Federal Funds Rates and its Effect

The Federal Funds Rate is the interest rate at which banks charge each other for short term overnight loans. It serves as a barometer for all other interest rates, so if the Fed Funds Rate increases, all other interest rates should increase as well. Since real interest rates increase, the quantity of investment demand will decrease. This is because the cost of borrowing for businesses will increase, so the opportunity cost of businesses investing in new projects increases. This affects the economy by raising real interest rates and lowering aggregate demand, therefore lowering price levels and real GDP. The Fed is able to enact this change because the economy has experienced periods of steady economic growth. After the economic downturn in 2008, the unemployment rate has recently decreased greatly, and the economy is in a period of economic growth. Because of this, the Fed is able to raise interest rates to be sure that the economy does not experience a rate of too rapid inflation. This raising of the interest rates is an indication that the economy is doing well, and no longer needs the monetary policy support of low interest rates. This economic boost has not yet made its way into the consumer sphere, but will soon be represented in the economy’s real GDP.