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How The Federal Reserve Uses Interest Rates To Control The Money Supply
Welcome back!
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.
This media attention obscures an important fact. The interest rate, which is also called the discount rate, concerns the rate commercial banks must pay when they borrow money from Federal banks. The interest rate changes do not directly affect your credit card interest rate.
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.
Keep these two purposes in mind:
- The purpose of the Federal Reserve is control the amount of money in the economy.
- The purpose of banks is to make money by loaning money to their customers.
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.
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