Fed Rate - How it effects economic growth - Essay Example

Fundamentally, the Federal Reserve System operates to ensure that all American banks keep a certain level of reserves which are normally a percentage of the value of the bank’s demand accounts (Arnold, 2005). Since this is a regulatory requirement, banks may borrow money from each other to maintain such a level of reserves and the interest rate paid between banks would be the Federal Rate. Through these means, the Federal Reserve has considerable power over the supply and demand for balances of Reserve Banks.

The monetary experts at the Federal Reserve are supposed to ensure that the rate is set at such a level that it will create economic growth and stability in the economy. However, the economic demands have to be balanced with the political and social realties which may influence how and at what exact level the rate is set (Wikipedia, 2006). The Federal Reserve therefore adjusts the rate periodically to keep the economy running smoothly. However, even a slight change or even an expectation of change creates questions for the economic experts who have to reanalyze their estimates for the future of the economy.

Additionally, changes can influence the short term lending rates, long term mortgage rates, value of the dollar in comparison to other currencies and even have a significant impact on the stock markets. The change in this rate also creates a trickle down effect leading to changes in consumer spending decisions, saving rates and corporate spending. Therefore the adjustment of this rate is a very powerful tool by which the Federal Reserve can influence the economy in significant ways (Federal Reserve, 2006).

Although the Fed rate is considered a short term rate, it also influences long term lending rates which are connected with treasury bills, corporate bonds, commercial and consumer loans as well as mortgages (Luedeman, 2006). Expectations of the long term loan rates are usually not that