ECON430-Topic #3: Investment and Interest Rates

One of the fundamental economic theories of economics is that changes in real interest rates should have an impact on output. There are several channels through which monetary policy is expected to impact the overall economy. As noted by the Austrian central bank, through the interest rate channel “a raise in key interest rates triggers an increase in short-term market rates. As a result, both the real interest rate and the cost of capital rise, putting a brake on investment.” The Bank of Canada also notes:

The main transmission channel is the effect that changes in the Bank’s policy rate have on various commercial interest rates, e.g., for mortgages, for consumer loans, as well as for deposits at financial institutions. A decline in commercial interest rates reduces both the cost of borrowing and the money paid on interest-bearing deposits, which tends to encourage borrowing, spending and investing, and to discourage saving.

–Bank of Canada

In the US, it is supposed to work much the same way. At a fundamental level, the Federal Reserve has many explanations of how monetary policy works to impact employment and inflation. The mechanics of this are to utilize changes in the Fed’s familiar policy instruments as explained by the St. Louis Fed for one basic example and San Francisco for another more detailed story. The New York Fed–who actually conducts the open market operations–explains what happens in the greatest and probably most accurate detail. However, the traditional story does not seem to work well when the central bank’s balance sheet is where it is now. There have been many stories about what the Fed needs to do in order to “normalize” monetary policy after the crisis, but they do not seem to be in much of a rush to get to this point.

Furthermore, Federal Reserve economists Steven A. Sharpe and Gustavo A. Suarez have recently put together a report that shows many firms are not particularly sensitive to changes in interest rates.  As noted in their abstract:

A fundamental tenet of investment theory and the traditional theory of monetary policy transmission is that investment expenditures by businesses are negatively affected by interest rates. Yet, a large body of empirical research offer mixed evidence, at best, for a substantial interest-rate effect on investment. In this paper, we examine the sensitivity of investment plans to interest rates using a set of special questions asked of CFOs in the Global Business Outlook Survey conducted in the third quarter of 2012. Among the more than 500 responses to the special questions, we find that most firms claim to be quite insensitive to decreases in interest rates, and only mildly more responsive to interest rate increases. Most CFOs cited ample cash or the low level of interest rates, as explanations for their own insensitivity. We also find that sensitivity to interest rate changes tends to be lower among firms that do not report being concerned about working capital management as well as those that do not expect to borrow over the coming year. Perhaps more surprisingly, we find that investment is also less interest sensitive among firms expecting greater revenue growth. These findings seem to be corroborated by a cursory meta-analysis of average hurdle rates drawn from firm-level surveys at different times over the past 30 years, which exhibit no apparent relation to market interest rates.

 –Steven A. Sharpe and Gustavo A. Suarez

So, while there are other channels through which monetary policy works this fundamental one seems to be ineffective in the last couple of years. The “portfolio balance channel” is another which is expected to help improve economic conditions through changes in the quantity of existing reserves. Quantitative easing in particular, is expected to have different effects when the central bank is facing the “zero-lower bound” on policy rates. Fed economists Fawley and Neely examine these channels in more detail. Finally, Ben Bernanke himself authored several papers explaining how the “financial accelerator” channel would work during a period of interest rates at the zero-lower bound.

Questions you might answer:

  • Can the central bank affect the overall economy through the interest rate channel? How large is this effect expected to be? What do the authors above have to say about the effectiveness of monetary policy over the last several years? You do not have to read all these papers, but choose one or two to try gain some deeper insight about policy. You may also choose to some related news articles.
  • If the Fed is poised to raise rates, and there is no impact on overall investment, how can the central bank impact demand in a way that avoids accelerating inflation?
  • If the Fed is poised to raise rates, and that negatively impacts investment, then why do stock markets positively react to this? Wouldn’t the subsequent fall in investment lead investors to think that the overall value of the stock market would fall in the future? Think about what the Fed is saying about the current state of the economy if they are saying that it is OK to raise rates.

