The financial markets have been in turmoil due to the credit crunch, housing market and the fall out from the sub-prime mortgage crisis. This anxiety has made banks and mortgage companies less eager to lend, opening the doors for the Feds to slash interest rates.
On Tuesday, December 11, 2007, the Fed’s cut interest rate by a quarter percentage point, to 4.25%, this not long after two other rate cuts earlier this year. This rate cut should help keep adjustable-rate mortgages affordable, which may help the housing slump.
In conjunction with this cut, the Fed also lowered its discount rate, the interest rate it charges banks for loans, by a quarter percentage point, to 4.75% (Mankiw, Macroeconomics, Chpt.19, pg. 516).. This will allow banks to obtain the cash they need to ease the borrowing of money between banks and consumers. By reducing the discount rate, and not the federal funds rate, which is the interest rate banks charge one another for overnight loans, the Fed quickly injects liquidity into the banking system (Mankiw, Macroeconomics, Chpt. 11, pg. 312). This will increase the monetary base and money supply, to help ease the credit crunch in housing and mortgage lending, to stimulate moderate growth over time (see graph on page 2).
Only time will tell if the Fed rate cuts will help restore confidence in the U.S. economy. The rates cuts can help stimulate growth, but let’s take a look at the short-term. Because of the downturn, in the short run, the risk of inflation and recession are still unclear, due to a weakening dollar and higher oil prices. A dollar’s decline can help boost gross domestic product, which helps exports, by making them relatively cheaper and more competitive and hurts imports by making them ...