What happens when the Fed cuts interest rates?

Lower federal interest rates make it easier—that is, less risky and burdensome—for large businesses, especially private banks, to borrow money from the federal government. This in turn makes these large businesses more willing to loan to individuals and smaller businesses; they generally lower their interest rates too, to stay competitive.

The intended effect (or advantage) of a lower federal interest rate is to increase activity in the national economy. With lower interest rates, people and businesses are more willing to engage in financial risk (since borrowing costs less and loaning is less risky) and therefore to engage in more business ventures.

The greatest risk (or disadvantage) is inflation, or devaluation of the currency being loaned (relative to the “absolute” value of real property). If the fed lowered rates “all the way,” we’d have a system in which dollars were being given away for free…and the dollar would therefore be worth nothing at all. By the same token, a very small drop in interest rates can negatively effect the value of currency. The problem here is that if a lowered rate simultaneously increases the amount of money being lent and also decreases the real value of that money, the economy is not really becoming more active at all. More dollars are changing hands, but not more real value.

The idea is to sometimes lower and sometimes raise rates in order to maintain a balance between the perceived risks of investing and the practical value of currency, all the while avoiding the ‘overheating’ of an inflated economy or the ‘stagnation’ of an economy with overvalued currency and too-high rates. (Adding the question of growth to the equation makes stagflation an equal danger, though a more complex problem: http://en.wikipedia.org/wiki/Stagflation)

Other than the gigantic corporations that are directly effected by changes in the federal interest rates, the most direct impact is upon the stock market and upon people trying to borrow money. (If you invest in the stock market, your money is directly tied to the fortunes of big companies, whose stocks generally will rise, at least for a time, when the fed lowers rates. And if you want to, say, get a loan to buy a house, banks will in theory be more willing to loan you money when the rates they pay are lower, and they should charge you less interest too.) But because of the huge impact that federal economic controls have upon the market, a change in interest rates should “trickle down” to every aspect of the economy, including the price of cheap consumables.

For more information, try:
http://en.wikipedia.org/wiki/Federal_Reserve_System

When the Fed Cuts interests rates its cutting the rate that money is lent to financial institutions. And in turn the banks usually lower the rates they have for loans that they originate to consumers and businesses.

Advantages:
Lower Interest Rates on Home Loans, Business Loans, Car Loans, etc

Increases Consumer confidence and willing to spend more because of lower interest rates

Stock Market Stabilizes because of increased consumer confidence

May Prevent a recession

Disadvantages

Recession may still occur

People get further into debt

There are not too many disadvantages I can think of, by cutting interests rates in the current market.

Good Luck!
R

@robhaya: per above, inflation is the major disadvantage…and one that US economists would do well to head, given that the dollar is already losing ground to other currencies.

@soethe6: I forgot to mention inflation, thanks for pointing it out!
R

I am a huge supporter of Ron Paul. I feel this is a very important issue right now. Are either of you familiar with his take on this? He talks about having sound money being one of the most important things to a free society. I am a 25 year old union electrician in NJ. I am paid very well. I am struggling a little bit now, but don’t see how its gonna get better. Should we be paying much more attention to the Fed and its actions? Most countries fail due to bankruptcy. Are you aware of the Amero? Is having the federal reserve control our money finally catching up to the lower and middle class? After all, it is less than 100 years old.