13 thoughts on “ECON430-Topic #3: Investment and Interest Rates”

  1. Traditionally, it is believed that when the Federal Reserve Bank increases the federal funds rate, and subsequent market interest rates increase, then there is a decrease in investment which lowers overall output. This is because increased interest rates make capital more expensive to rent. Typically the Fed strives to use monetary policy to achieve stable prices and full employment. The Fed primarily achieves this by adjusting the federal funds rate to manipulate interest rates. Recently the Fed has placed more priority on achieving their inflation target, which is 2 percent. Over the past year, however, the Fed has shifted its attention to the volatile unemployment we are currently experiencing. The current financial crisis has seen unemployment rates as high as 14.8 percent and as of February of this year it is 6.2 percent. That is almost double the 3.5 percent it was in February of 2020. As a result of focusing on unemployment Fed chair Jerome Powell has said that he is willing to let inflation raise above the target rate. Since last April, the Fed has set the federal funds rate at zero. Conventional wisdom suggests this should have spurred investment, increased inflation, and lowered unemployment. Unemployment not lowering can be attributed to the pandemic, but after 11 months with an effective federal funds rate less than .1 percent inflation was only 1.7 percent. CPI excluding food and energy was only 1.3 percent. This and a 2013 paper by Sharpe and Suarez, that says firm investment is less sensitive to changes in interest rates than previously believed, suggests that lowering the federal funds rate only has a moderate effect on the economy. Since this financial crisis was caused by a pandemic, that led to the economy being partially shutdown, it is possible that the federal funds rate being set so low so quickly into the crisis may have prevented the economy from getting worse. Powell plans on letting inflation rise freely until 2023 so expectations of inflation are increasing. Americans are expecting inflation to hit 3.1 percent this year and GDP growth is projected to be around 3.1 percent, a vast improvement over the -4.27 percent in 2020.

    https://fred.stlouisfed.org/series/UNRATE
    https://fred.stlouisfed.org/series/FEDFUNDS
    https://www.federalreserve.gov/pubs/feds/2014/201402/201402pap.pdf
    https://www.statista.com/statistics/263614/gross-domestic-product-gdp-growth-rate-in-the-united-states/
    https://www.wsj.com/articles/higher-gas-energy-prices-boost-consumer-inflation-at-start-of-year-11615384703?st=htfk3d5ph2d6ydv&reflink=desktopwebshare_permalink

  2. If the Fed wants to raise rates and it continues to fail to impact overall investment, they might resort to increasing consumer demand to increase inflation. One of many things they can do is reduce the reserve requirement. This will cause commercial banks to have a greater opportunity cost of holding money since they are allowed to lend out more deposits and therefore earn more interest on their deposits as loans. The abundance of money that is now available to consumers through loans will ultimately drive down their rates causing consumers to consume more. In time, this increase in consumption will lead to greater inflation. Something to keep in mind is when comes to mitigating the length of recessions through such policy, the central bank needs to be careful not to overshoot the increase in inflation and aggregate demand. During the lag stage of policy during recessions (a stage we quite possibly are in right now) prices could and most likely are naturally adjusting on their own. On top of this natural price adjustment, a zero bound federal funds rate and reduced reserve requirement may overcorrect and propel ourselves in a position where the inflation rate is much too high. This would put ourselves into an equally vulnerable position to the one we were trying to correct in the first place because of instability. This discrepancy of whether or not to intervene to try to shorten the lengths of recessions through policy is what diverged many economists from the classical economics mindset of letting prices adjust in the long run. It is important to find the correct approach to counter a recession. That being conducting policy when we have a better estimate of the rate that prices are adjusting on their own and then supplementing with the correct policy. This will help avoid an overly accelerating inflation rate.

    1. https://www.thebalance.com/reserve-requirement-3305883
    2. https://www.frbsf.org/education/publications/doctor-econ/2001/august/reserve-requirements-ratio/
    3. https://www.frbsf.org/economic-research/publications/economic-letter/2016/february/case-for-inflation-overshooting/

  3. Even with the strong evidence that says the central bank has little impact on investing through the interest rate channel, the central bank can still impact the economy through that channel. (1)

    Primarily, this effect plays out is with asset prices. (2,3) When the interest rate gets lower, the cost of borrowing gets cheaper. Although that may not spur investment, it does spur consumer demand. Consumer demand is spurred due to balance sheet strengthening.

