For the very first time in its nascent history, the United States established a permanent central banking institution, thanks to the passage of the Federal Reserve Act of 1913. Today, this influential central bank – known as the Federal Reserve – is responsible for guiding the course of the U.S. economy by raising and lowering interest rates borrowers have to pay to lenders. How exactly does the Federal Reserve control interest rates? And why does the interest rate impact the broader economy so much?

Background

Prior to the establishment of the Federal Reserve in 1913, economic panics caused by banking emergencies were common events as investors would lose confidence in the safety of their bank deposits. In order to fight this sense of financial instability, the U.S. Congress authorized 12 leading national banks to legally issue Federal Reserve notes (also known as paper money), adjust lending rates these banks could charge their borrowers and to purchase or sell U.S. treasuries.

Interest Rates and the Economy

Consider the following scenario: Would you be more willing to purchase a house if the interest rate you had to pay every month for borrowing the money from the bank was higher, or lower? Whether they are interested in a car, a big-ticket item like refrigerators and dishwashers or even a house, buyers are more likely to purchase goods and services when the interest rate is low. As more goods and services are consumed, the economic growth rate climbs higher. This growth further fuels demand for more jobs as well as industrial machinery and raw goods.

Interest Rates and Inflation

As the demand for labor increases, workers begin asking for more pay, resulting in higher inflation. As the price of goods increases, the value of money decreases. Buyers will not be able to purchase as many goods and services as before. This lack in consumer and business demand can cause the economy to contract, resulting in job losses. It is the mandate of the Federal Reserve to maintain financial stability throughout this cycle of growth and contraction by properly adjusting interest rates.

As inflation increases, the value of money decreases and the Federal Reserve counters by increasing the interest rates. During times when job growth is low and the economy is stagnant, the Federal Reserve lowers the interest rates to spur economic growth.
According to the Federal Reserve website, manipulation of the interest rates “triggers a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables including employment, output and prices of goods and services.”

As history has shown, the twin effects of uncertainty and panic resulting from tough financial crises can trigger periods of even greater economic malaise. Due in large part to the stabilizing effects afforded by the Federal Reserve Act, such unstable periods became less common as the U.S. economy experienced periods of rapid economic expansion in the last century.

 

For more information, check out ” The Dangers of an All-Powerful Federal Reserve“.