Question

In 2017 , an article in the Wall Street Journal had the headline "Federal Reserve Expected to Deliver Rate Increase." a. What rate is the headline likely to be referring to? b. Who is able to borrow and lend at that rate? c. Given your answer to part \((b)\), why do the Fed's actions to increase or decrease that rate attract so much attention?

Short answer

a. The 'rate' likely refers to the Federal Funds Rate. b. Banks and other depository institutions can borrow and lend at the Federal Funds Rate. c. The Fed's actions to change this rate attract attention because they can significantly influence overall economic activity, including inflation rates, employment, and the pace of economic growth.

Step-by-step solution

Understanding the Referenced Rate

The rate that the article is most likely referring to is the Federal Funds Rate (FFR). This rate is the interest that banks and other depository institutions charge each other for overnight loans of federal funds. These funds are the reserves they maintain at the Federal Reserve.

Identification of Participants

Primarily, it's the banks and other depository institutions that can borrow or lend at the Federal Funds Rate. These institutions include commercial banks, savings and loan associations, and credit unions.

Significance of Rate Fluctuations

Changes in the Federal Funds Rate by the Federal Reserve, commonly known as 'the Fed', garners a lot of attention because it plays a key role in monetary policy. When the Fed raises or lowers the FFR, it influences the interest rate at which banks lend to each other overnight. This, in turn, affects the rates at which consumers and businesses borrow for various purposes, impacting the overall economy’s performance including inflation rates, employment, and economic growth. A lower rate can stimulate economic activity by encouraging borrowing and investing, while a higher rate can slow inflation by deterring borrowing and encouraging savings.

Key concepts

Understanding Monetary Policy

Monetary policy is the process by which a central authority, often a country's central bank, manages the money supply and interest rates to achieve specific economic objectives.

For instance, in the United States, the Federal Reserve (often referred to as the Fed) is responsible for setting and adjusting the Federal Funds Rate (FFR), which is the interest rate at which depository institutions borrow and lend reserve balances held at the Federal Reserve overnight. These adjustments can have significant effects on the country's economic health.

Goals of Monetary Policy

Typically, the goals of monetary policy include controlling inflation, managing employment rates, and maintaining stable prices. Policymakers accomplish these goals by manipulating the FFR, which indirectly influences borrowing, spending, and investment across the economy. When the Fed lowers the FFR, borrowing becomes cheaper, which can lead to more business investments and consumer spending. Conversely, increasing the FFR makes borrowing more expensive, which can slow down economic overheating and control inflation.

The changes made through monetary policy are monitored closely due to their profound impact on the economy's direction. Moreover, these changes signal the Fed's outlook on economic conditions, hence, they are tracked by banks, investors, and policymakers worldwide.

The Role of Interest Rates

Interest rates are a vital tool for managing economic activity. They are the cost of borrowing money, serving as a reward for lenders and a cost for borrowers.

Central Bank Rates and the Economy

The central bank sets a benchmark interest rate, which influences all other interest rates within an economy, including mortgages, savings, and business loans. In the context of our exercise, the benchmark rate in focus is the Federal Funds Rate. This rate guides banks in setting their own interest rates for lending to businesses and individuals.

Here's why it's crucial: a higher Federal Funds Rate means banks will charge more for loans, which can reduce the incentives for businesses to invest and consumers to spend, typically leading to slowed economic activity. Conversely, a lower Federal Funds Rate encourages more investment and spending, which can stimulate the economy. However, if left unchecked, this could also lead to inflation, which may erode the value of money over time. This delicate balance is one reason why the Fed's rate adjustments are so closely watched by all players in the economy.

Economic Activity and Its Drivers

Economic activity encompasses all actions that involve the production, exchange, distribution, and consumption of goods and services within an economy. It is a broad indicator of economic health and includes metrics such as Gross Domestic Product (GDP), unemployment rates, and the balance of trade.

Influencing Economic Activity Through Monetary Policy

The Federal Reserve employs monetary policy to either stimulate or restrain economic activity. By influencing the Federal Funds Rate, the Fed can affect consumer confidence, capital flows, and business cycles. For example, when the economy is sluggish, the Fed might implement an expansionary monetary policy, which entails lowering the FFR to stimulate borrowing and spending. When the economy is growing too fast and inflation is a concern, the Fed may do the opposite, enacting a contractionary policy by raising interest rates to cool off economic growth.

Consequently, these changes in monetary policy trickle down to consumers and businesses, either encouraging them to spend and invest (by lowering rates) or save and reduce debts (by raising rates). These actions help guide the economic activity to a more sustainable path, aligning with the central bank's broader economic objectives.