    Take housing for example. As interest rates decrease, it makes it easier to obtain a mortgage and buy home. With this process being repeated broadly, it pushes up housing prices. The existing house owners see that benefit.

    These homeowners have a stronger balance sheet as a result of their appreciating home value. (3) That then induces greater consumer expenditure due to lower financial distress. (3,4) These are called wealth effects and can also be seen in the impact of stock market prices on consumer investment portfolios.

    An instructive example of this can be seen in the Japanese economy in the 1980s. (5) Loose monetary policy helped push Japanese asset prices to all time highs. That growth helped propel the macroeconomy to similar levels as well. There were profound wealth effects from it. Like all good things, however, it came to an end, the asset bubble in Japan crashed and the economy is now mired in a period of stagnation.

    The key then for the Federal Reserve is push asset prices to influence consumer demand without sending them to stratospheric heights.

    1. https://www.federalreserve.gov/pubs/feds/2014/201402/201402pap.pdf
    2. https://www.nber.org/system/files/working_papers/w5464/w5464.pdf
    3. https://www.nber.org/system/files/working_papers/w8617/w8617.pdf
    4. [Wealth Effects Revisited 1978-2009 | NBER](https://www.nber.org/papers/w16848)
    5. [ASSET PRICE INFLATION AND ECONOMIC POLICIES on JSTOR](https://www.jstor.org/stable/43295961)

  4. The central bank does have the ability to affect the overall economy through the interest rates channel however the effectiveness depends on firms responses to changes in the rates. In theory, the central bank lowering interest rates would promote investment as firms would have easier access to funds. The lower interest rates and increase in investment could also have effects on employment. When firms have easier access to funds, they are more equipped to hire new workers which reduces the unemployment rate. In the long run, as more individuals are employed, the demand for goods would increase resulting in a rise in prices. Despite these possibilities from a decrease in interest rates, firms typically do not respond to these decreases in interest rates. Firms are typically insensitive towards these decreases as they already have adequate amounts of reserves or because the interest rate is already low (1). The insensitivity of firms to decreases in interest rates shows monetary policy to encourage investment has little effect.
    Despite little effect on investment resulting from decreases in interest rates, an increase in interest rates could have a larger effect. Firms are slightly more sensitive to increases in interest rates particularly those that are concerned about capital or expect less revenue (1). A firm that is concerned about capital or revenue would be less likely to borrow funds at a higher rate as it may be harder to repay in the future. Firms are concerned for their own financial well being which can be seen through this sensitivity. The resulting lower levels of investment could have effects on both unemployment and inflation. Firms would be less willing to hire workers resulting in decreases to wages. The decrease in wages results in a drop in demand for goods and leading to price decreases. Due to sensitivity by firms, the effect from an increase in interest rates could be larger than the results from a decrease in wage. Having only mild sensitivity does not mean the possible effect is very large. However, compared to the insensitive nature of firms to decreasing interest rates, this shows that monetary policy can have some effect on the overall economy.

    1. https://www.federalreserve.gov/pubs/feds/2014/201402/201402pap.pdf
    2. https://www.federalreserve.gov/faqs/money_12856.htm

  5. The Federal Reserve has used the interest rate channel to affect control inflation, economic growth and asset prices (2). When the central bank decides to raise interest rates, it slows investment and decreases demand for goods and services (1). The central bank may choose to begin expansionary monetary policy by decreasing the interest rates when the economy is facing a decline to give support to households and businesses (4). A decrease in interest rates would theoretically push households and businesses to expand their investments, purchase more goods and services since it will not be as valuable to hold onto cash and it will be cheaper to borrow. The effectiveness of interest rates in influencing the economy is evident by it being Federal Reserve’s primary tool for conducting monetary policy (4). However, it should be noted that there are often significant lags to when this policy decision will take effect (2). The change in interest rates will eventually have an impact on household’s and firm’s decisions on whether to save or spend (2). These decisions will then impact the demand of consumers and how that demand will affect the prices, thus impacting inflation (2). History would show that this monetary policy tool has been effective, even with its lags.

