How can the Fed use its powers to encourage or discourage business activity?

2 Answers

pohnpei397's profile pic

pohnpei397 | College Teacher | (Level 3) Distinguished Educator

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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.

thanatassa's profile pic

thanatassa | College Teacher | (Level 1) Distinguished Educator

Posted on

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. 

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