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Federal Reserve Bank Interest Rates

The institution responsible for inflation and employment management is the Federal Reserve. It has the obligation of keeping inflation rates low, while maintaining full employment, which is 4 to 5% of unemployment. This responsibility includes many subtleties that require great balancing capabilities.

One of the main tools of influencing the economic activity is the ability to change the direction of interest rates.

Low Interest Rates

One of the triggers to greater economic activity is the low interest rates, because under such conditions it is easier to acquire. People have the natural inclination of spending more when they have more money. As a result of the lower interest rates, people have access to more resources and embark on more purchases. Unfortunately, this may result to inflation.

The main reason for this inflation will be the fact that there is too much money in circulation, whereas goods are relatively scarce. Thus, business will realize that due to the scarcity of products and services they can benefit by increasing the prices for what they produce, thus rising up the levels of inflation.

High Interest Rates

While low interest rates can lead to inflation, the opposite is true about high interest rates. The main consequence of the latter is deflation in some of the cases and most often a recession. High interest rates have a devastating result on the economic activity. For example, it will cost you more to pay back your mortgage than it used to in terms of purchasing power.

The Federal Reserve can avoid the happening of such economic disturbances by either increasing or decreasing the discount rates or influencing indirectly the movement of Federal funds rates.

Next we provide an explanation and analysis of both Federal Reserve techniques.

Discount Rates

Banks are allowed to borrow money from any of the Federal Reserve Banks. This can be done overnight and the incurred by the bank-borrower interest rate is referred to as a discount rate. As a result the borrowing of money in your bank may become more expensive. In turn you are discouraged to borrow more money since it is too costly to turn them back. This leads to less money in circulation. The prices of goods and services are directly influenced, because less money is available for their purchase and the ability of producers to increase the prices is reduced. The opposite is true in the case of low interest rates, which have been caused by lower discount rates.

Federal Funds Rates

Many times it is possible that one bank borrows money from another. In such cases the first is charged by the second a federal funds rate. Under Federal Reserve requirements every bank should maintain cash on hand or deposits that is presented as a particular percentage of assets. This cash should be allocated in one of the banks of the Federal Reserve. Reserves to deposits ratio is established by the Fed, which is being updated regularly. Depending on the increasing or decreasing of the ratio requirement the banks should change the reserves they hold in the Fed's banks. If the ratio is increased, the cost of acquiring funds is increased. On the other hand, if the ratio is decreased, less money are required to be held, so capital is more easily obtained.

As a result of the changes in the interest rates, the burden or relief is mainly transferred to the end consumers, since the banks adjust their prime lending rates to compensate for the changes they have experienced. Nevertheless, not all banks adjust in the same way their rates. As a result, the most objectively sited prime rate is the one from the Wall Street Journal. It is computed on the basis of the prime rates of US's thirty largest banks. If any one of them makes any alterations in their numbers, the Wall Street Journal makes the necessary updates.

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