The Federal Funds Rate is the interest rate that Federal Reserve uses to trade funds with banks. Changes in this rate can trigger a chain of events that can be beneficial or devastating to the economy. If a bank is charged a higher interest rate to trade money or take out a loan, then the increase will be passed on to their customers, causing them to pay higher transaction fees or more interest. Each month, the Federal Open Market Committee meets to determine the federal funds rate. This in turn affects other short term interest rates. The determining rate immediately impacts the rates at which banks borrow money and the interest rates the banks use to charge their customers on loans. If the rate raise is too high, then money flow drops dramatically and banks and customers curtail lending and borrowing, waiting until a better rate is reached. This effect can have a dramatic impact on the economy and economic spending.
Long term interest rates differ from short term interest rates in that they are not directly influenced by the Federal Funds target rate. Usually investors will want a higher interest rate for a long term investment. A higher Federal rate will trickle down to consumers, resulting in a higher interest rate to borrow money. Consumers will then reduce spending, slowing down the economy. This was seen in the housing market when adjustable mortgage rates went up. People could not afford their payments any longer and their homes went into foreclosure. This drove home values down, which lowered homeowners’ equity against which they could borrow, causing panic and a dramatic decrease in spending.
Unemployment can also be directly affected by the Federal Reserve. If the Federal rate goes up, there will be less spending which means less revenue for businesses. If revenues do not result in a profit, then businesses will not operate at the same rate, resulting in scaling back operations. Cut backs could be that employees take pay cuts, resulting in even less money available for spending. Cut backs can also be that the number of employees is reduced, causing the remaining workers take on more of a work load. The employees laid off will increase the number of people drawing unemployment, and increase the number of job seekers trying to get a reduced number of jobs.
Obviously all of these factors can have some kind of effect on the economy. With cut backs comes a slowdown in output and production from businesses and can cause inflation to occur where people make the same or less amount of money but the price of goods goes up. Essentially, interest rates control the whole economy: if interest rates go up then the economy slows down and vice versa. However if interest rates go too low or stay low for a long period of time it can lead to inflation which also hurts the economy. In essence, higher interest rates are not necessarily a bad thing. Higher interest rates can curb inflation, meaning your pay will go further. A good example of this is the...