What Determines the Federal Reserve Interest Rate?
The Federal Reserve (Fed), a system of regional banks, and a Board of Governors, headed by a Chairman, controls the money supply of the United States. The Board of Governors, which sits at the top of the Fed’s organizational structure, makes decisions regarding monetary policy under the direction of the Chairman of the Board. Monetary policy tools include open market operations, the reserve requirement and the discount rate.
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Discount Rate
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Banks seek to make a profit so they try to keep their reserves close to the minimum reserve requirement set by the Fed. Because they keep their reserves close to the minimum, banks run the risk of falling below reserve requirements occasionally. The Fed functions as a central bank, or banker’s bank, that lends reserves to banks. The discount rate is the interest rate that the Fed charges for lending these reserves to private banks.
Function
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The Fed uses the discount rate to directly influence the size of bank reserves. It changes the cost of borrowing reserves by raising or lowering the discount rate. High discount rates make it expensive for banks to borrow reserves while lower rates encourage banks to borrow.
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Effects
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The Fed uses all three policy tools to address the problems of unemployment and inflation in the economy. To combat unemployment, the Fed can lower reserve requirements, buy bonds on the open market and lower the discount rate, which will increase the amount of money that banks can lend. To fight inflation, the Fed can raise reserve requirements, raise the discount rate and sell bonds in order to discourage banks from making more loans.
History
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During the 1800s and early 1900s, people used banks to deposit their money and take out loans to start a business or build a home. Banks issued these loans as banknotes that could be redeemed for silver or gold. Bank runs, where large numbers of people redeemed their banknotes in a single day, undermined public confidence and created general financial panic. Congress established the Federal Reserve System in 1913 to hold the reserves of banks and make short-term loans available to ensure a bank’s credit availability.
Considerations
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The Fed has used the discount rate infrequently since World War II. When the Fed raises or lowers its discount rate for bank reserve loans, the interest rates charged for consumer loans will also change. Announcements that Federal Reserve interest rates are being lowered can bolster an economy facing a crisis, such as the 1987 Wall Street crash, by reassuring both banks and consumers.
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