Question

When the economy is in a recession, the Federal Reserve usually cuts interest rates. Why would the federal government do this?

Answer 1

When the economy is in a recession the demand in the economy is very low. The business sentiments are low and people are not demanding or investing. The reason why FED reserve cut the interest rates when the economy is in a recession is,

• At the time of recession, the demand function in the economy is very less. People spend less an save more. To keep the loanable fund market in equilibrium the fed has to decrease the interest rates. This will cause the savings to decrease and investment to increase at a lower rate.
• At a lower interest rate, the marginal efficiency of capital increases and the firms will increase the investment process i.e. they will generate economic activity. By hiring more people and increasing income.
• This increased income will be used to create demand in the economy and that will bring the economy out of recession.