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September 16th, 2008 11:22 AM by David W. Welch
The Fed primarily impacts short term interest rates. It does this a couple of ways. First, through open market operations the Fed can expand or contract the money supply by purchasing or selling treasury bonds on the open market. Yesterday, they infused $70 billion into the money supply. They do this regularly, and it typically does not get much press. By putting that much more cash out into the marketplace, liquidity is improved. The credit crunch, and the recent financial failures have banks holding onto higher reserves of cash. Another way the Fed can effect short term rates, that involves the money supply indirectly, is through the reserve requirements they set for banks. If banks have to hold more in reserve, then they have less to lend. If money is more scarce, interest rates go up. Of course the most direct way the Fed has of impacting short term rates is through the rate that they charge to loan money to banks. This is the most direct, and least often used method of impacting rates.
It will be interesting to see if the Fed acts today by lowering the rate again. Apparently, it is at least a topic of discussion. With oil coming down, and the effect of slightly lower energy costs on inflation, they may just lower the rate preemptively. Hopefully, this will get banks to loan more money in turn stimulating business investment. I have taken way too many economics courses, so I hope this was not too dry.
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