The government can raises the money supply by loosening money or the reserve requirement for banks. Both actions work to expand the money supply through different channels. Central banks loosen money by cutting interest rates or quantitative easing.

Cutting interest rates creates incentives for investors to move money from the safety of risk-free or less-risky assets to riskier assets to create enough returns to keep up with inflation. This action boosts the value of all types of financial assets. In normal environments, stocks and bonds move inversely.

Stocks rise in response to a strong economy, which also implies inflationary pressures putting upward pressure on interest rates. Signs of a slow economy lead to falling stocks and rising bond prices. However, in a falling rate environment, stocks can rise while bond yields can decline.

In March 2009, the yield on the 10-year bond was 2.75% while the S&P 500 was at 666. In March 2015, the yield on the 10-year note was 1.95% while the S&P 500 was at 2,080. Over this time, the Federal Reserve was engaged in quantitative easing.

This is expansion of the money supply; boosting asset prices leads to stronger balance sheets and prevents defaults that contract the money supply. Lower interest rates also lead to more borrowing and more economic activity.

Besides interest rates, central banks can expand the money supply by cutting the reserve requirement. This is the amount of capital a bank must hold on to when making loans. Cutting this number allows the bank to make more loans with the same amount of capital, stimulating lending activity. More lending on the same amount of capital leads to more money circulating in the economy as well as making lending more profitable for banks.

  1. What are some different kinds of expansionary policy?

    Learn the most popular types of expansionary policy used by the federal government and the Federal Reserve to increase the ... Read Answer >>
  2. What are the implications of a high Federal Funds Rate?

    Learn the implications of a high federal funds rate, which include constriction of the money supply, a stronger dollar and ... Read Answer >>
  3. How can bond yield influence the stock market?

    Learn how bond yields influence the stock market. The relationship between bond yields and stocks changes depending on the ... Read Answer >>
  4. Who determines interest rates?

    In countries using a centralized banking model, interest rates are determined by the central bank. In the first step of interest ... Read Answer >>
  5. What impact does quantitative easing have on consumers in the U.S.?

    Dig deeper into the Federal Reserve's quantitative easing policies and what potential impacts they may have on American consumers. Read Answer >>
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