The most widely publicized way the Federal Reserve controls the money supply is by changing its interest rates.
Before scheduled Federal Reserve meetings, the media will report about the effect of any possible interest rate changes on consumer items, such as credit cards and mortgages. It is typical for the stock market to react before the meeting, based on speculations about what the Fed might do with interest rates.
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.
The change in the discount rate affects the commercial banks directly. It makes it more or less profitable for the banks to borrow money, which the banks then loan 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.
It is a matter of profit. If the banks must pay more to borrow money whenever the Fed raises the interest rate, the banks make less profit from their loans to customers. If the banks can pay less to borrow money whenever the Fed decreases the interest rate, the banks increase their profit from loans to customers.
When the Fed changes the interest rate it charges banks, this affects the speed of money in the economic system. The lower the interest rate, the faster banks can loan out money and increase the amount of money in the system. The higher the interest rate, the slower banks can loan out money. So, even though the interest rate directly affects banks, these rate changes matter to all of us.
Ultimately, a change in the Fed interest rate might affect the interest rates on your credit cards and adjustable mortgage, but it is not a direct result. The Fed does not change consumer interest rates. Banks do. If your interest rate goes down on your credit card, it because the bank decided to lower the rate, not because the Federal Reserve changed its interest rate.
By Kalinda Rose Stevenson, Ph.D.
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