People says US is a free market. Everything is decided by market, from price of crude oil to the price of aspirin sold in gas station. Government does not interfere or doesn't control price of any commodity. The job is government is to provide competitive and equal environment to all players in business. Sounds good...isn't it?
Yesterday's news that Feds are cutting interest rate by half percent caught my attention and made me thinking that why govt doesn't let market decide what interest rate prevail? Is it against US govt open market statement?
If your are not familiar with stock market or collage level finances you must be wondering how does it matter to you? When interest rates are changed, it affects every single persons life in country whether you know it or not. How? lower interest rate means you get lower returns on you saving, and that is just tip of iceberg, if returns are low in saving people save less and spend more . Lot more money become available in system. More money means higher inflation and price will go up and every one feel the heat. So why govt does that? The answer is simple, to fuel the economy. When bank saving becomes less attractive due to lower interest rate, people invest more in stock market, buy goods and spend their money. So its not surprising when ever feds declare rate cut you see triple digit gain in stock exchanges index.
To understand how feds works we have to go in past. In early nineteenth century all the money in market used to backed by gold in govt reserves. So even govt need more money, they couldn't just print that until they had sufficient gold reserves to back it up. As industrial age arrived, people felt that gold backed economy is inefficient and can't meet demand of new growing economy. So govt decided to remove gold backed currency restriction. With this new power is was in govt control to print what ever money required without backing it with actual gold.
This was very good step for businesses and rapidly growing economy. But extra money in market also could create high inflation and destabilize economy. To avoid this problem govt introduced regulatory bodies, who's whole job is to make a proper money balance, which affects liquidity and inflation, in the market. Fed(Central Bank) works as regulatory body in US.
To regulate money in market Fed has different instrument in their hand. They can either print more money, which generally happens whenever govt budget goes in deficit, or they can change interest rate to move money from one section of market to another section.
So in ideal sense US market is not totally free but rather regulated, which is quite necessary to maintain proper liquidity and inflation in 21st century largest economy in the world.