How can the Fed affect the money supply by using the discount rate?

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pohnpei397's profile pic

pohnpei397 | College Teacher | (Level 3) Distinguished Educator

Posted on

The Federal Reserve (the Fed) can affect the money supply by using the discount rate because it will affect the amount of lending that goes on in the economy.

The discount rate is the interest rate that the Fed charges banks that want to borrow money from it.  The interest rate that the Fed charges then affects the interest rates that banks themselves charge.  The interest rate that banks charge is, in essence, the price that people and firms must pay to borrow money from the banks.

Basic economic laws tell us that when the price of something goes down, people will buy more of that thing.  In this case, when the price of borrowing money drops, people will borrow more of it.  When people borrow more money, the supply of money increases.  That is because every time people borrow money, they in essence make more of it.  If there is $1,000 in a bank and I borrow that $1,000, the money supply has increased by $1,000.  The original $1,000 is still in the bank and whoever it belonged to can still come and get it.  At the same time, I have $1,000 that did not previously exist.  This means that the bank and I created $1,000 in new money when I borrowed money from them.

Thus, if the Fed decreases the interest rate, it increases the supply of money.  If it increases the discount rate, it raises the price of borrowing and the money supply drops.

luke18035's profile pic

luke18035 | Student, Grade 9 | (Level 1) Honors

Posted on

It can increase/decrease they money supply by buying and selling bonds by using open market operations. (Buying bond will raise the money supply and selling will lower it

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