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THE FINANCIAL ENVIRONMENT AND THE LEVEL OF INTEREST RATES CHAPTER 2 O ne of the most important institutional players in the financial system is the Federal Reserve System (called the Fed). In fact, it is some- times said that the chairman of the Federal Reserve Board is the second most powerful person in the United States—second only to the president. Where does all of this power come from? It comes from the Fed’s role as the nation’s central bank—the institution that controls the money supply. The Fed “manages” the nation’s economy by conducting monetary policy, which affects how much money is avail- able in the economy. One way it does this is by setting a target short-term interest rate at which large money cen- ter banks lend to each other (called the federal funds rate) and by buying and selling Treasury and federal agency securities to achieve this rate. Increases in the money supply put downward pressure on short-term interest rates. Over time, this can lead to increases in the level of economic activity, along with higher inflation. Conversely, decreases in the money supply put upward pressure on short-term interest rates. This can lead to a lower level of economic activity and lower inflation. Small wonder that when the Fed speaks, everyone stops and listens. Ben Bernanke, the current Fed chair- man, described the effects of Fed announcements on the stock market as follows: Normally, the [Federal Open Market Committee, or] FOMC, the monetary policymaking arm of the Federal Reserve, announces its interest rate decisions at around 2:15 p.m. following each of its eight regularly scheduled 1. Discuss the primary role of the financial system in the economy, and describe the two basic ways in which fund transfers take place. 2. Discuss direct financing and the important role that investment banks play in this process. 3. Describe the primary and secondary markets, and explain why secondary markets are so important to businesses. 4. Explain why money markets are important financial markets for large corporations. 5. Discuss the most important stock market exchanges and indexes. 6. Explain how financial institutions serve consumers and small businesses that are unable to participate in the direct financial markets and describe how corporations use the financial system. 7. Explain how the real rate of interest is determined in the economy, differentiate between the real rate and the nominal rate of interest, and be able to compute the nominal or real rate of interest. LEARNING OBJECTIVES ©AP/Wide World Photos 27
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meetings each year. An air of expectation reigns in finan- cial markets in the few minutes before to the announce- ment. If you happen to have access to a monitor that tracks key market indexes, at 2:15 p.m. on an announce- ment day you can watch those indexes quiver as if trying to digest the information in the rate decision and the FOMC’s accompanying statement of explanation. Then the black line representing each market index moves
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