How can the Fed use its powers to encourage or discourage business activity?
The Federal Reserve Board is able to influence business activity in the United States mainly by controlling interest rates.
If the Federal Reserve Board is concerned that the economy is growing too fast or if inflation is rising too quickly, they will raise interest rates. This will discourage businesses from investing, as it will cost more money to borrow money when interest rates rise. Consumers will also be more hesitant to borrow money to make purchases because the cost of any loan will increase when interest rates rise. By raising interest rates, the Federal Reserve Board is restricting the amount of money circulating in the economy. When there is less money circulating in the economy, the demand for products should drop, and businesses should produce fewer products.
If the Federal Reserve Board wanted to increase business activity, it would lower interest rates. This will encourage businesses to invest and consumers to spend money. By lowering interest rates, the money supply will increase. Loans will be less expensive with lower interest rates. This action should help spur a sluggish economy. Businesses should produce more products, and consumers should be more willing to buy these products.
The main instrument the Federal Reserve has at its disposal for affecting business is setting the interest rate at which it loans money to banks. Although one of the main objectives it has in setting interest rates is controlling inflation, this also has a major effect on business conditions.
If the Fed lowers interest rates two things happen. Businesses are encouraged to borrow money which they can use to invest in research and development or in expanding their business. Low interest rates also make holding cash less attractive and reduce the return on government bonds, increasing the likelihood of people investing in equities. Low interest rates should also cause businesses sitting on large amounts of cash to invest, since when interest rates are close to zero, holding cash actually loses money if inflation is greater than the rate of return on cash-like instruments such as money markets.
Alternatively, if the Fed sees the economy becoming overheated, and businesses overextending themselves by being highly leveraged, it can raise interest rates to discourage borrowing.
The Federal Reserve can use its powers to manipulate business activity by raising or lowering the money supply. This is one of its main responsibilities.
When the Fed wants more business activity to happen, it raises the money supply. It can do this in a variety of ways. The two most common are by lowering interest rates or by buying government securities. If the Fed lowers interest rates, it becomes easier and cheaper for companies to borrow money. Therefore, they borrow and spend more. This increases the level of business activity. If the Fed buys government securities from banks, it is giving them money that they did not have before. The banks will want to lend that money, again, more lending means more business activity.
If the Fed thinks that there is too much business activity (which means that it is worried that excessive inflation will occur) it will take the opposite steps. It will raise interest rates and/or it will sell government bonds. This will take money out of the economy and make it harder for banks and people to borrow.