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Interest Rates and Monetary Policy Answer

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ECONOMIC CONCEPT: the
concept chosen is the effect of monetary policy on interest rates. Monetary
policy refers to changes in money supply. FED employs a variety of tools to
influence the amount of money that is available with banks to provide as
credit. These tools include:

  • Discount
    rate: It is the rate at which central bank loans money to commercial
    banks.
  • Federal
    rate: It is the rate at which banks give loans to each other for very
    short term.
  • Open
    market operations: They refer to purchase/sale of government securities
    which influence the amount of funds available with banks/public to supply
    as credit. A sale of securities reduces the amount available for credit
    purposes, while a purchase increases money supply.

While each of the above
tools has its own limitations and advantages, the discount rate is often taken
as a sign of the stance of FED and FOMC on the state of the economy. FOMC is
the policy making branch of the FED. It
makes the important decisions on interest rates and other monetary policies This is generally the most commonly used tool to
deal with economic fluctuations. It is fully in the control of FED and has
little lags in implementation. At the core level, it represents the cheapest
cost of borrowed funds. All other rates are based on this rate, so it is like a
benchmark for all rates of borrowing in the economy. Banks respond quickly to
this rates and it is closely monitored by experts and businesses as a mark of
the future direction that the economy is expected to take. This is because the
decision on this rate is taken after noting all key parameters in the economy.
The FOMC that takes all decisions is free from any political interference which
makes its views and decisions more credible and sound.

  The
effect of changes in r on money supply can be seen in the IS LM diagram. A rise
in money supply causes LM to shift to the right and down. This causes GDP to
rise while r falls. This lowering of the cost of funds for investments
encourages higher GDP.

Ever
since the recession hit USA in 2008, FED has adopted an expansionary and
liberal monetary stance. It has kept money supply growing so that interest
rates are at the lowest levels today. This trend has been followed by most
troubled nations today- Japan, UK, European Union, among others.  ‘On
March 29th the average rate on a 30-year mortgage was just 3.57%, not far above
the 3.31% reached in November, the lowest since data started to be compiled in
1971’; this is proof that the discount rate acts as the lowest benchmark
for all other rates of interest.  

Some
experts point out that easy money can encourage demand leading to inflation. It
can also cause stock market/housing bubbles as cheap money is used in these
asset, rather than new investments. The intended effects of cheap money include
higher investments that spur job creation, and higher incomes. The cause rise
in GDP levels and, an improvement in the overall business sentiment. In the
recent case of USA this intended effect is not so visible-growth rates of GDP
have not really picked up. Recovery has been slow and there are doubts on the
efficacy of an easy monetary policy.

These
doubts must be re-evaluated in the light of past experience. In the Great
Depression of 1929, FED was accused of not doing anything, resulting in the
economy ‘falling’ into a severe recession. It was argued that Fed actions could
have moderated the harshness of the recession and softened the troubles faced
by people. This time FED took no risks and immediately sprung into action. It
initiated policy measures to provide for money if needed for investors,
businesses and consumers. Term Auction Facility (TAF) was introduced to
maintain the low interest rate so as to regulate the credit flow in the money
market. A series of Quantitative Easing measures were undertaken, along with as
TARP and Operation Twist. Quantitative easing is an expansionary monetary policy
wherein central bank prints more money and uses it to buy government security
(or treasury securities) from the market. This causes a rise in demand for
these securities, reducing the rates of return on them as well increasing the
liquidity in the system. The latest in
these efforts is the QE 3 measures this implies
pumping of $40 billion every month into markets by large-scale
purchases of assets.  

The
long run effects of a loose monetary policy will become evident only in the
long-run. However, it is obvious that this is a common tool to influence the
costs of funds and rates of interest in the economy. Its efficacy is evident in
the recovery witnessed in USA in recent times. It does play a role in recovery
from a recession though the extent of it contribution is judged only in hind
sight in the long run.     

ARTICLE:http://www.economist.com/news/briefing/21575773-central-banks-have-cushioned-developed-worlds-economy-difficult-period-they-have-yet

 
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