Question

Use the following news clip to work. Fed Sees Unemployment and Inflation Rising It is May 2008 and the Fed is confronted with a rising unemployment rate and rising inflation. a. Why might the Fed decide to cut the interest rate in the months after May 2008 ? b. Why might the Fed decide to raise the interest rate in the months after May 2008 ?

Short answer

The Fed might cut interest rates to stimulate economic growth and reduce unemployment. Conversely, it might raise interest rates to control rising inflation.

Step-by-step solution

- Understanding the Situation

Analyze the economic conditions described in the news clip. The economy has rising unemployment and rising inflation as of May 2008.

- Why Cut Interest Rates

Identify reasons why the Fed might cut interest rates in this economic environment. Cutting interest rates can help to stimulate economic growth by making borrowing cheaper, which can lead to increased investment and consumer spending. This could reduce unemployment.

- Effects of Rate Cuts on Inflation

Explain how cutting interest rates can affect inflation. While it can stimulate economic activity, cutting rates might also risk further increasing inflation if demand outpaces supply.

- Why Raise Interest Rates

Identify reasons why the Fed might raise interest rates instead. Raising interest rates can help to curb rising inflation by making borrowing more expensive, which slows down consumer spending and investment, thereby reducing the pressure on prices.

- Effects of Rate Hikes on Unemployment

Explain how raising interest rates can affect unemployment. While it helps control inflation, it might also slow down economic growth and potentially increase unemployment if businesses cut investment due to higher borrowing costs.

Key concepts

Economic Growth

Economic growth refers to the increase in the production of goods and services over a period of time. When the Federal Reserve (often called the Fed) cuts interest rates, it makes borrowing money cheaper for businesses and consumers.

As a result:

• Businesses are more likely to take out loans to invest in new projects, expand operations, and hire more workers.
• Consumers are encouraged to spend more on big purchases like houses and cars.

This increased spending and investment can boost economic growth. However, it's important to monitor this closely, as too much growth too quickly can lead to inflation.

Unemployment

Unemployment refers to the situation when people who are willing and able to work cannot find jobs. Rising unemployment often signals economic troubles.

When unemployment rises:

• The Fed might lower interest rates to stimulate the economy.
• Lower rates make loans cheaper, encouraging businesses to invest and hire more workers.

However, if the economy grows too fast, leading to inflation, the Fed may have to raise rates again, which could increase unemployment.

Inflation

Inflation is the rate at which the general level of prices for goods and services rises, leading to a decrease in purchasing power.

When inflation rises:

• The Fed may raise interest rates to control it.
• Higher rates make borrowing more expensive, which can reduce spending and investment.
• Slower spending and investment can help cool off the economy and reduce inflationary pressures.

However, this can also slow down economic growth and potentially lead to higher unemployment.

Monetary Policy

Monetary policy involves the actions of a central bank, such as the Federal Reserve, to influence the supply of money and credit to achieve macroeconomic goals like stable prices and low unemployment.

The tools of monetary policy include:

• Interest rates adjustments: Lowering rates to stimulate the economy or raising them to curb inflation.
• Open market operations: Buying or selling government securities to influence the money supply.

The challenge for the Fed is to balance these tools to promote economic stability.