CHANGING THE DISCOUNT RATE
The Federal Reserve Board may change the discount rate in an effort to guide the economy through the business cycle. Remember, the discount rate is the rate that the Fed charges member banks on loans. This rate is highly symbolic, but as the Fed changes the discount rate, all other interest rates change with it. If the Fed wanted to stimulate the economy, it would reduce the discount rate. As the discount rate falls, all other interest rates fall with it, making the cost of money lower. The lower interest rate should encourage borrowing and demand to help stimulate the economy. If the Fed wanted to slow the economy down, it would increase the discount rate. As the discount rate increases, all other rates go up with it, raising the cost of borrowing. As the cost of borrowing increases, demand and the economy slow down.
FEDERAL OPEN MARKET COMMITTEE
The Federal Open Market Committee (FOMC) is the Fed's most flexible tool. The FOMC will buy and sell U.S. government securities in the secondary market in order to control the money supply. If the Fed wants to stimulate the economy and reduce rates, it will buy government securities. When the Fed buys the securities, money is instantly sent into the banking system. As the money flows into the banks, more money is available to lend. Because there is more money available, interest rates will go down and borrowing and demand should increase to stimulate the economy. If the Fed wants to slow the economy down it will sell U.S. government securities. When the Fed sells the securities, money flows from the banks and into the Fed, thus reducing the money supply. Because there is less money available to be loaned out, interest rates will increase, slowing borrowing and demand. This will have a cooling effect on the economy.