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The Fed Attempts to Control Inflation and the Cost of Money.

There's always a lot of talk and speculation about "what the Fed will do" at its next meeting, and newspapers and reporters hang on every word that a Fed governor says at some luncheon that might give some hint of future Fed actions.

The Fed does have an impact on the economy, certainly. But its impact is related to the cost of money—specifically, to two key indexes: the federal funds rate and the federal discount rate.

The federal funds rate, or fed funds, is the rate at which banks lend to one another. Why do banks do that? Banks have reserve requirements, meaning that at the end of the day, a bank needs to have cash reserves that are a certain percentage of its amount of loans outstanding.

Just as any rate can be affected by market forces, such as banks competing to lend money to other banks that want it, the fed funds rate is actually a "target" or goal set by the Fed, but it is generally adhered to by banks when they lend to and borrow from one another.

So how does raising or lowering the fed funds rate affect the economy in general? If money is cheap, lenders will be more inclined to make loans, stimulating a possibly weak economy. In times when the economy is overheating, leading to inflation, increased rates can reduce the demand for money, making it more expensive. When money is more expensive, businesses and consumers alike are less likely to borrow.

This money control is an attempt to keep inflation in check.

The discount rate is similar in nature to the fed funds rate, except that this is the rate set by the Federal Reserve for lending to commercial banks, again on a short-term basis and again to make reserve adjustments.

Both indexes can affect the economy, which can affect mortgage rates, but there is no direct correlation.

 
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