Jennifer Wilber works as an ESL instructor, substitute teacher, and freelance writer. She holds a B.A. in Creative Writing and English.
Interest rates are an important tool of monetary policy used by the Federal Reserve to control the United States economy. The Federal Reserve can control every economic variable and attempt to promote economic stability and growth by controlling interest rates, either directly or indirectly. But how exactly does the Federal Reserve decide when interest rates should be increased or decreased, and how does the Federal Reserve use its influence over interest rates to control the economy?
What is Interest?
Before we can look at how and why the Federal Reserve, or Fed, controls interest rates, and how interest rates affect the economy, we must first look at what interest is. Interest is the price that the borrower pays the lender in order to borrow money. Interest exists to compensate lenders for the effects of inflation, and for the risk that the borrower won’t pay back the loan. If the lender is a bank, interest also covers the cost of staying in business (Interest Rates: An Introduction). Interest rates are a vital tool of monetary policy used by the Fed. The two interest rates that the Fed influences are the discount rate, which the Fed controls directly, and the federal funds rate, which it only has indirect influence over. The Fed uses these rates to exert control over the money supply and other economic variables.
The Discount Rate
When banks take out short-term loans from the Fed through the Discount Window (the Federal Reserve’s lending facility), the rate of interest that they are required to pay is the discount rate. When the discount rate is lower, commercial banks are likely to borrow more from the Fed, which will increase the amount of money that banks have available to lend. Since there will be more money available for banks to lend, the amount of money in the economy will also increase (Money, Banking, and the Federal Reserve). Because the Federal Reserve is meant to be a “lender of last resort,” banks should try to borrow from another lender, such as another bank, before asking to borrow from the Fed (Interest Rates: An Introduction). Because of this, the federal funds rate is much more important.
The Federal Funds Rate
The federal funds rate is the rate that banks pay to borrow reserves (the amount of money that banks are required to keep on hand in cash or as deposits in their account at a Federal Reserve Bank, based on their demand deposits) from each other. This rate is determined by the supply and demand of bank reserves and fluctuates daily. While this rate is not directly controlled by the Federal Reserve, the Fed does strongly influence it with open market operations (Tarr). Before we can look at how the federal funds rate affects our economy, we must first look at how the fed uses these open market operations to influence this rate.
Open Market Operations
The Federal Open Market Committee, or FOMC, meets eight times a year to decide on short-term interest rate targets (Inflation: Inflation and Interest Rates). To reach these interest rate targets, the FOMC uses open market operations, or the purchase and sale of government securities on the open market, to influence the federal funds rate. When the FOMC purchases securities from banks, the Federal Reserve creates the funds needed to pay the seller simply by electronically increasing the balance in their reserve account. With the sale of securities, the opposite occurs. When the Fed removes funds from the purchaser’s reserve account, the money simply disappears (Edwards 862). Because a bank’s reserves at the Fed drops when the bank purchases securities, and because banks are required to maintain a certain level of reserves at the Fed, the bank must borrow more from other banks. Since there is more demand to borrow money, the federal funds rate will naturally increase (Stitt et al). Even though the federal funds rate is set by the banks themselves, the Federal Reserve indirectly controls it by directly controlling the supply and demand of bank reserves with open market operations, using the interest rate targets set by the FOMC as guides.
The Fed’s target for the federal funds rate will usually be identical to the changes it makes to the discount rate. When the Fed lowers the discount rate, it generally signifies that the Fed is trying to stimulate the economy, while increases to the discount rate show that the Fed is concerned about inflation. The discount rate is usually lower than the federal funds rate, but because the Federal Reserve is a lender of last resort, banks are not allowed to borrow from the Fed for the purpose of lending the funds to other banks for profit (Interest Rates: An Introduction). Banks will generally only borrow from the discount window when overall market conditions have tightened enough to push the federal funds rate close to the discount rate. This happens very infrequently, however. A recent example of this would be the market disruptions resulting from the terrorist attacks of September 11, 2001 (Board of Governors of the Federal Reserve System 33). While the discount rate is the only interest rate that the Fed actually sets, it is still able to indirectly control the federal funds rate, and in effect, the entire banking industry. But what does this have to do with businesses and the average consumer?
How the Fed Uses Interest Rates to Control the Economy
As I have already shown, the Fed uses these rates to control the supply and demand of bank reserves, which affects the money supply in the economy. It’s possible for the Federal Reserve to manipulate the money supply by creating or destroying bank reserves in such a way because the United States uses fiat money, or money that is not backed by a gold standard. Since there is nothing to back it up, the Fed can increase the money supply by creating money out of nothing or decrease the money supply by electronically deleting funds out of existence. By manipulating the money supply, the Fed controls inflation. When there is more money in the economy, as there is when the FOMC purchases securities, the purchasing power of money will of course decrease. This is inflation (Money, Banking and the Federal Reserve). Inflation also affects the interest rates that banks charge their borrowers.
