Question

In response to problems in financial markets and a slowing economy, the Federal Open Market Committee (FOMC) began lowering its target for the federal funds rate from 5.25 percent in September 2007 . Over the next year, the FOMC cut its federal funds rate target in a series of steps. Economist Price Fishback of the University of Arizona observed, "The Fed has been pouring more money into the banking system by cutting the target federal funds rate to 0 to 0.25 percent in December 2008." What is the relationship between the federal funds rate falling and the money supply increasing? How does lowering the target for the federal funds rate "pour money" into the banking system?

Short answer

The relationship between the federal funds rate falling and the increase in money supply revolves around the cost of borrowing. When the federal funds rate decreases, banks find it cheaper to borrow and thus increase their lending to customers, effectively increasing the money supply in the economy. Lowering the federal funds rate is equivalent to 'pouring money' into the banking system since it promotes borrowing and circulation of money within the system.

Step-by-step solution

Understand the Federal Funds Rate

The Federal Funds Rate is the interest rate that banks charge each other for overnight loans of federal funds. These are the reserves kept by banks at the Federal Reserve. In simpler terms, it's the rate at which banks lend money to each other overnight.

Identify the Relationship Between Lower Federal Funds Rate and Increased Money Supply

When the Federal Reserve lowers the target for the federal funds rate, it essentially reduces the cost of borrowing money. Banks can, therefore, borrow more at a lower cost which increases the amount of money that they have available to lend to customers. This causes an increase in the money supply in the economy.

Explain how Lowering the Federal Funds Rate 'Pours Money' into the Banking System

Lowering the federal funds rate target makes it cheaper for banks to borrow money. This can lead to an increase in borrowing, and therefore an increase in the amount of money in circulation. This is because, once banks borrow more money, they will likely lend more to consumers and businesses, effectively injecting or 'pouring more money' into the economy. So, in essence, cutting the federal funds rate is like 'pouring money' into the banking system.

Key concepts

Money Supply

When talking about the 'money supply,' we are referring to the total amount of money — including cash, coins, and balances in bank accounts — available in an economy at a particular time. The central bank, which in the United States is the Federal Reserve, uses several tools to manage the money supply, one of which is the federal funds rate.

Understanding the relationship between the federal funds rate and the money supply is crucial. A lower federal funds rate makes borrowing more affordable for banks, which then encourages them to increase lending to businesses and consumers. As these loans are made, new money enters the economy, effectively expanding the money supply.

This expansion has a ripple effect: businesses might invest in new projects or hire additional staff, and consumers may spend more on goods and services. More money in circulation can stimulate economic activity but can also lead to inflation if growth outpaces production capabilities.

Central Banking

Central banking is embodied by an institution like the Federal Reserve, which plays a critical role in a country's economy. It is responsible for conducting monetary policy, providing financial services, and supervising and regulating banks to ensure the safety and stability of the financial system.

The Federal Reserve uses the federal funds rate as one of its primary tools to influence economic activity. By adjusting this rate, the Fed can nudge banks toward lending more or less, depending on what is needed. For example, in a slowing economy, the Fed might lower the rate to stimulate activity, as it did in 2008 during the financial crisis. Higher rates, on the other hand, can help to cool down an overheating economy.

Role of the Federal Reserve

As the central bank, the Fed also ensures that the financial systems operate smoothly by providing various services, including managing currency distribution, processing payments, and serving as a bank for the government and other banks.

Economic Policy

Economic policy encompasses the actions that governments take in the economic field, including tax policy, government spending, labor market regulation, and monetary policy. The latter, which is informed by central banking, includes managing interest rates and regulating the money supply to achieve specific economic objectives, such as controlling inflation, maximizing employment, and stabilizing currency.

When a central bank such as the Federal Reserve modifies the federal funds rate, it is exercising its monetary policy to influence economic growth. Lowering the rate is a policy action aimed at stimulating the economy by making loans cheaper, thereby encouraging spending and investment. This monetary policy tool can stimulate demand and lead to economic growth during periods of economic slowdown.

Balance of Objectives

In implementing economic policies, central banks must balance between stimulating growth and preventing excessive inflation. Rate changes are carefully considered decisions that require analyzing a wide range of economic indicators and projections to support the overall economic health of the nation.