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How Does the Federal Reserve Bank Affect the Economy?

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    Function

    • The Federal Reserve does not set actual interest rates, but determines how much it costs private banks to borrow money from each other at federal reserve bank locations. The Fed does not set real interest rates because it cannot accurately predict future inflation -- an increase in prices and lowered relative value of the dollar.

    Effects

    • The markets set long-term interest rates based on what they think the Fed will do with the nominal interest rate and its effects on inflation. This in turn affects consumer demand and lending. If, for example, inflation is at 10 percent, but real rates are eight percent, the borrower will end up repaying less than he owes making most loans unprofitable.

    Potential

    • U.S. monetary policy extends beyond our borders. Lowering the value of the dollar, for example, makes our goods cheaper overseas and increases exports. Higher interest rates will also attract more foreign capital.

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