The Fed’s Job
One of the Federal Reserve‘s most important jobs in protecting our economy is stabilizing our nation’s price level, protecting our society from extreme levels of inflation or deflation. They achieve this by controlling the interest rate that banks pay on overnight loans to one another. When the news reports that the Fed Chairman has raised or lowered interest rates (usually by .25% or .50% at a time), it is this rate that they are talking about.
Why Change Interest Rates?
Altering interest rates might, at first glance, appear to be a pretty purposeless thing to do. But the interest level is possibly one of the strongest forces that can impact our in economy. Interest levels affect everything from consumption and purchases, to unemployment levels, from inflation to taxation. The basic gist of it is that as interest rates increase we are more likely to invest and save our money, and as the rates decrease we’re more likely to spend our money.
Generally whenever the interest rate becomes either too high or too low, the economy will suffer a recession period. It is the Fed’s legal obligation to do whatever they can to prevent that. Sometimes they have better luck than others.
A low interest rate makes borrowing money more attractive than loaning money. If you could choose between paying a bank a 1% APR to loan you $10,000 or have a bank pay you 1% APR to keep $10,000 of your money, most of us would choose to take the loan. Thus times of low interest rates tend to cause an increase in bank loans, an increase in new homes being constructed, new cars being purchased, new businesses being created, and the everyday citizen making more purchases more often because it’s likely that the inflation rate is higher than the interest rate. Short-term savings becomes useless for most people.
The same things occur within the government: they are more likely to borrow money, spend that money, create new jobs, and innovate while it’s cheaper to do so. When all of this occurs, the GDP increases, employment increases (the unemployment rate decreases), and our economy enters into an expansionary period. Therefore the Fed’s ability to lower interest rates is, usually, one of our country’s best tools in combating recession.
These duties that the government has entrusted to the privately-controlled Federal Reserve Bank are known as economic Monetary Policy. In contrast, the actions that government agencies can take to influence our economy is known as Fiscal Policy.