I learned that low fed interest rates makes ppl borrow more, stimulating economy as money circulation is higher. why ever increase it then, if increasing it worsens the econ?
Also ,is the fed reserve actually the goveernment bank? heard it was still a giant private bank and the goverment has nothing to do with it
In: Economics
The Fed has to balance between two issues – economic activity and inflation.
Decreasing rates, generally speaking, increases economic activity – spurring investments, increasing employment (reducing unemployment), increases income etc. But the downside is that general price level increases (inflation)
Increasing rates, generally speaking, does the reverse.
However inflation is a dangerous thing. Some inflation is considered good (due to price/wage friction etc – beyond ELI5) but excessive inflation is bad. One reason is that high inflation also increases EXPECTATION for future inflation (eg if price rises 10% this year, many people expect prices will rise 10% next year) This means people might tend to hoard goods (rather than hold money) and/or move their assets out of the country which further increases inflation (so this is the inflation spiral)
Too high inflation affects producers, for example if you bake bread as a business, if the cost of flour increases too fast, by the time you sell your bread, you cannot afford to buy more flour. So you raise the price of bread – which leads to further inflation. Ultimately no one wants to produce because profits become uncertain. This then leads to more inflation and general shortage of goods. (see Venezuela recently for real world example) The entire economy starts to breaks down. Once this happens it is VERY VERY VERY difficult to recover from.
TL;DR The Fed wants to stimulate economic activity but cannot risk high inflation. Therefore it has to set interest rate to balance between the two.
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