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Real rate of interest

Question: Hubbard argues that the Fed can control the Fed funds rate, but the interest rate that is important for the economy is a longer-term real rate of interest.   How much control does the Fed have over this longer real rate?

Answer:

It is true that the Fed can control the short term interest rates through its monetary policy. However, the long term interest rates are a resultant of mainly variables which make the control of Fed over it difficult. Long term interest rates are formed by expectation which builds up over the period of time. Also, an external shock can cause investors to shift their money from short term to long term bonds or vice-versa which will affect both type of interest rate. Fed, in that case, can control the short run interest rate by monetary policy changes, but the long term rates will depend upon how the investors perceive that monetary change. Based upon their perception and expectations about the future, they decide their investment decisions which decide the long term interest rates.

 

 

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