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AP Macroeconomics · About 25 minutes · thedime.news/resources/worksheets/interest-rates-and-the-fed/

Interest rates and the Fed

Why the Federal Reserve raises and lowers interest rates, and why bond prices move the other way. Fits AP Macro Unit 4, the financial sector.

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The Federal Reserve, or the Fed, is the U.S. central bank. One of its main tools is a target for the federal funds rate, the interest rate banks charge each other for overnight loans. When the Fed raises that target, borrowing usually gets more expensive across the economy, from car loans to credit cards to mortgages. When it lowers it, borrowing usually gets cheaper.

Why make borrowing cost more? When prices are rising too fast (inflation), higher rates cool spending. When the economy is weak and jobs are disappearing, lower rates encourage borrowing and spending.

Interest rates and bond prices move in opposite directions. If you own a bond paying 3% and new bonds start paying 5%, nobody will pay full price for your 3% bond, so its price falls. That's why a bond's yield rises when its price falls.

Words to know

Write what each word means in your own words.

Federal Reserve
Inflation
Interest rate
Yield

Questions

The Fed raises its interest rate target. What usually happens to interest rates on new car loans?
1. They rise
2. They fall
3. They stay the same
4. Car loans stop being offered
Which problem is the Fed usually trying to fight when it raises rates?
1. Inflation
2. Unemployment
3. A trade deficit
4. Low stock prices
When the Fed raises rates, does each of these usually go up or down?
Item Up or down?
Interest rates on new mortgages
Borrowing and spending by households
Interest paid on new savings accounts and CDs
Prices of bonds people already own
You paid $1,000 for a bond that pays 3% a year. New bonds now pay 5%. Would a buyer pay more or less than $1,000 for your bond? Why?
Look at the scoreboard in today's issue at thedime.news/today/. What is the 10-year Treasury yield, and did it go up or down?
AP practice: Explain how an increase in the federal funds rate affects consumer spending, investment and aggregate demand in the short run.

Item	Up or down?
Interest rates on new mortgages
Borrowing and spending by households
Interest paid on new savings accounts and CDs
Prices of bonds people already own

Answer key: Interest rates and the Fed

Words to know

Federal Reserve: The U.S. central bank, often called the Fed. It raises or lowers a key interest rate to keep prices stable and jobs plentiful.
Inflation: When prices rise across the economy, so each dollar buys a little less.
Interest rate: Interest shown as a percent of the amount borrowed or saved, usually per year.
Yield: The yearly return an investment pays, shown as a percent. For bonds, yields go up when prices go down.

Questions

A. They rise, because borrowing costs move up across the economy.
A. Inflation. Higher rates cool borrowing and spending.
Mortgage rates: up. Borrowing and spending: down. Savings and CD rates: up. Existing bond prices: down.
Less. A buyer can get 5% on a new bond, so your 3% bond is only worth buying at a lower price, which raises its yield.
Answers depend on the day. Check them against the issue's scoreboard.
Higher interest rates raise the cost of borrowing, so consumption and investment spending fall. Aggregate demand decreases (shifts left), lowering real output and the price level in the short run.

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