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How does Federal Reserve Manipulation of Interest Rates Affect the Business Cycle?

I was in high school during the 2008 Great Recession. The significance of that event made me critically question our current economic system. It made me very interested in how our system of money and banking works. This path of inquiry led me to research and understand the truly complicated and underdiscussed issue of fiat currencies, and the subsequent powers that gives government and bank in manipulating our economy. In my opinion, the modern world has a money problem. This money problem not only translates into issues of materialism, but also is represented in poor monetary policy on the part of the societal elites. Below is a paper I wrote in high school which discusses how the manipulation of interest rates, made possible by fiat currencies and fractional reserve banking, leads to dangerous business cycles that lead to the great economic collapses we have experienced.

How does the interest Rate Manipulation Work?

            With the fractional reserve system in place, the Federal Reserve has three powers that they use to adjust the interest rates of banks to carry out their policies. The first conceptual milestone to be achieved in answering the question of the Federal Reserve’s effect on the business cycle is to understand how the fractional reserve banking system works. It is legally mandated that all banks must have a certain percentage of their reserves in the vaults at all time. Though this is a reserve requirement, banks historically never in the long run hold onto excess reserves because that would bring economic disadvantage with the other banks (until recently because the federal reserve no pays interest to banks who hold some excess reserves). Therefore, the reserve requirements end up being the universal ratio of cash a bank holds at a time. This also means, that banks historically have never have the total financial holdings of all their customers. 

The first power is referred to as open market operations, and is key to the adjustment of the federal funds rate. The Federal Fund Rate is the overnight interest rate between banks. This rate is determined between banks based upon how much money bank A’s demand of money to fill their reserves, and the supply of excess reserves bank B has at the time. This interest rate between the banks in turn affects the interest rates of borrowers and investors. The Federal Reserve manipulates these interest rates by indirectly filling bank’s reserves with money. The Federal Reserve does not do this by simply printing money and giving it to bank B, but rather printing some money and purchasing Treasury bonds (or in the case of the 2008 period, Mortgage-Backed Securities) off of the open market. The money then, that the individual earned from selling the bond(s), will then eventually end up in the bank’s which will then either cause bank A to have less of a demand for money to fill their reserves, or cause bank B to have a higher supply of reserves, thus lowering the federal fund rate.

The second power is similar to the first in the sense that it also affects the federal fund rate but it done through the adjustment the reserve requirements. A bank’s need for money is based upon their reserve’s relationship with the reserve requirements. Therefore, the second power is the ability to lower (or raise) the reserve requirements of all banks, which will cause bank B to not have as high of demand for a loan, and will cause bank A to have a higher supply of excess reserves to loan.

The third power is the direct adjustment of the discount rate which is the rate between a depository institution and the Federal Reserve itself. These kinds of loans exist when a bank, like bank B, would rather loan from the Federal Reserve than other banks. However, as the Federal Reserve is only supposed to be a lender of last resort, the discount rate tends to stay higher than the federal fund rate.

These three powers cannot be performed independently without the consideration of the other. The power to buy bonds and adjust reserve ratios has a large effect on the economy’s money supply; Monetary base and M1.  This can be seen not only from the fundamental process at which these interest rates are manipulated, but by the law of supply and demand. Suppose the Federal Reserve wishes to lower interest rates, however there is a fixed amount of loanable cash and a fixed amount of demand (ceteris parabis). If the government is to artificially lower the interest rates, there will be a shortage of loanable funds, but an increase in demand for loans. As loans are not a product that can simply be produced like most goods in the economy, the only way to deal with this shortage is for the government to print the shortage of loanable goods. With this increased supply of loan-able funds, there is then a lower price, and higher demand. This also means then, that these two functions cannot be done at free will because they can result in rampant inflation of even hyperinflation due to the increased money supply. The discount rate also is centralized around the federal fund rate so one is usually adjusted around the other in order for there to be balance in reserves across the system.

