Final answer:
The Federal Reserve uses the discount rate to control the money supply by influencing banks' borrowing costs, thereby managing economic activity and inflation. The rate changes depending on whether the economy needs to be stimulated or cooled down. In extreme cases, such as the 2008-2009 recession, the fed funds rate reached near zero, limiting the effectiveness of interest rate adjustments.
Step-by-step explanation:
The Role of the Federal Reserve in Setting Interest Rates
The Federal Reserve (often referred to as the Fed) was established as the central bank of the United States through the Federal Reserve Act of 1913 following the Financial Panic of 1907. Its primary role includes regulating the banking industry and influencing monetary policy. One of the tools at its disposal is the ability to change the discount rate—the interest rate charged on loans to banks from the Federal Reserve.
When the economy requires stimulation, the Federal Reserve can lower the discount rate to encourage banks to borrow more money, which in turn increases the money supply available for businesses and consumers to spend and invest. Conversely, when the economy is showing signs of overheating or when inflation is rising, the Fed can raise the discount rate to make borrowing more expensive, which helps to reduce the money supply and slow down economic activity.
During the 2008-2009 recession, the fed funds rate—the interest rate targeted by the Federal Reserve's monetary policy—plummeted to nearly zero. This presented the Fed with the unconventional scenario of having to use other monetary tools, as the traditional mechanism of lowering interest rates was no longer effective.