The Effect of the Federal Funds Rate on Business Inventories

In the news, we constantly hear about the Federal Funds rate and how important it is. However, why is it important and what effect does it have on businesses? In this article, we are going to look at the relationship between the fed funds rate and the changes in business inventories. In order to determine what, if any, relationship that there would be between the two, we need to look at a couple of items. First of all, we are going to look at the fed funds rate and the same month growth in business inventories from 1981 and 2000 to determine if there is any relation between the two. To determine if there is any relationship, we will look also at short and long-term interest rates and exchange rates in their relationship to the fed funds rate.

Looking at the fed funds rate from 1981 to 2000 and comparing that with the same month growth in business inventories, we can see that there is a relationship. Looking at the graph, whenever the fed funds rate has decreased, there has been a decrease in the same month growth in business inventories. The same is true when there has been an increase. Taylor argues that there are a number of examples that show there is a relationship between monetary policy and implications to aspects of our economy. Using Taylor's argument, and applying it to business inventories, we will see that there is a relationship to the fed funds rate.

Taylor looks at how short-term interest rates have a simple relationship with the fed funds rate. He tells us that simply, if the central bank wants to lower interest rates, than all it has to do is increase the money supply, which is the fed funds rate. So when the fed funds rate is increase, or they increase the money supply, then short-term interest rates will decrease.

When we look at exchange rates, Taylor shows that there is a major correlation between the fed funds rate and exchange rates. He tells us that the interest rate difference between any two countries is equal to the expected rate of exchange. So, if a central bank decides to raise short-term interest rates, the expected exchange rate should increase. The reason for this is expected return on money. If the interest rate difference is so great that people will make a lot more money, then countries will pour money into the country until it balances out and the exchange rate changes. Taylor provides us with a graph showing the correlation between real exchange rates and real interest rates over the years.

When looking at long-term rates and their relationship with short-term rates, Taylor argues that there is a relationship there as well. While he does point out a lot of problems and other things that affect long-term prices, he shows that there is no denying the relationship. He shows that when short-term interest rates decrease, so do long-term interest rates. However, he also shows that this is only short-term, and that there is other factors in our economy that will change the long-term interest rate.

So overall, when we look at long-term interest rates, the exchange rate, and short-term interest rates, we can see that there is a relationship. While Taylor shows that there are flaws in each of these, and people will be quick to point those out, there is no denying that there is, at least to some degree, a relationship. But has this relationship changed over the years? Yes it has. According to Taylor, the relationship today has less of an effect than it did years ago. Taylor provides a graph looking at two different time periods for the U.S., Germany and Canada. The U.S. had the greatest change, but there has been a change.

So when we look back to our graph looking at the relationship between the fed funds rate and the same month change in business inventories, we again see that there is definitely a relationship. However, just like Taylor points out, the relationship has lessened over the past thirty years. When you look at the graph, we can see less of a shift in business inventories when there is a change in the fed funds rate. In fact, at one point between the years 1995 and 1999, when the fed funds rate was going up and down, the same month growth in business inventories was almost held the same, it was very consistent. So while there still is a relationship, that relationship has a lesser effect. What have we learned about the fed funds rate and its effect on the economy? Most people, Keynesians and Monetarists, must agree that when the fed funds rate changes, so will other things in the economy. However, that change is not the end all be all in our economy, it is only one step in a complicated system.