    The more recent economic climate is different from previous years and may require a new approach. Research has showed that the typical monetary policy approach is not working on businesses like history says that it would (3). According to the study, this seems especially true with expansionary monetary policy (3). Firms surveyed showed to be insensitive to decreases in interest rates intended to drive up investment (3). The reasoning behind the insensitivity was cited as being the possession of plenty of cash on hand and the low level of interest rates (3). Firms that are not worried about managing capital or who are not looking to borrow in the next year said that their investment plans would not change regardless of an interest rate decrease (3). The study did show that firms are slightly more likely to have their investment plans impacted by an increase in interest rates, especially if they were expecting to have to borrow money to finance the investment (3).

    The impact that higher interest rates have on the stock market is strange when using traditional economic theory. I expect that the stock market responds positively due to higher interest rate causing publicly traded firms stock prices to decrease as a result of a lack of consumption, the firm’s reduced investment and reduced borrowing. Investors would look at this low stock price and see an opportunity to buy at a low price. Buying the stock would increase the price, motivating more investors to join in on this investment. Investors would see this opportunity for return in the stock as being greater than the return they would get from holding cash in a bank. The central bank increasing interest rates would also tell an investor that the economy is doing really well and that the Fed expects the economy to keep doing well for a while.

    1. https://www.oenb.at/en/Monetary-Policy/How-Monetary-Policy-Works.html
    2. https://www.bankofcanada.ca/wp-content/uploads/2010/11/how_monetary_policy_works.pdf
    3. https://www.federalreserve.gov/pubs/feds/2014/201402/201402pap.pdf
    4. https://www.federalreserve.gov/faqs/money_12856.htm

  6. In my opinion, with the reduction of interest, bank deposits will decrease and loans will increase, thus stimulating consumption, increasing domestic demand from the side and increasing currency circulation, which will slow down the economic recession.

    The effect of interest rates on exchange rates. Interest rates affect the attractiveness of a country’s financial assets. A rise in a country’s interest rates makes its financial assets more attractive to domestic and foreign investors, leading to capital inflows and an appreciation of the exchange rate. Of course, the relative differences between interest rates in one country and those in other countries should also be taken into account. The effect of a country’s interest rate changes on the exchange rate can also work through the trade account.

    When the country’s interest rates increase, means that the opportunity cost of domestic residents consumption increase, resulting in a decline in consumer demand, but also means that the rising cost of funds use, domestic investment demand also drop, so, total domestic effective demand levels drop will extend export, import, thus increasing the country’s foreign exchange supply, reduce the foreign exchange demand, make its currency to appreciate. Loan costs are reduced and foreign investment is attracted, i.e., increased investment.

    After the interest rate rise, the loan interest rate rises, the cost of capital increases, and enterprises have to bear higher costs in investment, financing and operation management. Embodied in four aspects, at the same time also can respectively from short-term and medium-term impact analysis: 1, the operation cost of capital increase, maintain the same scale enterprise cost will rise, at this time will be conductive to the product cost, or reduce the profits, or forced enterprises to improve product price (product price rise indirectly affect the downstream demand). 2. The increase of financing costs affects the expectation of ROI and IRR, so that enterprises give up investment in projects with lower yields, thus reducing investment demand. 3. Increased financing costs, increased speculative costs and speculative debt risks, and reduced risk preferences of speculators. For example, speculation on agricultural products and non-ferrous metals with low cost borrowing will lead to increased repayment pressure and debt pressure. Speculators will reduce borrowing, thus reducing speculative demand. 4. Increased borrowing costs for consumers: This is the ultimate point of view. For example, the interest of borrowing money to buy a house or a car and consumption increases, forcing consumers to reduce borrowing and consumption, and consumer demand decreases accordingly. The above four aspects can be transmitted from different industries to the upstream and downstream of the chain, and the decrease of demand in a certain link will inevitably be gradually transmitted to the upstream.

