Wednesday, 27 January 2010

The Economic Climate (11): Fed and Money Supply

The agency in charge of climate control is the Federal Reserve System, also known as the Fed. 

It has a special way of heating things up and cooling things down - not by blowing on them, but by adding and subtracting money.  Given its huge importance, it's amazing how few people know what the Fed is all about.

In a survey from several years ago, some people said the Federal Reserve was a national park, while others thougth it was a brand of whiskey.

In fact, it's the central banking system that controls the money supply. (Monetary policy)

Whenever the economy is cooling off too much, the Fed does 2 things. 

(1)  It lowers the interest rates that banks must pay when they borrow money from the government. 
  • This causes the banks to lower the interest rates they charge to their customers, so people can afford to take out more loans and buy more cars and more houses. 
  • The economy begins to heat up.

(2)  The Fed also pumps money directly into the banks, so they have more to lend. 
  • This pumping of money also causes interest rates to go down. 
And in certain situations, the government can spend more money and stimulate the economy the same way you do every time you spend money at a store. (Fiscal policy)

If the economy is too hot, the Fed can take the opposite approach:  raising interest rates and draining money from the banks. 

This causes the supply of money to shrink , and interest rates go higher. 
  • When this happens, bank loans become too expensive for many consumers, who stop buying cars and houses. 
  • The economy starts to cool off. 
  • Business lose business, workers lose jobs, and store owners get lonely and slash prices to attract customers.
Then at some point, when the economy is thoroughly chilled, the Fed steps in and heats it up again.  The process goes on endlessly, and Wall Street is always worried about it.

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