59. How the Fed Changes Interest Rates

http://www.informedtrades.com/
A lesson on open market operations and how the federal reserve increases and decreases the money supply in order to move interest rates and what this means for traders of the stock, futures, and foreign exchange markets.

In our last lesson we looked at the structure of the Federal Reserve and the components of the FOMC, the portion responsible for implementing Monetary Policy. Now that we have an understanding of this, we can look further into exactly how monetary policy is facilitated and what happens to markets under differing scenarios.

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.

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[wojtek0000]

im confused. wouldn't an increase in the money supply cause prices to rise? more money means less purchasing power of existing money.

[InformedTrades]

yes in general an increase in the money supply should result in rising prices. Best Regards, Dave

[ndnbikerguy]

this was absolutely excellent. I am taking AP MAcro online and im struggling because i have to teach myslef, and this video helped me alot. Thankyou.

Is it ok if i email you if i have questions for my class?

[InformedTrades]

Hi ndnbikerguy, Thanks for the comment I am glad you liked it. I don't respond to questions via email however there is a free ask/answer question section which you can find in the discussion forum at InformedTrades. If you would like to post there I will be happy to respond and you should get some good input from others as well. Best Regards Dave

[spyce921]

First off thank you for your videos they are very informative and helpful. My question is when the Fed drops interest rates doesn't this have a major impact on foreign investment in the economy? And from a monetary standpoint which is better having foreign investor loss faith in the economy or stop investing or having nationals being able to spend more? I hope my questions make sense thank you in advance

[InformedTrades]

Hi Spyce921, These are great questions which show you have a good fundamental understanding of the global markets. As I am limited in space for commenting here on YouTube I am going to send you over an email with a link to some more resources that answer these questions. Best Regards, Dave

[D4Shawn]

Not to nick pick, but the "value" of government fiat currency isn't based on "faith", but rather, on the threat of force. Obviously, if people weren't forced by law to employ government fiat currency, they wouldn't. Fiat currency has NEVER (historically) arisen naturally (on a voluntary basis) in the market.

[lingojac]

Thank you for helping me review for my macro test tomorrow :D

[th4n4t0s25]

omos are not cool! XD! nice video helped a lot!

[DMPFace]

Please explain why they got rid of the Gold Standard in 71' and the impact of that decision.

[DMPFace]

I believe one can learn more from researching himself then any one man can from a semester of a college class.

Thanks for video.

[annolvasundew]

@InformedTrades Hi Dave, really thanks for your series of videos which really help a alot! I am reading the comments with interests and i have the same questions with spyce921, can you kindly forward me the resouces which help answer those questions too? Many thanks in advance!

[hhaassaann134]

That was well explained, people (and textbooks) often forget to mention that an open market purchase involves the fed pumping in money that was previously not in circulation.Secondly I have a question, what is the difference between an open market purchase and quantitative easing? Any help is appreciated

[jaghad]

@InformedTrades

I just watched video nr 59 and I must recommend you to change the message. It simply is not correct. When the Fed buys government securities they add to the money supply in circulation, simply because they take away government securities in circulation, but in doing so they create a temporary demand for government securities, thus increasing the price of the government securities, which in turn lowers the interest rate of the security. Interest rate is not a price.

[jaghad]

@InformedTrades vice versa regarding selling government securities