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The Federal Reserve Bank (The Fed) is the organization that changes interest rates to affect the econominc activity amongst businesses and consumers. The following sections tells you how The Fed can help moderate the economy so it doesn't get out of hand. The Fed usually keeps a steady eye on inflation and GDP and takes action accordingly as described below.

Inflation Rears Its Ugly Head

If the GDP is growing too fast, it means primarily that consumers are spending a lot of money (because consumer spending makes up the majority of the GDP). As you have already learned, when a lot of people with a lot of money are trying to buy the same goods, this typically results in inflation. (Recall that we discussed how on Valentine's Day roses are more expensive because more people want roses on that day). Things, in general, become more expensive when too many consumers have money (either money from their jobs or money they have borrowed) to buy these items.

The Fed Takes Action Through The Discount Rate

To stop consumers and others who contribute to the GDP from spending too much money too fast, the government (specifically, The Fed) makes it harder for people to borrow money by increasing the discount rate. This increase, which is known as "the tightening of monetary policy," eventually makes it more expensive for consumers and others to borrow money from banks. With less money being borrowed, there is less spending. This eventually reduces consumer spending, reduces the possibility of inflation, and causes the GDP to go down.

If the GDP is not growing at all, it probably means that consumers are not spending much money. To encourage people to spend more money, the Federal Reserve Bank can decrease the discount rate, which eventually makes it easier for consumers to borrow money. This action is known as "loosening monetary policy."

Making Sense Of The Fed's Actions

You might be puzzled as to why the Federal Reserve Bank has to interfere in the economy in the first place. The first question you might be asking yourself is why the Federal Reserve will raise rates to stop inflation. The best way to think about the Federal Reserve's action is to think of the economy as a train that is to pick up passengers at various locations at specific times. A train that is going too fast can derail and crash. This is what happens when the economy is too hot because of high inflation. Much like the motorman of the train who taps on the brakes to slow the train down, the Federal Reserve raises the discount rate to discourage people from borrowing and spending too much so as to slow down the economy and stop it from derailing.

If the train is going really slow, it will not meet its schedule. Much like the motorman who tinkers with the train's engine to increase its speed, the Federal Reserve stimulates the economy by reducing the discount rate in order to encourage more people to borrow and spend more money. The following passage from The Wall Street Journal (June 9, 2000) summarizes some of the concepts we have been teaching regarding the economy and the Federal Reserve Bank's action to keep it stable:

"The Nasdaq Composite Index gained 19% last week following a report that unemployment was rising and that businesses were eliminating jobs. That was bad news for job seekers, but it stirred hopes that the economy is slowing. If it starts seeing results from its yearlong campaign to cool the economy, the Fed might finally stop raising rates. Rising rates have been the main brake on the stock and bond markets.... While a slowing economy would help stocks, economic strength could send stocks down."

The Federal Reserve's actions to keep the economy on an even keel make sense if you pause and give it some real thought. The only problem is that it is very difficult to know how fast or how long to apply the brakes on the economy or how much stimulation is needed to get the economy moving again. Fear as to whether the Federal Reserve may do too much to slow down the economy can be a self-fulfilling prohecy because the fear itself can adversely affect the stock market. The following passage from teh May 17, 2006 Wall Street Journal illustrates this concept:

". . . .In recent days, though, concerns that inflation wil force the Fed to keep its foot on the brakes have sent stocks into a freefall. Yesterday, a report showing wholesale inflation was relatively tame did little to help stocks, raising concerns that the latest decline could continue."