Who sets the price of money?
The story so far You're about to graduate. You want an $8,000 loan for a used car to get to work, and the bank quotes you 9%. A year ago the same loan was 5%. Meanwhile your savings account, which paid almost nothing, now pays 4%. Nothing about you changed. What changed is that twelve people at the Federal Reserve, the US central bank, voted to raise interest rates. This lesson shows how one vote reaches your car loan.
Understand interest as the price of borrowing money, and who moves it.
One rate decision changes what your car, house, credit card and savings cost or earn.
The Federal Reserve raises rates to cool inflation and cuts them to protect jobs.
Fed economists make the call. Bond traders and bank treasury analysts bet on it.
What you're looking at: a sketch, not real data. The dial is the federal funds rate that the Fed sets. The ripples show it spreading out to the rates you pay or earn: on a mortgage, a car loan, a credit card and savings.
Turn one dial.
Watch every rate move.
The Fed controls one rate, the federal funds rate. It's what banks charge each other to borrow overnight. Banks then add an extra amount on top, called a spread, to set the rates they charge you. So when the Fed moves its rate, every rate below moves with it. Drag the slider and watch your own costs change.
- Federal funds rate
- The slider starts at 4%: what banks charge each other overnight.
- Spread
- At 4%, a car loan below is 8%. The bank added 8 − 4 = 4 points on top: that's the spread. A credit card adds about 16 points, so it's around 20%.
Spreads are simplified averages. Real rates also depend on your credit score (Unit 4) and on markets' guesses about the future.
What you're looking at: four kinds of rates, one card each. The slider sets the federal funds rate, from 0% to 10%. Each card's rate is the fed funds rate plus that card's spread, so they all move together. Under each rate is what it means in dollars, like a monthly car payment or a year of savings interest.
Two minutes. Just listen.
Tap any line to jump to it.
Rate Dial
You chair the Fed for eight meetings, two years. Your job, set by Congress, has two goals: keep inflation (how fast prices rise) near 2% and unemployment (the share of people who want a job but can't find one) near 4%. Raise rates to slow prices down; cut them to help hiring. One catch: a rate change takes months to work, so you're steering a big ship, not a car. Pick a moment in history to start.
What you're looking at: your 8 meetings as the Fed, from left to right, in percent. The orange line is inflation and the blue line is unemployment. The shaded bands mark the goals: inflation near 2% and unemployment near 4%. The dashed gray line is the rate you set.
The logic, step by step.
Interest is a price
When you borrow, you pay back what you borrowed plus a fee for using it. That fee is interest. The amount you borrow is called the principal. The simplest way to work out the fee:
In words: take the amount borrowed, multiply by the yearly rate (as a decimal, so 6% is 0.06), then multiply by how many years. Borrow $1,000 at 6% for 2 years: $1,000 × 0.06 × 2 = $120 of interest. This is called simple interest. Credit cards go further and charge interest on unpaid interest, which Unit 4 covers.
- Principal
- The $1,000 you borrowed.
- Simple interest
- $1,000 × 0.06 × 2 = $120. You pay back $1,000 + $120 = $1,120 in total.
Why does the rate go up or down? Think back to the supply and demand lesson. Interest is the price of money, so it follows supply and demand. Borrowers are the buyers of money and savers are the sellers. When lots of people want loans, or few people are saving, the price (the rate) rises. On top of that, the Fed pushes rates up or down on purpose.
Who votes
The twelve people from the story are the FOMC. That's the 7 Fed governors in Washington plus 5 of the 12 presidents of the regional Fed banks (they take turns). They meet eight times a year. Congress gave them two goals, called the dual mandate: as many jobs as possible, and stable prices, which the Fed defines as about 2% inflation.
- FOMC
- 12 voters: 7 governors + 5 regional bank presidents.
- Dual mandate
- The two targets you had in Rate Dial: inflation near 2% and unemployment near 4%.
How a rate hike travels
- The Fed raises its target for the fed funds rate, say from 4% to 4.5%. How? Banks keep spare cash at the Fed, called reserves, and the Fed pays them interest on it. If the Fed pays 4.5% on that cash, no bank will lend to another bank for less, because it can earn 4.5% risk-free by doing nothing.
- Banks raise their own rates. The prime rate is usually the fed funds rate plus 3, so it goes from 7% to 7.5%. Credit card and car loan rates are built on the prime rate, so they rise within weeks.
- Borrowing gets more expensive. Take an $8,000 car loan paid back over 5 years. At 8% the monthly payment is about $162. At 10% it's about $170. That's only $8 a month for you, but across millions of buyers, some decide not to buy at all.
- Saving pays more. When your savings account earns more, waiting to spend looks better. Businesses also hold off on new buildings and machines, because their loans cost more too.
- Spending slows, so prices slow. With fewer buyers, stores can't raise prices as easily, so inflation comes down. This takes about 1 to 2 years to fully show up, which is why the Fed has to act before it sees the result.
- Reserves
- A bank's spare cash parked at the Fed. At 4.5%, $1 million of reserves earns the bank $45,000 a year for doing nothing.
- Prime rate
- Fed funds rate + 3: 4.5% + 3 = 7.5%.
Other tools
Paying interest on bank reserves is the main lever, as you saw above. The Fed can also buy or sell government bonds, which adds or removes money from banks, and it lends directly to banks in an emergency. When its rate is already at zero and the economy still needs help, it can do quantitative easing (QE): buy huge amounts of long-term bonds, which pushes mortgage and other long-term rates down. Selling them off later is called quantitative tightening (QT). You'll see both in Unit 16.
