Interest Rate

December 9, 2003

On Tuesday, October 28, 2003, the Federal Reserve kept the federal funds rate (a benchmark for short-term rates throughout the economy) unchanged at 1.00 percent, the lowest since July 1961. Discuss the reasons why the Fed left the interest rate alone and how it will affect our current economy? At the next FOMC meeting, will the Fed increase or decrease the federal funds interest rate, and why?

The current interest rate is low enough because it is already pushing the economy forward. It seems to have affected our current economy by improving it slowly. For instance, the unemployment rate has dropped from 6.2 to 5.9. If the Fed decreased the rate, it would make borrowing less expensive, and businesses and people would have more loans and buy more, thus speeding the economy. Too fast growth can cause inflation. If the Fed increased the rate, it would make borrowing more expensive and businesses and people would have fewer loans and buy less, thus slowing the economy. Too slow growth can cause unemployment. 

The Fed will increase the federal funds interest rate if our economy becomes stronger. It will decrease the interest rate if our economy becomes weaker. Current economic indicators seem to say that the economy is currently growing at a moderate rate, after a jump in the third quarter. Therefore, the Fed will probably keep the current rate and wait to see the next trend.

The money supply affects the interest rate. If more money is available, the value of money goes down and interest rates go down. If less money is available, the value of money goes up and interest rates go up. The Fed also controls the money supply.

The value of a country's money is based on its purchasing power, which is related to the interest rate. If interest rates are low, a country's money has low value. Imports cost more and exports are cheaper and so sell more. Therefore, the interest rate affects imports and exports.

The interest rate also affects the ability to borrow. At low interest rates, a nation, business, or person can borrow more and so consume more. However, the savings rate decreases since saving has less value. Though businesses may still invest since rates are low, low interest rates cause investment to decrease,  Therefore, the affect of interest rate on investment is difficult to balance. Ideally, the interest rate should equal the marginal revenue product of all a nation's capital.

Economic expansion and contraction themselves affect interest rates. If an economy is expanding, people want more money and interest rates increase. The demand for investment is high and savings are low. If an economy is contracting, people spend less money and need less money so interest rates decrease. The demand for investment is low. Interest rate is one of the economic indicators that accompany the business cycle (called the coincident series).

Typically, a developed nation like the U.S. needs to keep interest rates high in order to keep the incentives to invest high. This also keeps jobs higher paying. Therefore, a time of low interest rates can cause changes to the types of jobs and affect the types of businesses that benefit. In addition, low interest rates can encourage inflation. The social consequences of low interest rates can be important.