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Old 02-19-2008, 07:25 PM   #1 (permalink)
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An Explanation of How the Fed Moves Interest Rates


Monetary Policy very simply is anything which relates to action by the Federal Reserve to influence the amount of money and credit available in the economy. To understand exactly what this means, one first must understand the concept of fiat monetary systems.

Fiat Monetary Systems: The United States, like most major economies, has what is known as a fiat monetary system. A Fiat Monetary system very simply is any system which uses a monetary unit (in this case the US Dollar) which is not convertible to some commodity, in general a precious metal such as gold.

Fiat money, is money that is backed by the credit of some entity, normally a government, and the value for which is derived from its relative scarcity and the faith placed in it by the population which uses it.

This is important to us as traders because the fact that the Dollar is not convertible to a commodity such as gold gives the Federal Reserve the ability to increase or decrease the money supply as it sees fit, or in other words to enact Monetary Policy.

With this in mind the 3 tools available to the Fed for enacting monetary policy are:
  • Open Market Operations
  • The Discount Rate
  • Reserve Requirements
The most common tool that the Fed uses, and therefore the one that we will cover, is Open Market Operations. Once we have an understanding of this and how increases or decreases in the supply of money affect demand and prices, the other two less commonly used tools will be more easily understood.

Through something which is known as the Open Market Committee, the Fed increases and decreases the supply of money by buying and selling US Government securities.

When The Fed wishes to reduce interest rates they will increase the supply of money by buying government securities using money that was not available in circulation before they made their purchase. As with anything, when additional supply is added and everything else remains constant, price normally falls. In this case the price that we are referring to is the cost of borrowing money or interest rates.

Conversely, when the fed wishes to increase interest rates they will instruct the open market committee to sell government securities thereby taking the money they earn on the proceeds of those sales out of circulation and reducing the money supply. When supply is taken away and everything else remains constant, price (or in this case interest rates which represent price) will normally rise.

When the fed increases or decreases the supply of money they are doing so to try and directly influence something which is known as the Fed Funds Rate, or the interest rate in which charge to each other for overnight loans. With this in mind we now when we hear the fed has lowered or raised the Fed Funds rate by a quarter of a percentage point, for example, what has actually happened is they have increased or decreased the supply of money in the economy.

As you can hopefully now begin to see if you’ve watched our lesson on fiscal policy, monetary policy is a strong tool which can affect the business cycle and therefore the markets in much the same way as fiscal policy. In tomorrow’s lesson we will look at exactly how this is done so we hope to see you in that lesson.

As always if you have any questions or comments please leave them in the comments section below so we can all learn to trade together, and have a great day!



External Links:

History of fiat money

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Old 09-30-2008, 08:51 PM   #2 (permalink)
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Fed funds rate increase = market goes up, vice versa?


Hi David,

Thanks for the awesome lessons! I have learned a lot from all those videos.

In short, When Fed increase the Fed funds rate in the government security, market (stock) will goes up right? considering everything else is the same.

Fed rate increase -> More money in the market -> Interest rate goes down -> more people borrow money -> more business, more demand, more paycheck -> market price goes up (stock/index)

Thanks for your help.
Jeff
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Old 10-01-2008, 08:14 AM   #3 (permalink)
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Hi Jeff,

Glad to hear from you.

When the Fed increases interest rates then generally the stock market will go down all else being equal.

Fed rate increase -> Less money in the market -> Interest rate goes up -> less people borrow money -> less business, less demand, less paycheck -> market price goes down (stock/index)

Let me know if that does not make sense.

Best Regards,
Dave
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Old 10-01-2008, 08:43 PM   #4 (permalink)
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Originally Posted by David Waring View Post
Hi Jeff,

Glad to hear from you.

When the Fed increases interest rates then generally the stock market will go down all else being equal.

Fed rate increase -> Less money in the market -> Interest rate goes up -> less people borrow money -> less business, less demand, less paycheck -> market price goes down (stock/index)

Let me know if that does not make sense.

Best Regards,
Dave
Hi Dave,

When Fed increase the interest rate, what actually happen? (physically) What is the relation between fed rate increase and less money in the market?

is this because the bank borrowing money from reserve bank, thus when fed rate increase bank need to pay more money to reserve bank?

