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The Role of the Fed
The Federal Reserve, or the Fed, is the central bank of the United States, and its role is to keep the U.S. economy headed in the right direction – toward sustainable growth, stable prices, low inflation and employment growth. This is not an easy task, of course. But the Fed has a very powerful weapon at its disposal: interest rates.
The Fed sets the interest rate that banks charge each other for short-term loans. And this in turn affects the rates that banks charge companies and individuals when they borrow money. By raising or lowering its rate, the Fed can make money more or less available in the economy.
If the Fed wants to stimulate economic growth, it might lower the rate. For example, during the period from May 2000 to June 2003, the Fed lowered its rate from 6.5 percent to 1 percent in an attempt to counteract falling stock prices. During an eight-day period in January 2008, the Fed cut rates by 1.25 points to try to stem the economic unrest caused in large part by falling housing costs and problems in the lending market. This was the largest one-month reduction in 25 years.
By lowering rates, the Fed expects to make money more available to companies and individuals, and thus stimulate the economy. The idea is that companies will make more investments in their operations and hire more people, and individuals will be able to buy more goods and services, which in turn will benefit the companies that provide those goods and services.
However, if the economy heats up too much it may cause inflation, in which prices rise too fast, often faster than the ability of people to keep up. If the Fed thinks the economy is at risk for inflation, it may raise interest rates. This tends to slow down the economy by making money less available.
In practice, of course, it is rarely that simple. Currently, for example, the economy is struggling in the wake of sub-prime lending problems. But there also are signs of possible inflation. So the Fed must weigh whether or how much it can attempt to stimulate the economy by lowering rates before it runs the risk of creating inflationary pressure.