Federal Funds Rate Influences Unemployment

Monetary
System

How the Federal Funds
Rate Influences Unemployment Rate

The
correlation between the unemployment rate, as a gauge of economic stability, and
the federal funds rate has attracted a lot of discussion in the popular press
in the United States. Despite the several attempts to explain this
relationship, the most common pathway and explanation that ties these two
variables is the . Based on this model, a rise in
the federal funds rate often increases the interest rates (Short-termed), thus
increasing the lenders’ cost of funds. Therefore, consumers and entities will
respond to the raised interest rates by limiting their expenses, leading to a
fall in economic activity. Consequently, a plunge in economic activity yields
to an increase in the unemployment rate (Modeste & Mustafa, 2011).

Generally,
the relationship between the federal funds and unemployment rates can be viewed
as reverse causation. This is because changes in the economic activities, as
portrayed by the unemployment rates, can to alter the
federal funds’ rates in their countries. In other words, a fall in the
unemployment rate would lead to an increase in the federal funds rate, thus
stabilizing the economy.

How Changes to Federal
Funds Rate Affect the Inflation Rate

When
a country experiences a high inflation rate, its , and the economy
will often break down. Thus, the Federal Reserve is tasked with controlling a
country’s inflation rates by influencing federal funds rates and interest rates
(Wilson, 2019). Increasing the federal funds rate will cause the market
interest rates to rise, thus dampening business and consumer spending. This, in
turn, slows the economic activity in the country’s markets and reduces the
pressure caused by inflation. In other words, when the inflation rates are too
high, the Federal Reserve will often increase the federal funds rate to reduce
inflation and slow down the economy. Conversely, when inflation rates are too
low, reducing the federal funds rate will increase inflation and boost the
economy.