While the economy is affected by numerous internal and external factors, open-market operations remain the most common forms of changing and regulating prices via. interest rates and inflation.
Interest rates are a key deciding factor for many people to determine when and where their disposable income will be spent. The Federal Reserve (FED) has the ability to drive bond prices up through increased open market purchases (causing interest rates to fall). When interest rates fall, consumption increases; people are now more willing to buy houses, cars, and greater amounts of goods and services, thus the equilibrium Gross Domestic Product (GDP) will rise.
Alternately, when bond prices are made to fall, interest rates rise. With this rise consumption decreases and therefore so does the equilibrium GDP. While high interest rates have a negative effect on the individual person, it is at this time that greater profits are reaped by banks and therefore it is profitable for them to increase the amount of loans.
There are three basic ways in which the Federal Reserves can control the money supply and interest rates. First, they may adjust the reserve requirement. This is a dangerous and rarely used practice. Next, the FED may make adjustments to the amount of discount loans they approve, increasing or decreasing the monetary base.
In the most common form of control, the FED partakes in open-market operations. In this case the FED-open-market committee, (the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and a rotation of four of the 11 other district bank presidents) make a decision to buy or sell bonds or else make purchases. The price of the purchase or the value of the bond is now added or subtracted into the economy and exponentially affected by the multiplier effect (the increased impact of a base amount of money due to the loan process).
As any of these three methods infuse money into or decrease money from the economy, interest rates rise or fall accordingly. Lower interest rates result in higher consumption, and a higher equilibrium GDP, while a lower money supply causes higher interest rates (which cause higher prices) thus lower consumption and a lower GDP.
Monetary regulation is a delicate portion of the economic process, while each cause and effect relationship it ignites will have exponential effects on the economy, it is important that this balance is carefully monitored, and mindfully governed.