The Fed and interest rates

Essay by Ahned HamdyUniversity, Master'sB, January 1996

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The Fed and Interest Rates

Dave Pettit of The Wall Street Journal writes a daily column that

appears inside the first page of the journal's Money & Investment

section. If the headlines of Mr. Pettit's daily column are any accurate

record of economic concerns and current issues in the business world,

the late weeks of March and the early weeks of April in 1994 were

intensely concerned with interest rates. To quote, 'Industrials Edge Up

4.32 Points Amid Caution on Interest Rates,' and 'Industrials Track On

13.53 Points Despite Interest-Rate Concerns.' Why such a concern with

interest rates? A week before, in the last week of March, the Fed had

pushed up the short-term rates. This being the first increase in almost

five years, it caused quite a stir.

When the Fed decides the economy is growing at too quick a pace, or

inflation is getting out of hand, it can take actions to slow spending

and decrease the money supply.

This corresponding with the money

equation MV = PY, by lowering both M and V, P and Y can stabilize if

they are increasing too rapidly. The Fed does this by selling

securities on the open market. This, in turn, reduces bank's reserves

and forces the interest rate to rise so the banks can afford to make

loans. People seeing these rises in rates will tend to sell their low

interest assets, in order to acquire additional money, they tend move

toward higher yielding accounts, also further increasing the rate. Soon

this small change by the Fed affects all aspects of business, from the

price level to interest rates on credit cards.

Rises and falls in the interest rate can reflect many changes in an

economy. When the economy is in a recession and needs...