- Quantitative easing
- In 2020 the Fed bought trillions of dollars of bonds. By early 2021, 30-year mortgage rates had fallen below 3%, the lowest ever.
Real interest rate
You met nominal and real in the inflation lesson. The rate a bank quotes you is the nominal rate. But inflation shrinks what your money can buy while it's lent out, so what you really gain or pay is smaller. That's the real rate:
Example: your savings pay 5% but prices rise 8% this year. Your balance grows 5%, yet it buys 3% less than before, so the real rate is 5 − 8 = −3%. For a borrower that's cheap money, which is why high inflation keeps going if rates stay low. In 1979, inflation was over 11%, so the Fed had to push rates close to 20% before borrowing actually felt expensive.
- Nominal rate
- The 5% your savings account pays.
- Real rate
- 5% − 8% inflation = −3%. Your money buys 3% less after a year, even though the balance went up.
A rule of thumb traders use
Economist John Taylor suggested a simple way to guess where the Fed's rate "should" be, now called the Taylor rule. In words: start at 2%, add the current inflation rate, then add half of how far inflation is above the 2% goal. (A fuller version also adjusts for whether the economy is running hotter or colder than normal.) With 4% inflation: 2 + 4 + half of (4 − 2) = 2 + 4 + 1 = 7%. If the Fed's actual rate is far below that, traders say policy is "loose." The Fed doesn't follow it exactly; it's a yardstick.
- Taylor rule
- Inflation is 4%: 2 + 4 + 4 − 22 = 2 + 4 + 1 = 7%. If the Fed's rate is only 5%, that's 2 points below the rule, so traders would call it loose.
The Fed is a beaver with a dam.
A beaver can't make it rain, but it controls how fast the stream flows. Build the dam higher and water slows and pools. Open a gap and it rushes downstream. The Fed doesn't create spending either. It controls how fast money flows through the economy.
What you're looking at: an illustration, not data. A stream flows into a beaver dam, pools behind it and trickles out more slowly downstream. The dam is like the Fed's rate: higher slows money down, lower lets it rush.
Build it too high and the stream dries up downstream: that's a recession. Leave it too low during a flood and everything washes out: that's inflation. Beavers adjust their dams constantly as seasons change. So does the Fed, eight times a year.
The page you'd copy down.
- Interest rate: the price of borrowing money, as a % of the loan per year.
- The Fed: the US central bank. The FOMC sets a target for the federal funds rate.
- Dual mandate: maximum employment and stable prices (2% inflation).
- Raise rates → borrowing costs more, saving pays more → spending slows → inflation cools, unemployment can rise.
- Cut rates → borrowing is cheap → spending and hiring pick up → risk of inflation.
- Lags: rate changes take about 1–2 years to fully hit the economy.
- Prime rate ≈ fed funds rate + 3%. Credit card and car loan rates are built on top of it.
- Simple interest = principal × rate × years.
- Real rate ≈ nominal rate − inflation. 5% interest with 8% inflation is −3% real.
Fill in the blanks
Grab a friend or a study group.
Mock FOMC meeting
Give everyone a role: a worried factory owner, a retiree living on savings, a first-time homebuyer, a Fed economist. Inflation is 4% and unemployment is 4.5%. Debate for five minutes, then vote: raise, hold or cut. Who won, and who paid for it?
Read the real statement
Pull up the most recent FOMC statement on federalreserve.gov. Each person highlights one sentence and translates it into plain English for the group. What did they decide, and what are they worried about?
Chair showdown
Both play Rate Dial in the same year. Compare your rate paths side by side. Did one of you move early and gently while the other waited and slammed the brakes? Whose economy came out better?
Just you and your rates.
These stay on this device. Nobody else sees them.
Exam-style questions.
Written the way a college exam would ask them. Each right answer on the first try is worth 10 xp.
On the job: you're the bank treasury analyst
Your bank has $500 million in savings deposits paying 1% and $400 million in car loans at fixed rates averaging 6%. Analysts expect the Fed to raise rates by 2 percentage points this year (for example, from 3% to 5%). To keep savers from moving their money elsewhere, your bank will have to raise its savings rate to about 2.5%.
Your task: the bank's interest profit is what it earns on loans minus what it pays savers. Estimate how that yearly profit changes. Then explain why loans with a fixed rate (one that never changes) are a risk when rates rise.
See a model answer
Before: the bank earns 6% × $400M = $24M and pays 1% × $500M = $5M, so $19M of interest profit.
After: the loans are fixed, so they still earn $24M. Deposit costs rise to 2.5% × $500M = $12.5M. Profit falls to $11.5M, down $7.5M (about 39%).
Why it's risky: the bank's costs float with the Fed but its income is locked in. This "interest rate risk" is exactly what sank Silicon Valley Bank in 2023. Treasury teams manage it by matching fixed and floating assets and liabilities, or by hedging.
Interest rates power the rest of the course.
What you're looking at: a map of where this lesson fits in the course. Read it left to right: what comes before, this lesson in the middle, and the later lessons that build on it.
- Before · Unit 9Inflation and GDP
- You are hereInterest rates and central banks
- Next · Unit 9Booms and recessions
- Later · Unit 10Rates and compounding
- Later · Unit 14Bond prices
- Later · Unit 16The Fed's full toolkit