Question

What Happens When The Fed Raises Rates?

The Federal Reserve has signaled that they intend to increase interest rates three times during 2017. How will this affect the economy? What affect could the interest rate hike potentially have on unemployment? Why?

Answer 1

A rise in interest rate is intended to reduce the money supply in the economy. A higher interest rate increases the cost of borrowing of firms. Therefore, firms borrow less and when firms borrow less they invest less. Therefore, expansion of economic activities is negatively affected due to a rise in the interest rate. The output will fall and the economy will contract due to the higher interest rate.

When firms reduce investment, they hire fewer workers. This increases the unemployment rate.