Introduction and Article Summary
The article I chose from the New York Times talks about how the Federal Reserve Board has slowed down its plans to raise interest rates in both the near and far future. The rate the Fed is referring to is the Federal Funds Rate, which determines how much Fed money banks and other lenders can loan to businesses and other groups. The Fed voted not to raise the Federal Funds Rate, and currently plans to only raise rates by 0.5 percent this year, which is a sharp difference from its previous outlook in December, where it was predicted that rates would be raised by 1 percent this year. While the economy is growing at a steady rate, the Fed opted not to raise rates due mainly to the weak state of the global economy, and also because tight conditions in the financial markets are causing borrowing rates to rise, effectively the same as if the Fed had raised rates. Furthermore, the Fed’s goal of 2 percent inflation annually has not been met, though it is close at 1.7 percent according to the Bureau of Economic Analysis. However while some economists believe that the inflation rate is gaining strength, the Fed is predicting that inflation this year will only increase by 1.2 percent, a low estimate, which explains why they do not want to raise interest rates as 1.2 is relatively far from the goal of 2 percent. As such the Fed’s current plan of keeping interests rates low is sensible, as they do not want to take any measures that would negatively impact the inflation rate. In the long term, the Fed predicts that it will raise its interest rates to 3 percent by 2018, slower than what was predicted in December.
In summation, the article covers the Fed’s future plans to slow the raising of interest rates, in order to keep the economy growing at its current steady pace. By not raising the rates, the Fed is trying to ensure that the economy continues to expand at its current rate, through the rates effects on the money market, planned investments, and aggregate expenditure.
Theory Review and Analysis
The article states that the Fed is slowing the increase of interest rates in order to continue to foster domestic growth, and raise the inflation rate. This is in line with the macroeconomic theory taught in Econ 103, as a raise in the interest rate would ultimately cause a contraction in both the money market and planned investments, leading to a slow in growth of the economy and the inflation rate.
The Fed is trying to avoid the contraction of the economy by slowly raising interest rates, as opposed to raising them faster. Interest rates determine how much Federal Reserve money banks can lend, and thus can change the money supply. Interest rates impact the money supply as they make it easier or more difficult to borrow money from lenders, which in turns leads to contraction or expansion in the money market as a whole. An increase in interest rates decreases the money supply and contracts the money market, and likewise a decrease in interest rates results in the expansion of the money market. As such, a fast increase in interest rates would lead to contraction in the money markets. Thus, interest rates and the money market have an inverse relationship as shown in Graph 1. As interest rates increase from r0 to r1, the money market shrinks from m0 to m1. The Fed ultimately does not want to decrease the money supply too much, as that would lead to a decrease in the money market.
Since the Fed is trying to avoid the contraction of the money market, they are slowing the increase of the interest rate, which will contract the money market at a lower rate.. This is shown in Graph 2, as a smaller increase in the interest rate from r0 to r1 also results in a smaller contraction in the money market from m0 to m1. As the money market is ultimately tied to the growth of the economy, a smaller contraction in the money market is better for growth than a large one, so the Fed’s slower increases are in line with trying to keep economic growth and ultimately inflation steady.
In terms of the investment market, an increased interest rate will also have a contractionary effect. This is because, like the money market, interest rates and planned investments also have an inverse relationship. Planned investments rely heavily on there being money to invest, and an increase in interest rates is contractionary monetary policy. As interest rates go up, the money supply decreases, leaving less to be invested and causing a decrease in planned investments. Once again like the money market, decreasing interest rates lead to a larger money supply and an increase in planned investments. As the Fed ultimately wants to maintain growth, it wants to maintain interest rates low in order to keep planned investments from decreasing. As shown in Graph 3, a fast increase in the interest rate will lead to a decrease in planned investments, as a broad upward shift from r0 to r1 results in an equal decrease from I0 to I1. Conversely, a smaller increase in interest rates, like the one shown in Graph 4, will lead to a smaller investment decrease as well, similar to the situation with the money market.
Following this decrease in investment would be a decrease in aggregate expenditure, which is the total expenditures for a country, which is connected to GDP, or Gross Domestic Output. Since aggregate expenditure (AE) is composed of planned investments, in addition to government spending and consumption, a large decrease in planned investments leads to a sharper decline in AE. This is shown in Graph 5 where the decrease in planned investment shifts AE downwards, and consequently shrinks the GDP. Thus, a large decline in aggregate expenditure will lead to a decline in economic growth, which is exactly what the Fed is trying to prevent. By slowing the increase in interest rates, the Fed will maintain a lesser drop in investments and consequently a smaller drop in AE, in order to keep the economy growing at its current pace. This is shown in Graph 6, where a smaller decrease in investment leads to a lesser shift in AE and thus less contraction of GDP. Furthermore, a larger decrease in GDP leads to a decrease in inflation via an increase in unemployment, which is the opposite of the steady inflation rate of 2 percent that the Fed is aiming for.
Personal Opinion and Conclusion
My opinion is that the Fed made the correct decision in choosing to delay and slow down its plans for increasing the interest rate. The article state that the Fed wants to keep low in order to keep steady economic growth and inflation. As shown in my analysis and graphs 2, 4, and 6, a smaller increase in interest rates is ultimately fits the Fed’s goals, through smaller contractions in the money market, planned investment and AE. This in turn lead to a smaller economic contraction, in which steady growth and consequently steady inflation can be maintained. As such the Fed’s decision is economically sound and in line with macroeconomic theory to keep growth and inflation steady, and so I agree with the Federal Reserve Board.
The author of the article states that another rate increase is not expected until June, though there is an earlier meeting in April to again decide whether or not to increase interest rates. In regard to future rate increases, I would suggest putting off an interest hike at the upcoming Federal Reserve Board meeting in April, as the author of the article is predicting, as it is mentioned in the article that while the US economy may currently be growing, other developed nations are not growing at our pace, and this consequently diminishes our growth through trade. The most notable growth decrease currently would be China, which for the first time in decades is no longer in double-digit percentage growth, and as a large trading partner, this of course impacts our economy and can consequently slow our growth. Furthermore, with the possibility of the UK the EU, it would be unwise for rates to increase in April before it is known what will happen with that situation. If the UK were to leave the EU, new trading agreements would have to be drawn up with the UK, as currently it follows our trade agreements with the rest of the EU. With that much uncertainty surrounding our trading future with another large trading partner, increasing the interest rate could be a bad decision, especially if there is a negative impact to our economy from the UK leaving the EU. If such a contractionary policy taking effect right when the negative impact from the UK exit, it would only compound that and contract the economy even more.
In regard to the long term, I agree with the Fed’s plan to increase the interest rate to 3 percent by 2018, as this is a slow enough increase that there shouldn’t be any significant negative effects to the economy. With the current rate of growth and inflation, such a plan is well suited to maintain steady growth and inflation for the future, barring of course any situations in which the economy begins to grow at a much more rapid rate than now. Waiting until the the economy and inflation are growing faster is the right decision, especially since there is the looming possibility of negative effects from other countries with slower growth.
In conclusion, I agree with both the Federal Reserve Board’s current and future plans for slowing the increase of interest rates, as they both allow for the best amount of growth in the economy and inflation. Given the current economic state of the world, as well as the future outlook, I believe that the Fed’s plans are best suited to helping keep the American economy on a steady path of growth.