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Federal Reserve’s Influence on Interest Rates Essay

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Updated: Apr 10th, 2020

In a “Forbes Magazine” article that is titled “How Does the Fed Control Interest Rates in a Free Market?”, the author explores the Federal Reserve’s influence on interest rates. The article is authored by “Forbes Magazine” contributor David Marotta and it was first published in the month of March.

The author of this article investigates the connection between the actions of the Federal Reserve and interest rates. Some aspects of interest rates that are addressed in this article include bond markets, gross domestic product, monetary exchange, and bank loans.

The article begins by noting that interest rates in the United States used to be stable and at a higher rate than they currently are. The article attributes this development to the “Federal Reserve’s manipulation of the bond market” (Marotta, 2014). According to the article, bonds are loan-contracts that are uniquely structured as per their repayment methods.

The interest rate that is carried by a particular bond is defined by its coupon rate. However, the coupon rate is not the ‘actual’ interest rate. The actual interest rate of a particular bond is determined by its face value and price. Consequently, bonds that carry high risks will often be lowly priced and they will have high interest rates.

According to the author, the people who buy government bonds are very important to the stability of monetary markets and interest rates. Therefore, the interests that are attracted by bonds represent the rate of exchange between bond-financiers and bond-lenders. Currently, the government is a major player in the bond-market assuming the role of both a saver and lender.

The author of this article notes that the United States Government currently purchases bonds that amount to approximately $86 billion every month even although it does not have any ‘real’ money/savings to represent these purchases. In addition, the article notes that bonds are mere contracts that give purchasers a promise for repayment.

An increase in supply of ‘loan money’ often leads to low interest rates that aim to encourage borrowing. On the other hand, when there is a shortage of money to be lent, the interest rates go up to discourage borrowing. A balance of both borrowing and lending is vital to economic progress. However, all the entities that save money act as enablers of the economy. The Federal Reserve (Fed) acts as a saver in the bond market by floating around $1 trillion and this gives it the ability to lower interest rates.

Every time the Fed purchases bonds, it increases the supply of money and consequently brings down the interest rates albeit artificially. According to this article, the Fed is allowed to print money to finance Treasury bond purchases. If people do not save, there is no money to be used as loans. Consequently, the growth of GDP will be stunted. The government compensates for this shortcoming by creating artificial savings via the Fed and devaluing the dollar.

All these actions create an environment that favors the borrowers and negatively affects the savers. For instance, those who save money via bonds run the risk of receiving ‘worthless money’ as returns (Marotta, 2014). Rising inflation can be tamed using high interest rates that discourage borrowing and encourage saving.

Nevertheless, the author of this article is quick to note that unpredictable inflation rates are unfavorable for both borrowers and savers. The article concludes by stating that the variables that apply to interest rates are important when it comes to maintaining the integrity of GDP.

Reference

Marotta, D. (2014). ?. Forbes Magazine. Web.

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