    Both will be lower and faster than the Fed Fund Rate Future market is pricing in three rate increases in 16 years and three in 17 years. The interest rate will end up at 3%. The Fed’s $4 trillion bond holdings are not going to taper off anytime soon. The 2013 taper tantrum made the Fed cautious about tapering QE before it started. Reducing the stock of bonds will be years off the table. The market has been in an ultra-low interest rate environment near zero. In this environment, high interest/high dividend assets, such as corporate bonds, MLPs, and telecom stocks, have high relative returns. And the price-to-earnings ratio for the entire stock market is stretched too high. The economy has long had low inflation and the core PCE in a low growth environment has been below the Fed’s 2% target. Most research firms, including the Federal Reserve, estimate America’s potential growth at between 1.5% and 2%.

    https://www.nber.org/system/files/working_papers/w8617/w8617.pdf

    https://www.frbsf.org/education/publications/doctor-econ/2001/august/reserve-requirements-ratio/

    https://zhidao.baidu.com/question/452463173.html

    https://www.sohu.com/a/235766218_540573

  7. When the Fed decides it is necessary to raise interest rates, in accordance with their stated and recognized dual mandate of fostering economic conditions that achieve both stable prices (target inflation) and maximum sustainable employment (full employment); traditional market economics would predict a resulting decrease in overall investment, lowering output. The Fed cut rates in early 2020 and continued to cut rates to a near-zero rate by June 2020, following the economic guidance that lower rates would promote economic growth, offsetting the negative economic shock caused by several factors: namely the COVID-19 pandemic (1).
    While the Fed has committed many times; most recently in the past week, to not raise interest rates in the near-term; Dallas Federal Reserve President Robert Kaplan has stated that he believes the Fed will raise rates for the first time in 2022. Given the public stance of Fed Chair Powell, this is the most likely timeline for rates to increase. The Fed has recently noted that they anticipate real GDP growth of 6.5% in 2021, inflation running to 2.4%, and unemployment falling to 4.5% (2). Perhaps most importantly, given the Fed’s recent shift in focus towards full-employment and temporary allowance of increased inflation, the unemployment rate is expected to fall to near long-run full employment as estimated by the FOMC as 4.1% (3).
    When the Fed starts the process of increasing interest rates, it is possible that the inflation expectations of the American public and its business act to counter rate increases, as people may continue to borrow if they expect inflation to continue increasing beyond the Fed forecast (4). If this occurs, and the economy continues to “run hot” in the short-run, inflation expectations continue to pull inflation upwards, it is possible that the Fed can increase reserve requirements from the current 0% rate set for all depository institutions (5), in an effort to enact a different form of monetary policy which is expected to reduce the supply of money by reducing the funds available in the banking system available to create new loans, thus new investments and spending. While the Fed does not often make changes to the reserve requirement, they acted in 2020 to lower the requirement to 0%, an action which was designed to promote growth during the economic downturn.

    1. https://www.cnbc.com/2020/06/10/fed-holds-rates-near-zero-heres-what-that-means-for-your-wallet.html
    2. https://www.cnbc.com/2021/03/17/heres-where-the-federal-reserve-sees-interest-rates-the-economy-and-inflation-going-in-the-future.html
    3. https://www.chicagofed.org/research/dual-mandate/dual-mandate#note5
    4. https://fred.stlouisfed.org/series/MICH
    5. https://www.federalreserve.gov/monetarypolicy/reservereq.htm