The Prime Lending Rate
The interest rate that banks charge their most creditworthy customers, usually large corporations, is the prime lending rate, which is generally about 3% above the federal funds rate, and is therefore indirectly influenced by the Fed and open market operations. The prime lending rate changes regularly to reflect changes in inflation (Inflation, Interest Rates and the Fed). When this rate is lower, consumers and businesses are more likely to borrow money. In this way, the Fed can use its influence over this rate to control the economy. By influencing the change in interest rates, the Fed attempts to achieve maximum employment, stable prices on goods and services, and economic growth.
How Interest Rates Affect Businesses
When interest rates are higher, it is more difficult for businesses to take out loans to expand (Inflation, Interest Rates and the Fed). Lower interest rates make it easier for businesses to expand because they will be able to take out loans to invest in equipment, inventories, and buildings. Since the returns that such investments will produce are worth more when interest rates are low than when interest rates are high, businesses have a greater incentive to invest when rates are low. With increased investment in businesses, the economy will grow faster since the rate of productivity will also increase (Interest Rates: An Introduction). As businesses expand, so will the production and expansion of goods and services. Since businesses will expand more quickly when interest rates are lower, they will also need to hire more employees. By influencing interest rates, the Fed can attempt to control unemployment.
How Interest Rates Affect Consumers
Lower interest rates also benefit consumers. When interest is low, consumers are more likely to take out loans to buy new homes, refinance old mortgages, and buy new cars (Points of Interest). Credit card companies also generally use the prime lending rate to calculate interest. When interest rates are lower, people will be more likely to use credit cards. Since it is less expensive to use credit cards when interest rates are lower, people will spend more, which will boost the economy. When interest rates are higher, people will also be more likely to save their money. Not only do increased interest rates make it more costly to buy goods and services, they will also cause savings accounts to have higher returns. Even the average consumer’s spending and saving habits are controlled by the Federal Reserve.
Inflation and Hyperinflation
Economic growth is not always a good thing, however. When the economy expands too rapidly, hyperinflation can occur, whereas if there was no inflation at all, the economy wouldn’t grow at all. It is the Fed’s job to maintain economic stability, with a level of inflation somewhere between the two extremes. Interest rate increases are the Fed’s way of protecting lenders against future inflation, while interest rate decreases promote economic growth (Inflation: Inflation And Interest Rates). The Fed is able to use its control over the economy, and interest rates, to keep the economy stable.
The Federal Reserve is able to control every aspect of the economy via its control over interest rates. The Fed uses this power to control economic variables such as unemployment, investment, and inflation. By maintaining control over these economic variables, the Fed is able to promote economic stability and growth. Every action taken by the Fed to control or influence interest rates affects not only the banking industry and large corporations, but also you, the average consumer.
I wrote this paper in 2007 during my junior year of high school as my entry in the Economic Research Project competition for Business Professionals of America. I won first at regionals and third at state with this paper.
Recommended for You
Board of Governors of the Federal Reserve System. "The Implementation of Monetary Policy." The Federal Reserve System: Purposes & Functions. N.p.: Books for Business, 2002. 27-50.
Edwards, Cheryl L. "Open Market Operations in the 1990s." Federal Reserve Bulletin.
(Nov. 1997): 859-874.
"Inflation: Inflation and Interest Rates." Investopedia. 2006. 16 Dec. 2006.
"Inflation, Interest Rates and the Fed." InvestorGuide. 2006. 17 Dec. 2006.
"Interest Rates: An Introduction." Federal Reserve Bank of New York. 15 Dec. 2006.
Money, Banking and the Federal Reserve. 1996. Ludwig von Mises Inst., 2004.
15 Dec. 2006. http://mises.org:88/Fed.
"Points of Interest: What Determines Interest Rates?" Federal Reserve Bank of Chicago.
2006. 15 Dec. 2006. http://www.chicagofed.org/consumer_information/ points_of_interest.cfm.
Stitt, Jeffery J., et al. "Regulation: Federal Reserve and Interest Rates." The Investment FAQ.
25 Apr. 1997. 16 Dec. 2006. http://invest-faq.com/articles/regul-fed-reserve.html.
Tarr, Rob. "Greenspan, Interest Rates & Inflation." Capitalism Magazine. 27 May 2000.
16 Dec. 2006. http://www.capmag.com/article.asp?ID=574.
© 2018 Jennifer Wilber
Brian Leekley from Bainbridge Island, Washington, USA on June 07, 2018:
Jennifer, thanks for this lesson on the Federal Reserve. It is well researched and written and deserved the awards it got.
Regarding low interest rates being an incentive for manufacturing and retail businesses to expand production or retail space and hire more workers, an even more significant factor is whether there is sufficient demand for what a business is selling to warrant expanding, and the main factor there is whether potential customers have the spending money to become actual customers. I, for example, am in need of a car and a laptop computer but don't have the money to buy either or sufficient income to afford a loan. Car and computer manufacturers and retailers considering whether and how much to expand need a realistic estimate of not only how many people want their products but also of how many of those people can afford their products. The government influences the afford to buy factor with the minimum wage rate, income tax credits, investment in public projects, etc. Of course that aspect of the economy is outside the scope of this hub.