Federal Reserve Interest Rate Essay
The Impact of Federal Reserve's Interest Rate Hike on Aggregate Demand, Price Level, GDP, and Unemployment
Introduction
The Federal Reserve wields considerable power over the economy through its ability to manipulate the interest rates. In the context of full employment, an increase in interest rates can lead to changes in aggregate demand, price levels, the gross domestic product (GDP), and unemployment. This paper explores these impacts in the short run.
Aggregate Demand
When the Federal Reserve raises interest rates, borrowing becomes more expensive. This discourages consumers from obtaining loans for purchasing goods or services and dissuades businesses from securing loans for investments. Consequently, there is a decrease in consumer
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With lower aggregate demand, businesses are unable to sell their goods and services at higher prices, causing them to lower prices in an attempt to clear their inventory. As such, the overall price level in the economy decreases. This is an application of the law of demand, which posits that a decrease in demand leads to a decrease in price, all other factors held constant.
Gross Domestic Product (GDP)
The decrease in aggregate demand also leads to a decrease in real GDP in the short run. This is because, with reduced demand, fewer goods and services are sold, leading to lower production levels and thus lower output. As GDP measures the total output produced in an economy, a decrease in production leads to a decrease in GDP. Thus, the hike in interest rates leads to a contraction in the economy, with lower output and lower GDP.
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While the interest rate tool is essential for controlling inflation and stabilizing the economy, its use must be carefully calibrated to avoid negative impacts. Understanding these effects allows for more informed decision-making and better economic management.
The complex interplay between these macroeconomic variables underscores the importance of the Federal Reserve's role in guiding economic policy. Their decisions reverberate throughout the economy, impacting everything from the purchasing power of consumers to the hiring decisions of businesses.
References:
Greenlaw, S. & Shapiro, D. (2017). Chapter 11 | The aggregate demand/aggregate supply model. In Principals of macroeconomics 2e. Openstax. Licensed under CC-BY 4.0. https://openstax.org/details/books/principles-macroeconomics-2e
Clifford, J. (2020, October 7). Aggregate demand- macro topic 3.1 [Video]. YouTube. https://www.youtube.com/watch?v=ujiHgvLzEDw
Clifford, J. (2017, October 31). Aggregate demand and supply practice- macro topic 3.5 and 3.6 [Video]. YouTube.
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