Question

Over the past several years, the Federal Reserve has kept interest rates very low. Discuss the policy the Federal Reserve is following and the reasons for this policy given the conditions in the economy. Discuss the risks of keeping interest rates very low. Explain the effect low interest rates have on the economy.

Answer 1

The Federal Reserve has been keeping the interest rates low for the past several years. By keeping the interest rates low, the Fed is following expansionary monetary policy. This is because Fed is increase the level of money supplied in the economy which has shifted the money supply curve rightwards in the money market and thus led to fall in the level of interest rates in the economy. During the time of Great Recession when aggregate demand had fallen to a very low level, then fed increased the money supplied in the economy to reduce interest rates which will increase the investment level in the economy and thus increase overall aggregate demand in the economy because of the increase in investment expenditure. Thus, to move the economy closer to its potential level, the Federal Reserve was following such a policy.

Very low level of interest rates can reduce the return on investment for the investors. This might lead to fall in FDI and also movement of capital in other countries where interest rates are high. Thus, capital outflow will occur in the country resulting in depreciation of domestic currency. Thus, low rate of interest can lead to capital outflow and depreciation of domestic currency.