Controlling The Speed Of Money

September 19, 2007 · Filed Under Main Page · Comments Off 

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The most widely publicized way the Federal Reserve controls the money supply is by changing its interest rates.

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.

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 Fedcharges commercial banks to borrow money from the Federal banks. 

Anything related to the Federal Reserve is complicated. On the topic of interest rate
changes, there are two basic complications. The first concerns the type of bank and the second concerns the discount rate.

First, there are several types of banks,including:

Federal Banks, which are part of the Federal Reserve System.

Commercial banks were originally set up to serve businesses.

“Thrifts” are banks, such as savings banks  and credit unions, set up to meet the needs of people not served by the commercial banks.

Now, most commercial banks offer service to everyone, but the distinction is important to keep in mind.

(There are other types of banks, but these are the ones that affect most of us most
directly.)

Second: The second complication concerns the discount rate. Even the language is a bit
confusing because the “interest rate” is also referred to as the “discount rate,” because the interest rate is discounted in relationship to short-term market interest rates.

The Federal Reserve Banks offer three discount programs to commercial banks: primary credit, secondary credit, and seasonal credit, each with its own interest rate.

The type of interest rate change that gets all of the media attention is when the Fed  changes the discount rate for primary credit. This concerns loans from the Federal banks to commercial banks with good credit. These are very short term loans, usually overnight.

Whenever the Fed changes the discount rate, it does so to either make it more or less profitable for the commercial banks to borrow money from the Fed to make loans.

The two critical points to remember are:
    1. The Federal Reserve system exists to control the amount of money in the system
    2. The banks exist to make money by loaning money to their borrowers.

If the Fed makes money more expensive for thebanks to borrow, the commercial banks cannot make as much profit on loans it makes to its customers.

When the Fed makes money cheaper for the banks to borrow, the commercial banks are more willing to loan money to its customers.

This is why the change in interest rate matters to all of us. It increases or decreases the amount of money available for banks to loan, which increases or decreases the amount of money in economic system.  These changes affect the speed by  which money is increased or decreased.  

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. 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, PhD.

 

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