One reason the Federal Reserve has these powers is so that it can manage the economy and therefore the business cycle. The ability to adjust interest rates grants them the ability to monitor the rate at which people save and borrow. Higher interest rates will cause people to save more, and borrow less. In contrast, lowering interest rates will cause people to save less and therefore spend more which causes inflation (due to the process of lowering interest rates and the increase in the demand for overall goods) giving the market incentive to spend even more. This would be the growth time in the business cycle. The Federal tries to avoid the contraction aspect of the cycle by keeping interest rates down and keep inflation existent so people keep spending and not saving. The question that must therefore be asked is does this manipulated of the free market and these therefore artificially created interest rates affect the market in a negative way?

Artificial Interest Rate Cycles

What must first be noted is that in an artificial interest rate cycle, interest rates are pushed down in order to regulate the economy. The manipulated business cycle that will then be discussed is one in which interest rates are artificial lower than would have been without the Federal Reserve’s intervention.

In an artificially low interest rate business cycle, growth consists of massive consumption. Not only are interest rate low, which increases the demand for business and individuals to loan money to spend. But there is a touch of inflation due to the increase in the money supply. Demand for goods then much higher because people do not want to hold on to their money that is losing value. Not only that, but there is also no benefit to hold in banks because of the low interest rates. For these reasons, consumption increases, and savings are depleted. (As a side note, I would argue that the existence of this system is a large reason why we see such materialism and consumerism within modern day culture.) As savings deplete, supply for loan able cash drops, and prices will rise, but the Federal Reserve, in order to continue the growth, keep pushing rates down and increase the money supply more and more. This continuation of inflation also causes the market to begin to speculate continuingly rising prices. A strong example of this was the housing market before the financial crash of 2008. As people began to purchase houses because of their perceived value of always going up, prices rise.

As the prices for houses steadily went up for such duration of time and a rampant rate, people would view this trend to be never ending, further adding to the amount of people entering the market, making prices rise even more. Of course, this also means that the allocation of resources has very much shifted away from other goods that otherwise would have been purchased, and has now shifted toward housing or the various markets of the stocks being purchased. Keep in mind, that the increased demand for houses was not due to any increase on intrinsic need for house, but simply because people were wishing to gamble on the price going up. This is why we call it a “bubble” because it was being filled not with true value, but “air”

Inevitably, the growth period ends and the contraction begins. During the Federal Reserve induced growth session, prices were extremely high from everyone taking cheap loans and making money off of speculation. Once a contraction hits, prices begin to fall and people begin to save. This means that aggregate demand falls, and so do prices. This causes the speculation markets to radically loose demand because there are no longer people believing prices will rise. and as prices fall, all the people who owned a house or stock will lose money on their investment.

            After the prices fell, people immediately wished to leave the market and sell their house, and nobody wanted to enter the market and buy houses because the market no longer had the perceived future value as it did before. This caused a massive drop in house prices, and caused all the people who owned a house, lose money. Furthermore, most people made these investments with loans which now they can no longer pay back. Banks then can go bankrupt because of all of the new faulty loans, unemployment increased because businesses that made malinvestments now must lay off workers, and people will then begin to panic because the market is contracting and they had accumulated very little savings from the growth. This results in a loss in aggregate demand not only because there are no savings but because the market must recuperate after the massive amount of loan defaults and investment loss.

At the end of the cycle, the society does not seem to have made much economic process. Much of the production was shifted to houses which were only valued for their investment opportunities. Due to the massive debt and sharp drop in aggregate demand, there are also much less goods being produced as a whole as the economy must take a while to recuperate after the losses.

Natural Interest Rate Cycles

Before analyzing a business cycle with natural interest rates, a few things must initially be made clear. To have a truly natural interest rate society, the Federal Reserve would have to play no role in the economy, which would bring about the end of a mandated fractional reserve banking system. For the sake of the research question, this aspect of the argument will be left out, and the only difference between natural interest rate cycles and unnatural interest rate cycles will be that there will be no price controls on interest rate. The interest rate is determined by the supply and demand for loanable funds at the time. Where are also to assume inflation is near or below 0%. This is because if there is no manipulation of interest rates, the function of printing money to lower interest rates is non-existent.

With that said, the first difference that must be discussed is the demand for goods aspect during the growth time. In a natural interest rate growth time, the aggregate demand for goods over the long run of the growth period is much less than in an unnatural interest rate cycle. This is because, as the growth continues, the amount of loan able funds decreases because of the consumption. Interest rates then will gradually rise because of the gradual loss in supply of loan-able funds. savings will also be much higher in this cycle.

