Of all the ways the Federal Reserve controls the money supply, the one that gets the most publicity concerns interest rate changes.
You will see all kinds of speculation about what the Federal Reserve will do before such meetings, which affects the stock market. You will also hear media reports about how changes in the interest rates will affect interest rates for consumer items, such as mortgages and credit cards.
All of this media attention and speculation is a bit misleading, because any changes the Fed makes in the interest rate do not affect consumers directly. The interest rate, also called the discount rate, does not refer to your credit card interest. It refers to the interest rate the Federal Reserve banks charge commercial banks when they borrow money.
The Fed changes the discount rate to make it more or less profitable for commercial banks to borrow money. The banks use this borrowed money to make loans to their customers.
These are the essential points to keep in mind: 1. The purpose of the Federal Reserve system is to control the amount of money in the system. 2. The purpose of commercial banks is to make money. They make money by loaning money to borrowers.
Whenever the Fed increases the interest rate that the commercial banks must pay to borrow money, the banks cannot make as much profit on their loans to its customers. When the Fed decreases the interest rate, the commercial banks can make more profit on their loans to bank customers.
Even though this change directly affects banks, Fed rate changes affect all of us, because they change the speed of money. If banks can loan more money at lower costs to the banks, the increased loans will increase the amount of money available in the entire economic system. If the banks have less money to loan, because the banks have to pay higher rates to borrow the money, money will increase more slowly.
The critical point is that consumer interest rates are not directly related to changes in the Fed interest rate. The Fed does not change consumer interest rates. The banks might change your interest rates on credit cards or your adjustable rate mortgage, but the change is not directly tied to changes in the rate the Fed charges banks to borrow money.
By Kalinda Rose Stevenson, Ph.D.
Article Source: http://www.orbitaloc.com/
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