Children Series - How the Federal Reserve in the US changes interest rates


My son was asking me about this and I realized that though I had a general idea, and had a finance background, I had gaps in my knowledge; I was not able to articulate the answer properly so I wrote this up for him.

When the Federal Reserve wants to increase or decrease interest rates, it essentially simply first declares the value of an important rate, called Federal Funds Rate; for example, the Fed might say that our target for the Federal Funds Rate is 1%; the Fed never sets the interest rates directly, it just declares it first. It then conducts a few maneuvers to control the interest rates indirectly. 

In the second step, the Federal Reserve maneuvers the rate by dealing directly with a limited number of banks called “Member Banks”. The Fed either gives cash to member banks (in exchange taking securities) or takes out cash from the member banks (thereby giving them securities). 

It is through these two primary interactions with the banks that the Fed controls the interest rates; 

If the Fed wants to decrease the interest rates, it takes securities out of the bank (a predetermined list of “member banks”) and gives them cash (extends credit); this makes the member bank cash-rich; unless the bank uses that extra cash to meet its “reserve requirements” the bank has that cash sitting around; so the bank then is incentivized to loan this money out to a) either other banks, b) other people. 

If the bank lends money to the other banks, it charges the other banks interest (at a certain interest rate). The weighted average of this interest rate of member banks of the Federal Reserve is called the Effective Federal Funds Rate; the Fed sets the Target Federal Funds Rate but never the effective. 

The effective Federal Funds Rate in turn affects the general interest rates that you or I get from a Checking account from our bank or when we take out a mortgage or a car loan. The effective Federal Funds Rate also affects the stock market in the sense that if interest rates are low then there is no incentive for people to save; they would rather chase a little riskier asset classes and hence drive those assets (stocks, homes) prices up. In general interest rates and the stock market move in opposite directions.

If the Fed wants to increase the interest rates, it does the opposite; it takes cash out from the member banks (thereby giving them securities). This makes the member bank cash poorer and they possibly might need to borrow from other banks to meet reserve requirements.

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