What does it mean when FED will raise/reduce interest rates?

Question

sorry no space but...

what does it mean when FED will raise/reduce interest rates

how does it affect my parents who have a small business and want to purchase a new home. Does this affect me (soon to be college student)

Answer 1

The gentleman above is confusing a few things, I think.

In response to changes in the economic climate, the Federal reserve has a number of tools at it's disposal to help try to stabilize the economy. One of these tools is the interest rate.

Bascially, the interest rate describes the  percentage of the principal that must be paid back on a loan in addition to the original loan amount. So if I took out a loan from a bank for $100  at 10% interest, at the end of my loan I would have to pay back $110 dollars ($100 principal plus the $10 interest).

Sometimes changes in the economic climate can be caused by too much money in the system: basically it's so cheap to borrow money and use it that everyone is doing so. It doesn't mean there's too much printed money, it means there's too much money in any form being used to buy things, as opposed to sitting quietly accruing interest in a savings account or something comparable. When everyone starts buying things (say everyone suddenly wanted to buy houses because credit was cheap with low interest rates, which is exactly what happened until the housing bubble burst), the prices of houses would increase.

It's supply and demand: there are too many people who want too few houses, so prices rise until only as many people can afford to buy houses as there are houses available to buy.

Inflation is what we call the general rise in the avergae level of prices. I wrote and article all about it here:http://btgnow.net/perfina/inflation1.htm...

One of the Fed's jobs in monitoring the economy (actually probably THE job) is making sure that inflation doesn't get too high: in Canada the target is between 1-3% per year, in the US I believe the annual target may be slightly higher.

If inflation is at risk of going out of this range, the Fed (the Bank of Canada to us), can either cut or increase interest rates. They cut interest rates if inflation is too low, even negative, to encourage people to buy things and bring prices up a little bit. They increase interest rates if they want to encourage people to save money (at higher interest sitting in their banks) and discourage them fom spending it (by making credit more expensive), which brings prices down and brings down inflation.

A change by the fed in "interest rates" (ex: target rate, I think we call it the overnight rate here) affects all interest rates in the economy: the rate at which banks loan to each other, the rate at which banks borrow from the fed, and the rate at which banks loan to people are all connected: if one goes down so do all the others, and vice versa.

So any change this will affect both you and your parents: If your parents want to buy a house in 3 weeks and the fed cuts rates tomorrow, credit will be cheaper (they may pay 6% interest instead of 7% for example). If the fed increase rates, credit will be more expensive (they may pay 8% interest instead of 7% interest). The same will apply to you if you take out loans to go to college.  Higher interest rates will make it more expensive, lower interest rates will make it cheaper.

Whew! Kind of long winded so thanks for bearing with me. Lucky you getting 12 weeks of macroeconomics courses in a single answer!

Good luck!

Answer 2

What they change is the target rate, that means what they want short term interest to be. Basically what they do is, if they want to lower it, they print a lot of money(money is cheap) and if they want it higher they will hold back(money is more difficult to get). It affects everyone in two ways, if they are low, you can get credit but money will loose value so things will be more expensive in the future. If rates are high you have more difficulties paying a loan but things will not be so expensive in the future. Low inflation vs. easy money. I personally prefer low inflation always.

Had mortgage rates not been lower than what houses appreciate we wouldn't be in this mess now.