The Federal Reserve and Banks are two of the most important institutions in our economy. By working together, they can influence interest rates, borrowing, inflation, unemployment, and many other important aspects of the economy.
Although they are powerful in their own regard, there are certain aspects that are unique to them specifically.
The Federal Reserve (The Fed) and Banks
The Federal Reserve is known as the United States’ central bank, meaning it manages monetary policy (how much money is available for spending) and provides oversight to commercial banks.
The Fed controls monetary policy through the Federal Funds rate (FFR). The Federal Funds rate is the rate charged by banks when they lend money to one another. By law, banks are required to have a certain amount of money on hand to cover deposits and they make up for shortages by borrowing from other banks.
Banks make money by borrowing at low rates and lending at higher rates. When the Fed raises the FFR, it costs more for banks to borrow money. This results in banks increasing lending rates to customers to compensate for higher borrowing rates.
Whenever economic activity slows, or enters a recession, the Fed lowers the FFR to make bank lending cheaper. This effectively makes loan interest rates cheaper and encourages consumers to borrow money, injecting it into the economy.
Conversely, whenever economic activity rises, the Fed raises the FFR to make bank lending more expensive. This makes loan interest rates cheaper and discourages consumers to borrow money. This approach can help combat inflation.
For the Fed, changing interest rates isn’t as easy as hitting a button. The Fed purchases short-terms bonds to influence supply and demand which changes the rates. The Fed also purchases long-term bonds to influence long-term interest rates.
Long term interest rates influence lending costs on cars and homes since these purchases are financed for longer periods. Lower long-term interest rates allow companies to build more factories which results in more people hired, thus lowering unemployment.
The Fed has many levers it can pull on to control economic expansion, inflation, and unemployment. Working hand in hand with commercial banks, the Fed has wide power to influence our economy.