Money by Mohammad Ashraf

Author:Mohammad Ashraf
Language: eng
Format: epub
ISBN: 9783030503789
Publisher: Springer International Publishing

5.4 The Impact of Changes in Money Supply on the Economy

We have learned that the Fed changes the federal funds rate target. We have also learned about the tools the Fed uses to change money supply to meet that target. The question arises: How does this change in the federal funds rate affect the economy? In other words, what is the channel through which monetary policy affects the economy?

First, recall that various interest rates move in the same direction (Figs. 5.7 and 5.8). This means that interest rates that commercial banks charge the borrowers move in the same direction. For instance, when the Fed raises the federal funds rate target, and decreases the money supply to meet that target, other interest rates also increase. This increases the costs of borrowing for all borrowers. As a result of the increase in borrowing costs, some projects are no longer profitable (Table 5.2). The quantity of investment in the economy decreases. At this point, it is helpful to recall that investment is an addition to the existing stock of capital plus changes in inventories. The owners of the firm who wanted to build the plant to produce widgets do not deem the project profitable. They will scratch the plan. They will not buy the machines, build the building, and hire workers to product those widgets. Workers who would have gotten the jobs to produce widgets would no longer get those jobs. They will cut back on their consumption (Chapter 4). A household that wanted to build a bigger house reacts the same way. With an increase in the mortgage rates, the cost of borrowing for the household increases. The plan to build a bigger house is scratched for now. So on and so forth. The overall economic activity in the economy declines. The reverse happens when the Fed lowers the federal funds rate target and increases money supply to meet the target.

We, as consumers, often borrow to buy big-ticket items like cars and appliances. When interest rates increase, our costs of borrowing increase. We hold off purchasing a new car or a new refrigerator. This dampens the demand for consumer goods. The firms that build these consumer goods cannot sell the items they have already produced. Inventories pile up. They cut back on production. In order to cut back on production, they either ask workers to work fewer hours, or fire some workers, or a combination of the two. Workers’ incomes decrease. The affected workers cut back their consumption. Again, the overall economic activity declines. The reverse happens when the Fed lowers the federal funds rate targets and increases money supply to meet this new lowered target. The lowering of the federal funds rate target in the aftermath of the 2007–2009 financial crisis and the Great Recession that followed is one such example. These are the main contours of the channel through which monetary policy (i.e., changes in money supply) affect the economy.

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