Question

Discuss how the Federal Reserve bank uses interest rates to achieve macroeconomic stability

Answer 1

Interest rate is a primary monetary policy tool of Fed.

When the economy is expanding at a fast rate, inflation starts to increase. To stabilize inflation rate, Fed uses contractionary monetary policy by lowering aggregate demand by decreasing money supply, which can be achieved by increasing interest rate. Higher interest rate will dampen investment and consumption demands, thereby lowering aggregate demand and decreasing inflation rate.

On the other hand, when the economy is in recession, aggregate demand is very low. To boost aggregate demand and output, Fed uses expansionary monetary policy by increasing aggregate demand by increasing money supply, which can be achieved by decreasing interest rate. Lower interest rate will boost investment and consumption demands, thereby raising aggregate demand and output.