Economy

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If the Fed hold the growth rate of money supply constant while the government expenditures are having an expansionary impact on the economy then interest rates and private spending will reach disequilibrium. With the quantity of money demanded greater than the quantity of money supplied causes interest rates to rise. The increase in interest rates causes the planned investments spending to decline which means reductions in private investment spending (crowding-out effect)

The Fed tool of monetary policy may be ineffective in bringing the economy out of a recession. Low interest rates may not encourage higher levels of aggregate expenditures if economic confidence is low. It may be drawn out as long as two years if people are not confident and do not spend, even if interest rates are low. This may be circumvented by overseas borrowing, use of other forms of credit. However monetary policy can be used to stabilize output and employment around their trend levels, and help prevent the recessions from getting out of hand. When recession hits, the Fed can lower interest rates in order to encourage people to borrow money and make purchases. This works in the short run, but it has to be handled carefully so that inflation isnt impacted in the long run.

Inflation causes many distortions in the market. Inflation hurts people with fixed income when prices rise consumers cannot buy as much as they could previously and it discourages savings reduces economic growth because the economy needs a certain level of savings to finance investments which boosts economic growth and makes it harder for businesses to decide how much to produce, because businesses cant predict the demand for their product at the higher prices they will have to charge in order to cover their costs. Inflation will result if money and credit rise too fast compared to the ability of the economy to produce goods and services. And it will enable sellers to raise prices. However the growth of money and credit should not be too slow, or people and businesses will not be able to get loans they need for purchases that stimulate the economy. So when the Fed tries to prevent inflation the interest rates and bonds prices go up. When the rates go up it is harder for people to buy homes and cars and businesses will be less inclined to invest in new machinery and buildings. This is the Fed way of trying to curtail inflation and maintain economic growth.

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