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How lower interest rates affect the economy

Suppose that the Federal Reserve acts to lower interest rates. How this will affect the U.S. economy?

After the economic slowdown that started around the third quarter of 2000, the Fed lowered interest rates eleven times in the following year, 2001. What concerns would have about the effort by the Fed to smooth out this economic recession?

In contrarily, suppose that the Fed unexpectedly increases the rate of money growth. What are the effect on short-term and long-term interest rates, and why those effects are different.

Solution Preview

By lowering the discount rate, the Fed alters the supply and thus the demand for money. This is based on the premise that interest rates are a type of price. The Fed can lower the discount rate and lower the costs for banks holding low excess reserves which will lower the excess reserve rate. If the Fed lowers the discount rate, or sets a lower federal funds target, this can be accomplished if the Fed injects funds into the system which will drive down the price of those funds - interest rates. If interest rates are low people will not lose much money in foregone interest by holding a portion of their wealth as cash. If you happen to have $1,000 and hold it as cash, then you will be giving up the opportunity to earn $100 when the interest rate is 10%. If the interest rate falls to 5%, then by holding cash you will be giving up the ...

Solution Summary

How the U.S economy is will be affect by lower interest rates of the Federal Reserve is discussed.