The Influence of the Fluctuations - Research Paper Example

Introduction
Federal funds refer to the immediate borrowings by the banking institutions to keep the bank reserves stable which is conducted by controlling the federal funds rate (Thornton, 2007). The objective of this paper is to identify the influence of the fluctuations in terms of federal funds rate upon the demand in an economy, the trend of money supply, and the stock market along with the interest and spending as well as interest and investment-related aspects.

Explanation
The changes in the federal funds rate have been widely identified to lead towards a certain chain of events that in turn has significant effects on various interest rates and economic variables, such as interest rates, investment trends, and employment rates among others. For instance, a reduction in the target federal funds rate by the Federal Open Market Committee is quite likely to lead to a fall in the short-term interest rates which are mostly charged on commercial papers and treasury bills among other financial products (Federal Reserve Bank of Richmond, 2012). The short-term interests are affected not only by the current federal funds rate but also by the expected overnight changes in the rates (Board of Governors of the Federal Reserve System, 2011). The influence of federal fund rates on the interest rates has been shown in the figure below:

Source: Money Cafe (2012)
In addition, the changes in the federal funds rate also have certain noteworthy effects on the foreign exchange rates within an economy. For instance, if the fund rates increase in the United States, investing in dollar assets may seem to be more favorable, which in turn may result in the increase of the value of the dollar in the foreign exchange market (Board of Governors of the Federal Reserve System, 2011).
Furthermore, the Federal Reserve plays a vital role in setting up the monetary policies for a nation which includes the setting up of reasonable long-term interest rates as well. The changes in the long-term interest rates due to the alterations in the federal funds rate are related to the fluctuations in the short-term interest rates. The long-term interests that are affected by the federal funds rate are the interests rendered on treasury notes, corporate agreements, and consumer loans on vehicles and other financial products (Board of Governors of the Federal Reserve System, 2011).
One of the major functions of the Federal Reserve is to control the money supply and credit supply in the economy in order to support the economic goals of a nation (Federal Reserve Bank of Richmond, 2012). Likewise, the increase in the federal funds rate might also cause the short-term interest rates to rise. This can further lead the business houses and the customers to reduce their expenditures causing a decrease in economic activities and leading to a fall in the employment rate (Modeste & Mustafa, 2002).
A reduction in the interest rates of the Federal Reserve is likely to result in a decrease in the income and output level of the economy. The ‘contraction policies’ implemented by the Federal Reserve are mainly focused on controlling the cumulative demand in an economy. These ‘contraction policies’, have often been observed to lead towards a decrease in the aggregate supply of money within the economy. This results in an increase in the interest rates which eventually decreases the investment level within an economy leading to a substantial fall in the overall output level (Khawaja, 2012). The following diagram illustrates the influence of federal funds rate fluctuations on the output gap:

Source: (Bivens, 2012)
The federal fund rates have a significant effect on inflation as well. A decrease in federal fund rates is likely to result in an increase in the demand for goods and services. This increase in demand for commodities, in turn, enhances employment opportunities for laborers and the requirement for raw materials for production purposes (Board of Governors of the Federal Reserve System, 2011). This aspect can be evidently observed from the graph represented below:

Source: (ECRI, 2012)
Furthermore, a decrease in federal funds often results in a fall in the aggregate money supply. This decrease in the money supply further increases the rate of interest which in turn decreases the investment level within an economy (Khawaja, 2012). The following figure illustrates the effect of the federal fund rate on the interest rates which in turn influences the money supply:

Source: (Foxman, 2012)

Liquidity Trap Today
A liquidity trap is considered to be a Keynesian concept that refers to a situation in which the short-term rate of nominal interest is likely to be zero. According to this concept, once the supply of money has risen to an extent where the interest rate for the short term is zero, the money supply is likely to have no further effect on the prices and the output level of an economy (Federal Reserve Bank of New York, 2012).

It is worth mentioning that in recent days, there is no empirical evidence that would indicate the existence of a liquidity trap in the global economy. However, it cannot be assured that there is no chance of a liquidity trap situation to occur. Contextually, the Federal Reserve Committee acts continuously to control the interest rates and other economic variables which as a result reduces the chance of a liquidity trap to take place.

Conclusion
Federal fund rates have significant effects on various economic variables. From an in-depth point of view, it has often been argued that the fluctuation in the short-term interest rates has a strong influence on the long-term interest rates within an economic structure. Furthermore, in relation to the aspect of the liquidity trap, it can be concluded that in the present-day context, there are limited pieces of evidence that would confirm the existence of such occurrences within the global economy. Read More