Question

Use the following information to work. From 2009 through \(2012,\) the long-term real interest rate paid by the safest U.S. corporations fell from 4 percent a year to 2 percent a year. During that same period, the federal funds rate was roughly constant at 0.25 percent a year. What role does the long-term real interest rate play in the monetary policy transmission process?

Short answer

The long-term real interest rate helps transmit monetary policy by lowering borrowing costs, thus encouraging investment and spending.

Step-by-step solution

Understanding Real Interest Rate

The real interest rate is the rate of interest an investor, saver, or lender receives after allowing for inflation. It is calculated by subtracting the inflation rate from the nominal interest rate.

Monetary Policy and Long-Term Real Interest Rates

Monetary policy primarily influences short-term interest rates, like the federal funds rate. However, long-term real interest rates are also crucial because they affect investment and consumption decisions by businesses and households.

Correlation Between Interest Rates

There is often a correlation between short-term and long-term interest rates. When the central bank sets a lower federal funds rate, it typically aims to reduce borrowing costs across various maturities.

Transmission Mechanism

When the long-term real interest rate decreases, as seen from 2009 to 2012, it typically stimulates economic activity. Lower long-term rates reduce the cost of borrowing for long-term investments, such as corporate projects or mortgages, thereby boosting spending and investment.

Example of Impact

For example, if a corporation sees that borrowing costs have decreased from 4% to 2%, it is more likely to finance new projects, thereby increasing production and potentially hiring more employees. This is one way that changes in long-term real interest rates help transmit monetary policy effects throughout the economy.

Summary

In summary, the long-term real interest rate plays a crucial role in the monetary policy transmission process. Its reduction makes borrowing cheaper, encouraging investment and spending, thereby stimulating economic activity.

Key concepts

Real Interest Rate

The concept of the Real Interest Rate is essential to understand monetary policy transmission. The real interest rate refers to the rate of return on an investment, saver, or lender receives adjusted for inflation. This means it shows the actual purchasing power of the interest earnings. To calculate the real interest rate, subtract the inflation rate from the nominal interest rate. For instance, if the nominal interest rate is 5% and the inflation rate is 2%, the real interest rate would be 3%.
This adjustment for inflation ensures that investors and savers understand the true value of their returns. It is a vital parameter for economic decision-making as it directly impacts both the incentive to save and the cost of borrowing.

Federal Funds Rate

The Federal Funds Rate plays a pivotal role in monetary policy. It is the interest rate at which depository institutions (like banks) lend reserve balances to other depository institutions overnight on an uncollateralized basis. The Federal Reserve uses this rate to influence the supply of money in the economy, aiming to promote economic stability and growth. Even though it primarily targets short-term interest rates, the effects often ripple across to longer-term rates.
For example, if the Federal Reserve lowers the federal funds rate, borrowing becomes cheaper for banks. Consequently, banks can lower the interest rates they charge to consumers and businesses, stimulating economic activity by making loans for consumption and investment more attractive.

Economic Activity Stimulation

One of the primary objectives of monetary policy is to stimulate economic activity. This is achieved by influencing interest rates to promote spending and investment.

When interest rates are low, borrowing is cheaper. Individuals are more likely to take out loans for significant purchases, like houses and cars. Businesses are also encouraged to invest in new projects and expansion since the cost of financing these activities is reduced.
This increase in spending and investment can lead to more job creation and higher demand for goods and services, driving economic growth. Conversely, if the economy is overheating, raising interest rates can help cool down excessive spending and curb inflation, maintaining economic stability.

Borrowing Costs

Borrowing Costs refer to the expenses that individuals or businesses incur when taking out loans. These costs are influenced by the interest rate. When the central bank implements policies that lower interest rates, borrowing costs decrease.

Lower borrowing costs mean that consumers can afford more extensive purchases, like houses and cars, and businesses can finance more investments and expansion projects. This increases demand within the economy. Conversely, when interest rates are high, borrowing becomes more expensive, discouraging spending and investment which can slow down economic growth.
Understanding how borrowing costs fluctuate with changes in monetary policy helps clarify why managing these costs is vital to influencing economic activity.

Investment and Consumption Decisions

Investment and Consumption Decisions are crucial for economic growth and are heavily influenced by interest rates. When interest rates are low, both businesses and consumers are more likely to spend and invest.

For businesses, low interest rates mean cheaper loans to fund projects, purchase equipment, expand operations, or hire more staff. Such investments can lead to increased productivity and economic growth. For consumers, low interest rates reduce the cost of financing big-ticket items like homes or automobiles, encouraging spending.
On the other hand, if interest rates are high, the appeal of saving increases while borrowing and spending tend to decrease. This careful balancing act of interest rates helps keep the economy stable and thriving.