Learning Objective: Discuss how market interest rates are determined Topic: The

Question

Learning Objective:

Discuss how market interest rates are determined

Topic:

The Federal Reserve helps determine interest rates for the entire economy. Answer the following questions below.

How does the Fed stimulate the economy?

How does the Fed affect interest rates?

Does the Fed have complete control over U.S. interest rates? That is, can it set rates at any level it chooses? Why or why not?

Do you think that the Fed should control interest rates or let the free market set the rates? What are the pros and cons of having the Fed or free market determine interest rates?

Explanation / Answer

As per rules I will answer the first 4 sub parts of the question

1.The Fed influences the economy using the monetary policy which determines the supply of money in the country. This is done by changing the Reserve Requirement for member banks which influences the money supply in the economy. As the Reserve Requirement for member banks represents the amount of reserves that a bank is expected to maintain the Fed can stimulate the economy by reducing the Reserve Requirement thereby making more money available for lending to the general public.

The Fed may change the discount rate charged to the member Bank which is the rate that the Fed charges on the loans. As the discount rate changes the interest rates vary along with. If the Fed charges a lower discount rate it causes the interest rates to fall making the cost of money lesser which stimulates the economy. The Fed can also stimulate the economy by buying government securities which instantly injects money into the banking system and increases the supply of lending money.

2. As already discussed earlier the Fed influences the market interest rates by changing the discount rates that it charges to member banks. Higher discount rate is followed by an increase in the interest rate since the banks will increase the interest rates to pay a higher discount rate to the Fed. Similarly a lower discount rate causes the interest rates to fall since the banks pass on the benefit of a lower cost to its customers.

3. As per law the Fed can charge any discount rate that it wants thereby changing the interest rates to any level. However it has to be mindful of the impact of this change on the economy. Even a small change in the interest rate can have a major impact on the economy and hence the interest rate has to be set carefully and accordingly.

4.In my opinion the Fed should control interest rates since it is the best judge of the requirements of the economy. If the bank needs to stimulate the economy it should reduce the interest rates and Vice versa. In this manner the Fed will be able to act in the best interest of the nation. Keeping the interest rates free will allow the economy to act too freely and can lead to extreme recession or inflation.

Related Questions

Navigate

• Browse (All)
• Browse L
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.