have predicted that the sales of the full financial year 2019 to be around 16.9 million which is below 2018 sales of 17.27 million and much lower than 2016 sales of 17.55 million. The decline in sales demonstrates a continuous trend in the declining aggregate demand as the Federal Reserve slowly hikes the short-term interest rates.

Economists have long since established goals of the monetary policy that include economic growth, unemployment rates and stable prices. The stable prices goal encompasses interest rates. This implies that the Federal Reserve interest rates should always aim at establishing and maintaining stable prices. Taking into account the influence of interest rates on other economic factors such as unemployment levels, some economists have argued that the Federal Reserve should reduce economic rates to increase the aggregate demand. For instance, Kocherlakota (2019) states that reducing federal interest rates will in lead to reduced employment rates as well as increased demand for goods. Based on the study, the Federal Reserve should prepare for the next recession now despite the fact that the U.S economy is doing great at the moment with a low unemployment level and contained inflation which is in line with the Federal Reserve target of 2%. Previously the Federal has reduced the interest rates to prevent high unemployment rates. For instance, it lowered the interest rate with more than 5% points in the early 2000s in the aim of keeping the unemployment levels to be below 6% (Kocherlakota). In the financial crises which marked the last recession, the unemployment rate reached a double digit despite the aspect that the Federal Reserve significantly reduced the short-term interest rates. To prepare against such economic situations, economists argue that the Federal should maintain the interest rates at low level that increase aggregate demand and keep the rate of unemployment at the current manageable level.

Despite the economic challenges the rising interest rates presents, the strategy has effectively controlled inflation rates in U.S. As aforementioned, the restrictive money policy which is characterized by raised interest rates to reduce money supply, primarily targets at controlling the inflation rates. Increased federal interest rates translates to reduced money supply in the economy as consumers and businesses will tend to save more than spend on investment and consumption. This lowers the aggregate demand which eventually lowers prices thereby attributing to lower inflation. High inflation results from increased money supply in the economy where consumers and firms have high purchasing power leading to increased prices.

Some economists as the case with Wessel (2018) maintains that the hiked interest rates are well planned for and promote a stable and sustainable economy. Currently, the U.S economy is very stable with very low inflation rate as well as manageable unemployment rate. Considering these factors together with the economic backing the Trump’s government has over the recent period, the demand seems to grow faster than the supply. Therefore, Federal Reserve actions are aiming at stabilizing the aggregate demand to arrive at a sustainable equilibrium where demand matches the supply. Based, on this aspect, the U.S economy may be growing at a reasonable level. This can be supported by some industries experiencing growth. For instance, JPMorgan has profited from the raising rates. In fact, from the raising of interest rates Chase is up by 5% in the first quarter of 2019 since last year (Sweet, 2019). So it’s clear that one economic change may positively affect one industry and negatively affect another.

Conclusion

In summary, interest rates which is a common regulatory tool in monetary policy affects a variety of economic factors. Interest rate levels determines unemployment rates, the aggregate demand and the inflation rates. The increasing US Federal Reserve interest rates arguably reduce the aggregate demand which may increase the unemployment rate. However, the hike stabilizes the U.S economy by managing the inflation levels. It is clear from the study that while one industry reaps the benefits of the hike interest rates, others are affected adversely.

References

• Davidson, P. (2018, September 26). Fed raises key rate to range of 2% to 2.25%, keeps forecast for 4 hikes in 2018. Retrieved from https://www.usatoday.com/story/money/2018/09/26/fed-raises-rate/1426946002/
• Friedman, B. M., & Woodford, M. (Eds.). (2010). Handbook of monetary economics. Elsevier.
• Kocherlakota, N. (2019, April 15). The Fed Needs to Fight the Next Recession Now. Retrieved from https://www.bloomberg.com/opinion/articles/2019-04-15/u-s-economy-fed-needs-to-start-fighting-the-next-recession-now
• Krisher , T. (2019, April 02). High prices, interest rates push 1Q US auto sales down 2%. Retrieved from https://www.washingtonpost.com/national/high-prices-interest-rates-push-1q-us-auto-sales-down-2percent/2019/04/02/65f3e106-558d-11e9-aa83-504f086bf5d6_story.html
• Wessel, D. (2018, October 12). Wessel’s Economic Update: Are the Fed’s Interest rate hikes a mistake? Retrieved from https://www.brookings.edu/blog/up-front/2018/10/12/wessels-economic-update-are-the-feds-interest-rate-hikes-a-mistake/
• Sweet, K. (2019, April 12). JPMorgan’s 1Q profits rise 5%, helped by higher rates. Retrieved from https://www.washingtonpost.com/business/jpmorgans-1q-profits-rise-5percent-helped-by-higher-rates/2019/04/12/95431be2-5d18-11e9-98d4-844088d135f2_story.html?utm_term=.cc24aa3f2a17