How the Federal Reserve Determines the Interest Rate

Many Americans understand that the Federal Reserve plays a vital role in the country's economy. We have heard general statements about "The Fed" and how it affects us as individuals, however, when it comes to actually explaining how they affect us, many of us do not understand. The Federal Reserve once controlled the money supply and how much was produced. However, now their primary duty is to control the interest rate that prevails in the market. Many people do not really understand how this works even though it effects how much they will pay for a loan. Here are a few things to keep in mind in regards to the Federal Reserve setting the interest rate.

Banks Play a Role

The rate that you pay for a loan is affected by the Federal Reserve. However, the Federal Reserve is not the only part of the process. The Federal Reserve sets the discount rate which is the rate that they charge banks. However, the banks then add on to that rate in order to make money as well. This is how they cover their overhead and make a profit. This is why you can get a different rate from every lender that you check out. Therefore, just keep in mind that the banks play a big part in the process as well.

Economy

The Federal Reserve closely monitors the economy and the performance of the country as a whole. The interest rate that they charge has a big effect on the economy as a whole. They will periodically raise or lower the interest rate depending on how the country is performing as a whole. If the economy is down, they will in turn lower the interest rate. Lowering the interest rate will increase the amount of people that use credit. If more people are using credit then that means more goods and services are being sold. When sales go up, companies make more profit and can then hire more people. Unemployment rates go down and the economy recovers as a result. While it is not always that simple, this is accurate in many cases. 

If the economy is strong, then the Federal Reserve will raise the interest rate that it charges. When the interest rate is raised, it helps to limit inflation of the U.S. Dollar. While it might hurt individuals that want to borrow money, it can help the country as a whole. Therefore, when they lower the interest rate, they are doing so to the detriment of the currency as a whole. This makes it a risky move as the dollar is already valued low in comparison to many other forms of currency. 

Market Influences

With this in mind, you could say that the interest rate is primarily driven by the market. If there is high demand for loans, the interest rate will go up to accommodate this need. If demand is lower, then the rate will be lowered in unison to encourage people to get involved.


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