What the Federal Reserve Does

What the Federal Reserve does is to control the flow of money in the economic system. This means that the Federal Reserve plays an important role in one of the fundamental functions of government, which is to control the amount of money in the system.

Changing Federal Reserve Interest Rates

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 Federal Reserve meetings. You will also hear media reports about how rate changes will affect interest rates for consumer items, such as mortgages and credit cards.

Despite this kind of media attention, the decisions of the Fed do not directly affect consumers. These rate changes refer to the interest rate the Fed charges commercial banks to borrow money from the Federal banks.

Federal Reserve Discount Rate

Even the language is a bit confusing because the “interest rate” is also referred to as the “discount rate” because the rate of interest 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 type of loan has its own rate of interest.

Changing The Discount Rate For Primary Credit

The rate change that gets all of the media attention is when the Fed changes the discount rate for primary credit, which applies to 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, its purpose is to make it more or less profitable for the commercial banks to borrow money from the Fed to make loans.

Why The Fed And The Banks Exist

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.

How The Fed Uses Interest Rates To Control The Flow Of Money

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

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

Fed rate changes matter because they increase or decrease the amount of money available for banks to loan, which in turn increases or decreases the amount of money in the economic system.

How The Federal Reserve Interest Rate Changes Affect You

All of this means that a Federal Reserve rate change might affect the interest rates on your credit cards and adjustable mortgage, but it is not a direct result. If the interest you pay on your credit card decreases, it is because the bank decided to lower the rate, not because the Federal Reserve changed its discount rate.