The Federal Reserve, or “Fed”, controls money supply in the economy using three tools.
The first tool involves buying and selling bonds, in the bond market. These buying and selling activities are called open market operations.
The second tool is the discount rate - the interest rate on funds that the Fed loans to banks. Decreasing the discount rate encourages banks to borrow reserves from the Fed. Increasing the discount rate discourages banks from borrowing reserves from the Fed.
Changing the reserve requirements is the Fed’s third tool. Reserve requirements determine the minimum amount of reserves that banks must hold against deposits.
How is quantitative easing implemented? The Federal Reserve conducts open market operations, buying bonds from the public in the nation’s bond market. The Fed pays for these bonds simply by crediting the reserve balances of the sellers' banks. Although many people refer to this process as "the Fed printing money", the Fed’s purchase of bonds is just a bookkeeping entry between the Fed and the sellers' banks. This increases total reserves and the amount of money in circulation.
When the bond sellers receive the money from the Fed they keep some of the money as currency and some of the money is deposited in their bank accounts. Banks then lend this money to businesses and consumers. The economy’s money supply increases, and interest rates decline making it easier for the economy to expand.
How does monetary policy affect the economy? Let’s look at the demand and supply of money in the economy. The money supply curve is vertical because the amount of money is determined by the Fed independently. If the Fed implements an expansionary monetary policy, it buys bonds. This increases the amount of money in the economy and shifts the money supply curve to the right.
Banking reserves increase and banks make more loans. The supply of loanable funds curve shifts to the right. The increased supply of funds in the economy places downward pressure on real interest rates.
As the real interest rate falls from R1 to R2, lower interest rates stimulate consumption, investing and net exports. The aggregate demand curve shifts right from AD1 to AD2. Production increases from Y1 to Y2 and prices increase.
In summary, an expansion in money supply reduces interest rates. Lower real interest rates make investment and consumption cheaper. At lower interest rates, entrepreneurs undertake some investment projects they otherwise would not have. Spending, by firms, increases. Similarly, consumers buy more.
Lower interest rates also tend to cause financial capital to move abroad. As funds move out of the country, the dollar depreciates in value and net exports expand. As domestic interest rates fall, both domestic and foreign investors shift some of their financial investment to countries where interest rates are higher and the investors can get better returns.
As investors shift funds abroad, they exchange dollars for the currency they need to purchase the new foreign assets. Consequently, the dollar depreciates in the foreign exchange market. In turn, the dollar’s depreciation makes imports more expensive for Americans and U.S. exports cheaper for foreigners. As a result, U.S. imports decline and exports expand. U.S. aggregate demand increases as foreigners buy more U.S. goods and services.
Finally, lower interest rates tend to cause the prices of assets such as stocks, houses, and other investment properties to rise. Why does this happen? When the Fed increases the money supply, people find themselves with more money balances than they want to hold. To reduce these excess balances, people increase their purchases of goods and services, and their purchases of assets like houses and corporate equities. Increased demand for these assets raises their prices.
As the prices of real financial assets rise, household wealth increases. Because people are wealthier, they increase their consumption spending more. As the prices of houses and other physical assets rise, these assets become more profitable to produce. Entrepreneurs invest to expand production and their new investment contributes to increased aggregate demand. In summary, reduced interest rates increase aggregate demand in the economy.
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