The Federal Reserve is responsible for maintaining full employment (generally considered to be around 4 to 5 percent unemployment) while keeping inflation low. This task may sound simple but, in reality, it’s a delicate balancing act.
The most powerful weapon in the Fed’s arsenal is the ability to influence the direction of interest rates. When interest rates are low, capital is easier to acquire. This can spur economic development because, human nature being what it is, the more cash you have available, the more you are likely to pay for something you want – whether it is a car or that new plasma screen television. Left unchecked, however, and the result is “too much money chasing too few goods,” as the saying goes. This leads to inflation as businesses realize they can charge higher prices for their goods and services. Suddenly, it costs you more to fill up your gas tank and refrigerator.
If interest rates are too high, however, the result can be a recession and, in extreme cases, deflation; the result of which can be economically devastating – imagine going to pay off your mortgage and realizing that, although the balance has not increased, it’s going to cost you more dollars in terms of purchasing power than it did before!
How can the Federal Reserve influence the direction of interest rates? In one of two ways:
By raising or lowering the discount rate.
By indirectly influencing the direction of the Federal funds rate.
The Discount Rate
The discount rate is the interest rate banks are charged when they borrows funds overnight directly from one of the Federal Reserve Banks. When the cost of money increases for your bank, they are going to charge you more as a result. This makes capital more expensive and results in less borrowing. Spending decreases, causing it to become more difficult for prices to rise; the opposite being true when capital becomes less expensive due to a decrease in the discount rate.
