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Student Finance Series: The Impact of Interest Rates

By: Allison Kirschner

Changes in interest rates can have both positive and negative effects, depending on if you are a borrower or lender. The U.S. Federal Reserve, known as the Fed, often change their target interest in response to the economic activity: raising rates when the economy is strong and lowering the rates when the economy is in a hypothetical sinkhole.

We can get a good idea of how our economy is performing and what the Feds are planning to do about it. When rates change, there is a ripple effect across the entire economy. The U.S Federal Reserve manages inflation, supervises the banking system, maintains the stability of the financial system, and provides banking services. We must have this structure in our government because the Fed base their decisions on economic indicators and where they envision our long-term economic goals.

The most visible function of the Fed is to manage inflation. One way that the Fed can accomplish its goals is through the use of monetary policy. The monetary policy is, “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” The Fed can set the target for the federal funds rate and that then guides interest rates. The Federal Reserve’s monetary policy can judge inflation by the Personal Consumption Expenditure price index (PCE).

The Federal Reserve System is made up of 12 regional Federal Reserve banks. These 12 federal reserve banks oversee and serve as banks for commercial banks in their region. The network of the 12 Federal Reserve Branches is under the oversight of The Board of Governors. The Board of Governors are the body inside of the U.S. Federal Reserve. This is a seven-member committee that is chosen by the President and then also confirmed by the senate.

To maintain the stability of the financial system, the Feds day to day activities of conducting monetary policy, supervising, and regulating banks, and providing payment services all maintain that stability. The 2008 financial crisis revealed that the regulations that were put in place for individual banks were not enough. Passing The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 strengthen the Fed’s ability to maintain stability in our economy.

The Federal Reserve is essentially a bank for banks. It provides financial services to places such as banks, credit unions, and savings and loans. They provide services to each other just like they provide for their customers, collecting checks, transferring funds, etc. 

The Federal Reserve’s main purpose is to keep inflationary pressures under control, promote maximum employment, and support economic growth. The main tool of the Fed to achieve these goals comes from adjusting interest rates. When the economy shows signs of weakness, inflation rates will start to drop, and the Fed can lower interest rates.

Lower interest rates cause money to flow throughout our economy and promote spending, investing, and economic growth. Similarly, when the economy is doing well, inflation rates will increase above the Fed’s target, and that makes the central bank hike interest rates. This makes borrowing more expensive, reduces economic activity, and puts pressure onto things to increase prices.

The Federal Reserve is the central bank of the United States and potentially is the most influential central bank in the world. By having such an influence in the economy, it impacts all the lives of all Americans. The decisions that the Fed make influence how much interest you will earn on a savings account, or money market account.

Any changes will also affect interest rates on auto loans, credit cards, and some mortgages.  There will be changes in the stock market and that could potentially affect your retirement plan. It is very important to have a basic understanding of what interest rates are and how they influence our economy.

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