Three weeks ago, the Federal Open Market Committee (FOMC) met to discuss and vote on various topics regarding the economy of the United States. Among these is the question of whether or not to raise the interest rates paid on required and excess reserve balances. The Chair of the Federal Reserve, Janet Yellen, has spoken on the strengthening case for raising the interest rates, due to “…the continued solid performance of the labor market and our outlook for economic activity and inflation.”1 However, during the conference, the FOMC voted to maintain the interest rate at point five percent. While this decision seems odd when held against Yellen’s statement, the odds reported by Goldman Sachs Bank shows that this was still a contending possibility.
But why is the discussion on interest rates so important? In this paper I will address this, as well as other topics such as the history of the interest rates, as well as what changing it could do for the economy.
In 2006, the Financial Services Regulatory Relief Act authorized the Fed to pay interest on required and excessive reserves held by banks. The idea was to eliminate the implicit tax that reserve requirements used to impose on depository institutions.2 Why is this necessary? By placing reserve requirements on banks, the Fed lowers the possible amount of loans that can be made, which then lowers the possible amount of assets that can be generated. The interest rate on required reserves(IORR), and the interest rate on excessive reserves(IOER) helps to make up for those losses. The IORR and IOER both became active in 2008, and have not been changed since.
Eliminating the implicit tax caused by the reserve requi...
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...ulating, people purchase less goods and services, which lowers the demand for them. When demand is low, there is no need for employers to employ as many people, which means people will get laid off. Unemployed people don’t have money to spend, so demand for goods and services would continue to fall. This is what happened during the Great Depression.
I believe that raising interest rates is a positive step for the U.S. economy. Unemployment is low4, which means more people will be spending money on goods and services. With some states raising the minimum wage, companies will see an increase in production due to a more devoted workforce. Finally, 84% of voters say the economy is an important issue5, which could mean a potential mass withdrawal from the banks if their candidate does not win. By coaxing banks to hold more in reserve, the Fed is preparing them for this.
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