  8. The central bank has the potential to impact the economy through the use of interest rates. The Fed has two ways that they can impact the economy with interest rates. The first is by increasing interest rates, this increases the cost needed to borrow, making investment and credit harder to come by. This will slow down the economy. Secondly, the Fed can lower its rates, this does the opposite making it easier to borrow, encouraging spending on investment and credit. This will stimulate the economy and drive it forward. (1) This monetary policy conducted influences inflation and employment, the primary tool used ‘The Federal Funds Rate is the funds that banks pay for overnight borrowing. (2) These rates then influence the actions of both firms and households thus impacting the economy as a whole.
    With firms being able to get more funds, they can hire more workers and thus affect the unemployment rate. The demand for goods increases and we see a rise in prices as more and more employees are hired. Despite this, firms do not tend to respond to these changes effectively. This tells us that there is a minimal impact on investment from monetary policy.
    Multiple other factors can affect employment and inflation. The way that monetary policy affects employment and inflation is not direct, however, monetary policy can and does affect the economy.
    Sources:
    https://www.investopedia.com/ask/answers/031115/how-do-central-banks-impact-interest-rates-economy.asp
    https://www.federalreserve.gov/faqs/money_12856.htm

  9. Central banks have many tools at their disposal, not all of which are explicit monetary policy. If a central bank adjusted interest rates but saw no change in investment, the bank could still have an effect on the market by attempting to influence producer and consumer expectations about the future. By managing expectations, a central bank could spur investment without changing interest rates, keeping inflation in check. The European Central Bank regularly releases statements to carefully regulate future expectations to control inflation (1). This is also demonstrated by the United States’ central bank, The Fed. By releasing a statement with intended goals, the FOMC can kickstart investment before a given change has even taken effect. The San Francisco branch of the Fed even stated that the wording they choose for their FOMC statements is carefully tailored to provide the desired effect on investor behavior (2).

    Central banks can also lower the reserve requirement if they want to increase investment without disturbing the level of inflation. When the reserve requirement is lowered, banks are required to hold to hold less deposits liquidly as cash and can therefore generate more loans. This increase in the amount of loans available will increase investment without raising the interest rates (3).

    (1) https://www.ecb.europa.eu/press/key/date/2007/html/sp070615.en.html
    (2) https://www.frbsf.org/education/publications/doctor-econ/2006/april/federal-open-market-committee-fomc-short-term-interest-rate/
    (3) https://www.federalreserve.gov/monetarypolicy/reservereq.htm

  10. The central bank’s manipulation of the real rate through open market operations certainly has the potential to create real effects in an economy but to a smaller extent than the Fed and the public might expect. Amongst 500 CFO’s surveyed if they would cut back on their debt-financing due to a 1% increase in interest rates, 91% of the financial officers indicated they would not reduce capital spending(1). Given the Fed raises rates in increments of 0.25%(although it can change higher or lower than 0.25%, which is not typical) and assuming they continue doing so every six weeks when the FOMC meets, the Fed can effectively raise rates by an aggregate of 2% each year. In response to a 200-basis points increase and whether that would affect their capital expenditures, 96.3% of respondents in the same participant pool said they wouldn’t cut back on their capital spending, implying that rate hikes create more inelastically for the demand of capital. Debt is a highly structured asset that is quite difficult to restructure and usually involves high opportunity costs. Restructuring is usually indicative of either a change in a company’s capital structure or a business in financial distress that’s struggling to meet its liabilities. While most introductory textbooks have created this notion that changes in the interest rate have substantial real effects on an economy, the reality of such a reaction is minuscule at most and should not give individuals a false impression when developing their future expectations.

