Analysis Of "The Federal Reserve Discount Rate And The Effect That It's Reduction Has Had On The U.S. Economy"

Abstract

The purpose of section I of this paper is to examine the Federal Reserve discount rate as a monetary tool, as well as the impact that its recent reductions have had on the U.S. economy. Whenever the discount rate is reduced, it historically has had the effect of causing all of the various market interest rates to also fall. According to traditional monetary theory, this should have a significant impact on economic activity within the the United States. First of all, as lower interest rates strengthen the net reserve positions of the nation's banks, this should then make them more willing to extend additional credit to consumers and business firms at a lower cost. Business firms should then take advantage of the lower cost of capital to increase investment expenditures, thus leading to a higher level of output and employment. Additionally, consumers should be induced to borrow more and save less, therefore leading to an increase in consumption expenditures. Contrary to theoretical expectations, this has not taken place. The nation's banks have been hesitant to lend funds, business firms have not increased their investment, and consumers have not significantly increased their consumption outlays. As a result, the U.S. economy has been slow to emerge from its current recessionary state. The conclusion drawn from this is that interest rates are only one of many economic variables that have an effect on the economy. In the case of the nation's banks, such factors as a more conservative attitude towards extending credit and an insufficient borrowing demand for additional loan funds have acted to restrain growth. As for business firms, a high level of internal financing, uncertain future business forecasts, and a short-term positive correlation between interest rates and business investment have slowed down investment expenditures. Likewise, consumers have been preoccupied with a relatively weak liquidity position, a high level of unemployment, and dismal future expectations about the economy's ability to pull itself out of the recession. Therefore, lower interest rates have not been able to significantly boost consumer outlays. All of these economic factors are not accounted for in the traditional monetary theory, yet all of them have played a key role in determining the nation's current level of economic activity. The theoretical information and empirical data which this paper is based on is solely dependent on the following sources; Economic textbooks which deal with monetary theory, current magazine and newspaper articles, confidential interviews, the U.S. Department of Commerce, and the 1992 Economic Report of the President. Section II and III, respectively, simply explain the internship part of this SIP and how it has had a direct impact on my post-graduate plans.