How The Fed Uses Interest Rates To Control Money

By: Kalinda Rose Stevenson, PhD.....

Interest rate changes are the most widely publicized method the Federal Reserve uses to control the money supply.

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.

Despite this kind of media attention, the interest rate changes do not directly affect consumers. When the Fed announces a change in interest rate, it does not affect your credit card interest rate directly. It refers to the interest rate the Fed charges commercial banks to borrow money from the Federal banks. This is also called the discount rate.

Whenever the Fed changes the discount rate, it does so to either make it more or less profitable for the commercial banks to borrow money from the Fed to make loans.

Keep these two purposes in mind: 1. The purpose of the Federal Reserve is control the amount of money in the economy. 2. The purpose of banks is to make money by loaning money to their customers.

If the Fed makes money more expensive for the banks to borrow, the commercial banks cannot make as much profit on loans it makes to its customers. When the Fed makes money cheaper for the banks to borrow, the commercial banks are more willing to loan money to its customers.

This is why the change in interest rate matters to all of us. It increases or decreases the amount of money available for banks to loan, which increases or decreases the amount of money in economic system. These changes affect the speed by which money is increased or decreased.

The bottom line fact is that the Fed does not change consumer interest rates. The banks might decide to change interest rates on credit cards and adjustable rate mortgages, but these changes are not directly tied to any changes the Fed makes in the rate it charges banks to borrow money.

By Kalinda Rose Stevenson, Ph.D.

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