    (1)https://www.federalreserve.gov/pubs/feds/2014/201402/201402pap.pdf

  11. The Fed seems to always be playing catch up. When the Covid pandemic hit, the Fed played a reactionary role trying to ease the hurting of the recession. Their actions never seem to dictate market events, they only come in response to such events. Instead of being a driver of the economy, they respond to the economy by to either help during a recession or prevent overheating. Nominal rates do not dictate the demand for goods, rather real interest rates are related to demand. The Fed operates in the nominal interest rate market because they are the sole supplier of reserves. Since the Fed can not directly set inflation expectations, they can not directly set real interest rates (1). A borrower will find a more optimal scenario if their loan is 4% when the inflation rate is 6%. However, it might be a bleaker situation if the borrower kept the same 4% loan, but inflation was only 2%. The nominal rate remains the same, but inflation more closely dictates the ability for the borrower to pay back the loan. People’s expectations have a much greater effect on the economy than the rates set by the Fed. Real interest rates are determined by the supply of savings and the demand for goods financed by those savings (2). A household will save to where the return on the last dollar saved compensates the household for the consumption, they would lose in saving that dollar. This can also apply to firms and other actors in the economy. The Fed may set rates which can incentives players in the economy in these decisions, but ultimately households and firms are doing what is best for them. Depending on their financial position, they could have sufficient cash on hand or have no need to make investments at this time, leading to little effect in interest rate changes. Rarely is the Fed the black swan event that alters markets. More often the case, the Fed responds to black swan events by manipulating interest rates.
    1. https://www.frbsf.org/education/teacher-resources/us-monetary-policy-introduction/real-interest-rates-economy/
    2. https://www.stlouisfed.org/publications/regional-economist/january-2016/focus-on-low-real-interest-rate-might-be-misplaced
    https://www.stlouisfed.org/publications/regional-economist/april-2013/low-interest-rates-have-yet-to-spur-job-growth

  12. The natural inclination when thinking of monetary policy and the Fed is to talk about interest rates. However, Sharpe and Suarez bring a new light to one of the Fed’s key policy tools, showing that the Fed may need to rethink how strong the reliance on changing interest rates should be. However, as they note in their conclusion, the survey questions were only asked once in September 2012. It would be interesting to do the survey again, and see the sensitivity, or lack thereof, of investment to interest rates during a pandemic.

    With the news from the Dallas Fed President Robert Kaplan stating that he favors raising interest rates before 2022, it is important to look at the necessity of keeping low interest rates until the economy reaches full employment and inflation at the target of 2%. Interest rates were initially lowered as a way to encourage not just businesses, but families and schools to borrow in a time when stores were shut and restaurants were closed (1). While it seems great on the surface, the Fed did essentially lose one of their monetary policy tools, as negative interest rates are not normally used in the United States. While the stock market did not like this move by the Fed, it is important for the Fed to keep these low interest rates to help consumers economically during the pandemic.

    However, although Sharpe and Suarez do not discuss negative interest rates, the IMF found that negative interest rates may be able to help ease financial conditions without raising major red flags around stability (2). With introducing negative interest rates in the US economy, the Fed essentially reopens their tool box by being able to continue to lower the interest rate.

    Although Sharpe and Suarez collected interesting data on the use of interest rates in the US, I do not believe the Fed will completely stop changing interest rates to help speed up or slow down economic growth. Despite the fact that low interest rates do put the Fed in a tough spot if the recession deepens, negative interest rates are used in other countries, and may not be completely off the table for the Fed (3).

    1. https://www.npr.org/2020/03/15/816175414/fed-cuts-interest-rates-to-near-zero

    2. https://blogs.imf.org/2021/03/03/the-evidence-is-in-on-negative-interest-rate-policies/

    3. https://www.cnbc.com/2021/03/02/guggenheims-minerd-says-dont-count-on-rising-yields-believes-us-could-even-see-negative-rates.html

  13. Yes, the central bank can affect the overall economy by changing the interest rates. Lets say they decide to increase the interest rates, it increasing the cost of borrowing money. Which in turns causes the purchasing of goods and services to decrease, while the money supply also shrinks. When purchasing declines, the economy will slow down, which may lead to a recession. For example, before the housing market crash of 2008 the interest rates had been increasing since 2002. Following the crash the FED decreased interest rates, this helped battle the unemployment rate and start to boost the economy.

    With the FED decreasing the interest rates it stimulates economy growth. With low interest rates it encourages borrowing and investing. The two quotes from above also stated that with the decrease of interest rates it also gives a boost the businesses as well.

    https://www.frbsf.org/economic-research/publications/economic-letter/2009/may/fed-monetary-policy-crisis/
    https://www.imf.org/external/pubs/ft/fandd/basics/monpol.htm
    https://fred.stlouisfed.org/series/INTDSRUSM193N

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