How do the federal funds rate, inflation, and the unemployment rate all relate to each other?  How does the Fed's monetary policy affect you in your daily life?  Be specific.

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kipling2448 eNotes educator| Certified Educator

The relationships among federal funds rates, inflation and unemployment are a little complicated, especially where the latter, unemployment, is concerned.  Federal funds rate is a subset of monetary policy, so is distinct from inflation and unemployment.  Briefly, monetary policy refers to the process by which the nation’s central bank, the Federal Reserve, and its governing body, the Board of Governors, operating through its Federal Open Market Committee, dictates interest rates in an effort at minimizing the rate of inflation without adversely affecting the ability of businesses to borrow the financing necessary to expand operations and remain competitive.  The Federal funds rate is a component of monetary policy that determines the rates at which banks can borrow money from the Federal Reserve System and determines the rate that banks charge each other when transferring cash among themselves. 

As noted, a primary objective of monetary policy has historically been controlling rates of inflation.  The more money poured into the financial system, the old theory went, the more buying power enjoyed by consumers, which pressured demand, causing prices to rise.  Increasingly, however, many economists (an academic field of remarkably little consensus regarding virtually all economics) are refuting the connection between monetary policy, including federal funds rates, and inflation, arguing instead that inflation is principally caused by what they call “demand/pull,” meaning prices rise as demand for goods outpaces the supply of those goods, to which one could logically respond, “well, duh.”  It is, then, the relationship between “demand/pull” economics and inflation that would seem to be of interest.  One could logically argue that, when the Fed eases up on money supplies, and businesses respond by reinvigorating their activities, that supply will grow to meet demand, which would put downward pressure on prices.  Conversely, however, instances of hyperinflation have historically occurred precisely when supplies of cash grew excessively, devaluing the value of that currency and causing prices to rise astronomically.  Lost somewhere in this discussion is the connection between money supply and inflation.  The late free-market theoretician and Nobel laureate in Economics Milton Friedman noted the following:

Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. ... A steady rate of monetary growth at a moderate level can provide a framework under which a country can have little inflation and much growth. It will not produce perfect stability; it will not produce heaven on earth; but it can make an important contribution to a stable economic society.”

Regarding unemployment levels, the challenge, again, has historically been to minimize both inflation and unemployment, as the two have frequently been perceived as inextricably linked.  The role of monetary policy is to keep the economy growing every single year, and at relatively high rates – a daunting challenge.  Employment improves, obviously, when new businesses start-up, and when existing businesses expand.  In order for many businesses to expand – especially with publicly-traded companies, much of the profits of which are issued to stockholders rather than conserved and reinvested in the company – they need to borrow money.  Borrowing money only becomes economically viable when interest rates are low enough to allow for the taking of loans and consequent assumption of debt.  When the Fed raises the federal funds rate, it becomes more expensive to businesses to borrow, and growth slows, causing employment rates to stagnate or contract. 

How the Fed’s operations affect an individual in his or her daily life can occur at two levels.  The first level can involve the owner of a small business, or even a large business.  That owner wants to borrow money to expand operations to meet perceived demand.  Whether he or she can borrow that money, however, is dependent upon the interest rates banks are charging.  At the more individual level, an un- or underemployed worker who hopes to be hired by this company after it expands loses that opportunity to increase his or her earning potential if the bank’s borrowing rates exceed what the business owner can afford to pay. 

At another level, the Fed’s actions routinely affect consumer decisions by determining the cost of many goods.  When contemplating the purchase of a new car, for example, for which a loan is necessary, the decision will very often hinge on the rate of interest the loaning agency (the automotive manufacturer’s financing division or a bank) offers.  When rates are lower, it is less expensive to borrow, so the purchase occurs, which helps the people who provide the raw materials that go into the car’s production, the people who assemble the car, and the people who sale and repair it.  Because the Federal Reserve System dictates interest rates, it has tremendous influence over the entire economy.