HOW MONETARY POLICY AFFECTS THE ECONOMY
Learn even more about this topic with the Encyclopedia of Personal Finance™
Imagine that you are interested in buying a new house. Let's say
that mortgage rates are only 3 percent but you expect them to rise to 5 percent
next year. Most likely, you and thousands of others would want to take advantage
of the current low interest rates by buying a home now. This demand would lead
to increased demand for lumber, cabinets, carpet, tile, construction workers,
etc., which in turn would have a ripple effect on the entire economy, spurring
production. Increased sales would lead to higher earnings and growth potential
for companies, thus boosting the stock market. As you can see, interest rates
have a tremendous effect directly or indirectly on the economy. Because the
Federal Reserve largely controls interest rates through its monetary policy, the
Fed has a tremendous impact on the overall economy.
The Fed influences the economy in two major ways: by changing the
interest rates it charges banks for loans, and by buying and selling government
Interest rates—The Fed will often raise
or lower the rate at which it charges banks for short-term loans; this rate is
called the discount rate. Banks will then raise or lower their interest
rates in response to the Fed's action.
Open market operations—This is the practice of
the Federal Reserve buying or selling U.S. Government securities, such as
Treasury bills (T-bills). When they sell these securities, the money received
from the sale is taken out of circulation, thus reducing the money supply. When
the Fed buys these securities, the money returns to the market, increasing the
Increasing or decreasing the money supply through open market
operations also affects interest rates. If the Fed decreases the money supply,
money becomes scarcer. Therefore, banks are able to charge higher interest
rates. If the money supply increases, money is relatively more abundant and
interest rates will decline as a result.
We have discussed how monetary policy affects the overall
economy. But now, let's look at how it affects your investments. We will start
with fixed-income securities.