Basic Economic Concepts - Interest Rates
Typically, when the supply of money increases, interest rates fall. And when the supply of money tightens, interest rates increase. So, the Fed actions discussed earlier have an impact on the following:
- Consumer spending
- Interest rates on newly issued bonds
- Market prices of existing bonds: when interest rates rise, the prices of bonds with lower coupon rates decrease and vice versa
Fed actions can also indirectly impact stocks:
- When monetary policy expands credit, lower interest rates make bonds less appealing as investments, and stocks more appealing.
- From the corporate perspective, company earnings may rise because of lower interest expense, which may cause the market price of the stock to rise.
- Of course, when the opposite occurs and monetary policy tightens credit, interest rates will rise, earnings will decrease, and the market price of the stock is likely to decrease as well. As interest rates rise, bonds become more attractive to investors.
Consider these sample exam questions:
- Which of the following short-term effects could result from increases in the money supply?
- Interest rate increases
- Bond price decreases
- Stock price increases
- I & II
- I & IV
- III & IV
- I, III, & IV
The correct answer is "c": increases in the money supply would decrease interest rates, not increase them, and bond and stock prices would both increase. Inflation does not always follow an increase in the money supply, but it usually does if the increase in the money supply is not accompanied by an increase in real output.
- All of the following are tools used by the Federal Reserve to control the money supply EXCEPT:
- Setting the Fed funds rate
- Setting the discount rate
- Changing reserve requirements
- Buying and selling government securities in the open market
The correct answer is "a". All the other actions are tools used by the Federal Reserve, but it does not have the ability to set the Fed funds rate. That rate responds to Fed actions but is not directly set by the Fed.