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This article discusses the increase in the United States Federal Reserve (Fed)

interest rate from 0.5 to 0.75 per cent in December 2016. The article accredits this
shift in monetary policy to confidence in the economic outlook and that inflation
will track closer to the two percent target. Monetary policy, are actions taken by
the central bank, in this case the Fed, to control the money supply with various
tools, including interest rate, to address a macroeconomic objective, in this case
dampening inflation

The article states, virtually all signs from the U.S. economy are showing
signs of improvement. This indicates high levels of economic growth and real
national output (GDP) (Y) and low unemployment. As the economy approaches full
employment (LRAS), labour shortages cause firms to give higher wages to
employees. Increased aggregate demand, measured by total expenditure, exceeds
what firms are able to supply causing firms to increase prices, resulting in demand
pull inflation. The Fed policy reduces inflation by hiking up the interest rate. The
impact of this is shown below:

Diagram 1

Impact of contractionary monetary policy


Higher interest rates cause AD1 to shift left to AD2 since there is less
spending. As the article states, the higher rate will affect what the savers and
borrower get on their variable rate. The increased interest rate means that there is
an increased cost of borrowing, resulting in increased cost of investment which
impacts both households and firms. Loans become more expensive; firms are likely
to reduce capital investment due to the increased opportunity cost of expanding the
business and households are less likely to invest in durable goods such as cars if
borrowing money is more expensive. Increased interest rates also increase return on
savings and this further incentivises households and firms to decrease consumption
and promotes saving. Consequently, the decrease of AD also decreases price level
from P1 to P2 as there is less demand-pull inflation. This shift causes the real output
to decrease from Y1 to Y2 as economic growth slows from the decrease in AD. Thus,
this is a contractionary monetary policy which would increase the cost of investing
to slow economic growth and prevent inflation.

The use of a contractionary monetary policy is advantageous as monetary


policies are easily implemented and easily adjusted once in place. Should the hiked
interest rate not yield the desired macroeconomic effect, they can raise or lower the
interest rate accordingly. Furthermore, because monetary policy is governed by the
Central Bank rather than the government, it operates independently and is
politically neutral. This allows policies to operate regardless of political stability or
popular opinion. Monetary policies also operate in anticipation of future inflation
which means that the policy is set in place before the problem becomes present

However, there are many uncertainties regarding the effects of a monetary


policy. The macroeconomic effects of a shift in monetary policy take time to reflect
observably to the GDP due to the time lag. Between effecting GDP and effecting
inflation, there is yet another time lag. Economic uncertainty, referring to the
unpredictability of the future economy, makes it difficult to determine how
households and firms will react and the final outcome. This is especially important in
this case since there is the possibility of causing a negative growth due to the
contractionary nature of the policy. If households and firms decrease their spending
too much, this may cause a recession. This would be counteractive to the objective
of maintaining the 2% inflation rate. In order to address inflation directly, fiscal
policies may be needed.
With the implementation of this policy, there is much uncertainty to the
consequences. In order to meet the 2% inflation goal from the current rate of 1.6%,
the economy must continue to experience significant growth and overcome the
contractionary policy. The central bank and the government must be prepared to
face unanticipated outcomes. Along with the strengthening economy, there is the
expectation of future inflation. The current monetary policy will only be effective in
the short run. The Feds can continue to control the inflation rate through interest
rate hikes should there be a sudden hyperinflation. if the AD falls to where the
economy enters a recession, an expansionary fiscal policy such as tax cuts may be
needed to promote economic growth.

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