It has a special way of heating things up and cooling things down - not by blowing on them, but by adding and subtracting money. Given its huge importance, it's amazing how few people know what the Fed is all about.
In a survey from several years ago, some people said the Federal Reserve was a national park, while others thougth it was a brand of whiskey.
In fact, it's the central banking system that controls the money supply. (Monetary policy)
Whenever the economy is cooling off too much, the Fed does 2 things.
(1) It lowers the interest rates that banks must pay when they borrow money from the government.
- This causes the banks to lower the interest rates they charge to their customers, so people can afford to take out more loans and buy more cars and more houses.
- The economy begins to heat up.
(2) The Fed also pumps money directly into the banks, so they have more to lend.
- This pumping of money also causes interest rates to go down.
If the economy is too hot, the Fed can take the opposite approach: raising interest rates and draining money from the banks.
This causes the supply of money to shrink , and interest rates go higher.
- When this happens, bank loans become too expensive for many consumers, who stop buying cars and houses.
- The economy starts to cool off.
- Business lose business, workers lose jobs, and store owners get lonely and slash prices to attract customers.