Economics Made Economical

What Is The Federal Reserve?

The Federal Reserve Bank, or the Fed, is a private organization that works closely with the federal government. It is the most important bank in the nation and sets our economy’s most basic interest rate, the interest rate at which banks loan other banks money for a one-day period.

The Fed Rate is the nation’s lowest interest rate applied to borrowed money at any given time. Why is this? Because banks, theoretically, should not profit in the long term from money loaned out at such a rate. The Chairman of the Federal Reserve, Ben Bernanke, generally has the most control over whether or not the Fed Rate is changed. This is done in an attempt to stabilize our economy, depending on whether we’re in a recession, an expansion, whether our currency is inflating, deflating, and several other factors.

Because theoretically the Fed Rate should be a rate at which banks neither gain nor lose money when loaning money to each other overnight, in order to make a profit off of customer loans a higher interest rate must be charged. Similarly the converse is also true. If a bank wishes to be loaned money by a customer, a rate lower than the Fed Rate must be charged so that the bank is able to reinvest the customer’s deposits and garner a higher return than they’re giving the customer.

Some Examples:

Let’s assume the current Fed rate is 5%. It’s likely that bank loans to customers (mortgages, credit card rates, installment loans, etc) will come with an interest rate of at least 7 or 8%. I’m being very generous here. I’m sure most of us would love to find a credit card that only charges 7%. If the Fed Rate is 5% it’s also likely that customer loans to banks (direct deposits, savings accounts, CD’s, etc) will come with a rate significantly lower than 5%. Many checking accounts do not provide any interest. Many banks’ savings accounts give their customers a whopping 1% or less. When a bank is able to borrow our money at a 1% APR and loan it out at an 8% or 13% or 25% APR, it is easy to understand how the banking industry has the power to cause major problems for our country’s overall economy.

The Fed’s Role

Abolishing the Federal Reserve Bank is not the solution to our economy’s problems. Strictly enforcing antitrust regulation and preventing banks from merging into nation-wide (or worldwide) monopolies and oligopolies is the solution. Local banks need governmental support so they’re able to compete on a level playing field with the massive corporate banks. Given a choice between a credit card with a 25% APR from a monopolistic banking entity or one with a 10% APR from a small local bank in market with near-perfect competition, nobody would hesitate to take up the smaller bank on its offer.




    1. Who Is Herman Cain? « econprofessor
    2. Is Ron Paul a Serious Contender? « econprofessor
    3. The Fed’s Job « econprofessor
    4. Why Doesn’t The Fed Set The Interest Rate To Zero? « econprofessor
    5. The Glossary, Part II: Fiscal Policy vs. Monetary Policy « econprofessor
    6. Fed Decides Not To Change Interest Rate « econprofessor

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