Thanks
Jeff
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Old 10-01-2008, 09:06 PM   #5 (permalink)
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How does the Fed Change Interest Rates?


Hey Jeff,

Glad to hear from you.

When the fed wants to raise interest rates they reduce the money supply by selling previously issued treasury bills (US Government Debt) in the open market through what is known as Open Market Operations. Because the institutions that by this debt from the fed pay cash for it, this effectively reduces the money supply because those institutions now hold treasuries instead of the cash they used to buy them. Because there is less money in the system the cost of borrowing money (interest rates) rise based on simple supply and demand (supply has decreased so all else being equal price goes up).

Conversely, when the Fed wishes to decrease interest rates, they buy treasury bills from institutions in the open market which puts cash that was formerly not in the system into circulation as they by those treasuries directly from financial institutions who then lend that money out. This increases the money supply so the cost of borrowing money (interest rates) goes down.

Here are some links with more information on how the Federal Reserve changes interest rates:

Interest Rates: An Introduction - Federal Reserve Bank of New York

HowStuffWorks "Why does the Fed change the interest rate?"

US Monetary Policy: How it Affects the Economy

Hope that helps. If there are any other questions or comments on this one please feel free to post as always.

Best Regards,
Dave
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Old 10-07-2008, 01:12 AM   #6 (permalink)
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Quote:
Originally Posted by David Waring View Post
Hey Jeff,

Glad to hear from you.

When the fed wants to raise interest rates they reduce the money supply by selling previously issued treasury bills (US Government Debt) in the open market through what is known as Open Market Operations. Because the institutions that by this debt from the fed pay cash for it, this effectively reduces the money supply because those institutions now hold treasuries instead of the cash they used to buy them. Because there is less money in the system the cost of borrowing money (interest rates) rise based on simple supply and demand (supply has decreased so all else being equal price goes up).

Conversely, when the Fed wishes to decrease interest rates, they buy treasury bills from institutions in the open market which puts cash that was formerly not in the system into circulation as they by those treasuries directly from financial institutions who then lend that money out. This increases the money supply so the cost of borrowing money (interest rates) goes down.

Here are some links with more information on how the Federal Reserve changes interest rates:

Interest Rates: An Introduction - Federal Reserve Bank of New York

HowStuffWorks "Why does the Fed change the interest rate?"

US Monetary Policy: How it Affects the Economy

Hope that helps. If there are any other questions or comments on this one please feel free to post as always.

Best Regards,
Dave
Hi Dave,

In today's example, Fed announced fund rates to be cut 100 basis point today. Did they buy the government bonds first to release the money supply to the banks before the announcement made? Or they make the announcement first, then start buying the government bonds periodically (over 1 week/month period etc) to release more money supply to the banks until it reaches the certain amount of money supply in the market?

Thanks for the helps
Jeff

Thanks for the helps.
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Old 10-07-2008, 02:51 PM   #7 (permalink)
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Hi Jeff,

Glad to hear from you.

I am assuming you mean the Reserve Bank of Australia not the Fed but yes the Reserve Bank of Australia did cut interest rates by 1% today.

To be honest what I know is that the central banks target the money supply normally by buying and selling securities in the manner I have described to move interest rates. Beyond that I am not sure the exact details of when this takes place.

If there is someone who does know the answer here I would appreciate you posting it.

Best Regards,
Dave
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Old 02-02-2009, 05:37 AM   #8 (permalink)
 
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Hi David,

'Press Release
Federal Reserve Press Release

Release Date: January 28, 2009
For immediate release

The Federal Open Market Committee decided today to keep its target range for the federal funds rate at 0 to 1/4 percent. The Committee continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.'

Can you explain the key points in this statement in very layman terms.
I still don't get the part about FED funds and how does the changing of the FED fund help the market. I'm confused.
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Old 02-02-2009, 01:02 PM   #9 (permalink)
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Hi Forexer,

My goal in module 8 is to explain these things in very simple terms. If you have been through all of the lessons in module 8 and are still having trouble then I would recommend checking out the below resource which also is meant to give this explanation in simple terms.

HowStuffWorks "How the Fed Works"

Hope that helps.

Best Regards,
Dave
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Old 02-22-2009, 06:08 PM   #10 (permalink)
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fiscal stimulus


What is a fiscal stimulus. How is it it relates to money supply?
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