            As there is no flagrant expansion of the money supply, the demand capital is higher and interest rates are higher. With interest rates being higher, the incentive for saving is also higher. The allocation of goods is then much different in this cycle, because as it becomes more profitable to save, on top of the fact that there is very little inflation, there will be less speculative spending. Which means there won’t be overproduction of ventures like housing, which allows the market to allocate those resources to goods that increase welfare of everyday life.

What follows is the transition into contractions. In this business cycle, because more and more loan-able funds are being used up and savings begin to increase, a contraction period begins when the interest rates are too high and aggregate spending has transitioned to be higher than aggregate spending. During this time, as people begin to save more than they spend, interest rates will gradually begin to fall again. Similar to an unnatural interest rate cycle, prices will decrease, and there will be an increase in unemployment. The difference is during the growth time aggregate savings was higher than unnatural interest rate aggregate savings due to the price adjustment of interest rates. Which means all those who are now unemployed have more savings and are better off, and can spend more money.  There is also much less defaulting on debt because there were much less people acting on investment strategies in speculative markets because there were much fewer and smaller speculative markets. Due to all of this savings that now exist rather than the malinvestment and bankruptcy that existed in a Federal Reserve induced recession, more spending and consumption can be directed toward the production of goods. This leads to a much smoother, less volatile, and steady cycle.

At the end of a full natural cycle the production and demand for goods is much different without the Federal Reserve. Due to the absence of large growth and extreme contractions in a natural cycle, there were much less people who go bankrupt and default on debt. Due to all of this savings that now exist rather than the malinvestment and bankruptcy that existed in a Federal Reserve induced recession, more spending and consumption can be directed toward the production of goods. There is also a massive difference in the kind’s goods produced. Rather than having over production in commodities that were largely produced solely for their investment and perceived future market value, the market allocated goods to places where people demanded them for their lives. There is then much less misallocation because goods were bought for their consumer value rather than investment value.

Conclusion

To answer the question of: How does the Federal Reserve’s artificial adjustment of interest rates compared to natural interest rates affect the business cycle? One must observe the allocation of goods because of their profound their relationship between people’s wealth and welfare. In order to find the difference of allocation of resources in the two cycles, a business cycle with artificially low interest rates was observed. In this cycle, large speculative markets cause the allocation of resources to be directed to goods that are produced largely because of their perceived investment value, and not solely for their welfare value like most other goods. Furthermore, the massive debt and malinvestment that accumulates once the contraction occurs, disallows for increased wellbeing because there are less goods being produced.

            To gain a full understanding of the negative effects of the Federal Reserve’s adjustment of interest rates, one must also inspect what a business cycle would look like without the adjustment of interest rates. In this business cycle, there is less demand for speculative markets, and so the allocation of resources is directed to increased welfare goods, which depletes the issue of overproduction. Furthermore, there is a much more stable system of savings and spending, which lowers the amount of people going into bankruptcy once contractions hit. This allows for more goods and services to be purchased even when the economy is recovering from the growth. This is another reason why the allocation of resources is better because of the fact that there is much less malinvestment, which causes loss in productivity.

It is then evident that unnatural interest rates simply worsen a necessary part of the business cycle. It causes certain prices to go way beyond their true value (plus causes overall inflation), which causes people to end up in debt and causes the market to have case malinvestment and misallocation of goods. People during the time of need, will not have savings to fall back on or accumulate for the next boom.

By Sydney Bright

Passionate about understanding the human body in terms of health and happiness, Sydney Bright aims to use modern scientific research to promote more ancient wisdom. As a young child, Sydney attended a Chinese immersion school, where he was introduced to not only the Chinese language, but Chinese culture and traditions. His immersion education continued through high school, instilling within him a deep respect for philosophies surrounding holistic health and well-being. With a Master of Science degree, Sydney dives deep into the scientific literature to explain the importance of holistic health, in a new and modern way. It is his sincere intent and hope that those who read his work gain a new perspective on how to promote well-being in their own lives.

See more of his work at: themindfulinquisitor.com

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