Lesson 9: What is the Federal Reserve?

What is the Federal Reserve?

November 26th, 2011 by

the federal reserveThe Federal Reserve (the “Fed”) is the central bank of the United States.  Whether it be directly or indirectly, the Fed has an enormous impact on US interest rates.   Interest rates on everything from a savings account to a 30 Year corporate bond are affected by the decisions of the Fed.  While the Fed has the authority and responsibility to regulate the solvency of banks, most people (particularly bond holders) focus on the Fed’s influence on interest rates and the economy.

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If you look back at economic growth over long periods of time, you will notice that economies are cyclical.  This means that economies tend to move from periods of high growth to periods of slow or negative growth, and is also referred to as the “boom and bust cycle”.  The Fed functions on the theory that the government can influence the economy, and play a role in making both the ups and downs of the economy less drastic.  They do this by focusing on their primary goals of price stability (trying to avoid high levels of inflation or deflation) and full employment (trying to keep the economy growing at a rate where unemployment is low).

How does the Fed influence the economy?  Primarily they do this by increasing or decreasing the supply of money in the economy, which in turn affects interest rates.

Interest Rates and The Money Supply

Interest rates can be seen as the intersection of the supply and demand for money.  All else being equal if the supply of money available in the economy rises then interest rates should fall.  Conversely if the supply of money available in the economy decreases then, all else being equal, interest rates should rise.

Key Concept: An increase in the money supply generally equates to lower interest rates.  A decrease in the money supply generally equates to higher interest rates.

How Interest Rates Affect the Economy

When interest rates rise the cost of borrowing money increases.  All else being equal, if the cost of borrowing rises then individuals and businesses borrow less, and economic growth should slow.  When interest rates fall the cost of borrowing money also falls.  All else being equal, if the cost of borrowing falls then individuals and businesses should borrow more, and economic growth should quicken.

Key Concept: Higher interest rates tend to slow economic growth. Lower rates tend to accelerate growth.

The Federal Reserve, The Money Supply, and Interest Rates

While the federal reserve has a number of tools to affect the economy by far the most used and most important is their ability to increase and decrease the supply of money in the economy.  If the Fed thinks the economy is growing too quickly and inflation is a concern, they will sell government securities.  This lowers the supply of money available in the economy and causes interest rates to rise.  If they think the economy is growing too slowly and high unemployment is the primary concern, they will buy government securities.  This increases the money supply and causes interest rates to fall.

Key Concept: Through the buying or selling of Treasury Bonds, the FED has the ability to increase or decrease the money supply.

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