How the Federal Reserve Changes the Money Supply and Affects Interest Rates

How the Federal Reserve Changes the Money Supply and Affects Interest Rates
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  • 0:05 The Cause of the Great…
  • 2:09 The Fed Controls the…
  • 5:12 How the Fed Achieves…
  • 7:17 Illustrating Money…
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

Discover the connection between the money supply and economic output and how the central bank's tools lead to an increase or decrease in real GDP via expansionary and contractionary monetary policy.

The Cause of the Great Depression

In 2002, before he became the chairman of the Federal Reserve, Ben Bernanke wrote a paper and gave it to the famous economist Milton Friedman in celebration of his 90th birthday. In the paper, Chairman Bernanke made an amazing statement. Understand that Ben Bernanke is a scholar when it comes to the Great Depression. He's studied it more than almost any economist in the world, it seems like. Here's the comment he made: 'Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say... Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.'

Ben Bernanke acknowledged that the Federal Reserve was responsible for the Great Depression
Cause of Great Depression

What was Bernanke talking about? Isn't the job of the Federal Reserve to protect the banking system from collapse? How could he say that the Federal Reserve caused the Great Depression? He did say it, and he was right. What he was really talking about was the money supply, which is controlled by the Federal Reserve. When you study the Great Depression, you realize that it was caused by a major decline in the money supply. By the time the economy reached its low in March of 1933, the money supply had fallen by 33 percent!

Obviously, the Fed understands things today that it didn't understand back then. There wouldn't have been a Great Depression, or at least to the extent that we had it, if they understood that the money supply has an enormous influence over the economy. When the economy was in recession in December of 2007, the Federal Reserve did the opposite of what it did during the Great Depression - it increased the money supply. It's very interesting that the one economist who became an expert in his understanding of the Great Depression happened to be seated in the most powerful financial position exactly when his country needed him the most. His expertise is largely responsible for keeping our economy out of another depression.

But how can pumping money into the economy make it grow faster? In other words, how does the money supply affect real GDP?

The Fed Controls the Fire Beneath the Economy

To answer this question, let's go back to the town of Ceelo, where people all over the town are enjoying their Friday night. Imagine you're on a camping trip in the foothills, which is about an hour away from town - just close enough to drive there fairly quickly and just far enough to feel like the destination is 'out of town' and therefore disconnected from the hustle and bustle and grind of everyday living and the routines of waking up before the roosters even think about crowing.

It's about five o'clock, and the sun will start going down in a few hours. Along with a small group of three friends, you're at a campsite, and earlier that day, everyone agreed by text that it would be a rewarding experience to cook pasta for dinner over the campfire - like they probably did in Florence during the Renaissance, you think to yourself, with a healthy dose of optimism and hopeful expectation of enjoying the company of your friends. As a matter of fact, one of the other campers is Margie, the cake baker.

After spending a few minutes complementing her on the quality of her chocolate cake, you look around the campsite and begin thinking about how to accomplish the task of cooking a pasta dinner. You're so hungry that you're about to faint.

Suppose your group has a large pot for boiling water. There's a river nearby that someone can use to fill up your pot with water. Also, there's a wood-burning fire, boxes of pasta, and finally a large supply of gas (more specifically, lighter fuel) that can be poured onto the fire.

Now suppose Margie looks at you and gives you the choice of performing one of these three tasks. You can be responsible for the supply of water and the pot that goes with it, you can be responsible for the raw materials, in this case, the pasta, or you can be responsible for the fire and the gas that comes with it. You think to yourself, I'm so hungry I'm about to faint. How can I speed up this process?

What's the one role in the cooking process that you want to control in order to have the greatest influence over how fast the pasta gets cooked? If you choose to control the size of the fire and the gas that gets poured onto the fire, you would gain a great deal of control.

The bigger the fire is, the faster the water boils and the more pasta your group can cook. If you want the cooking process to go faster, you can simply pour gas on the fire to light it up quickly. The person who controls the fire supply can choose with one move to dramatically increase the speed of the cooking process.

When you compare the process of getting the economy to grow with cooking pasta, it's easier to understand why the Federal Reserve wants to control the money supply - not because it's filled with people of Italian descent, but because it can quickly light a fire underneath the economy to increase economic output. I bet that's the first time you've ever heard anyone compare the economy to cooking pasta.

Increasing the money supply is like lighting a fire under the economy to increase economic output
Increasing Money Supply

How the Fed Achieves its Objectives

In order to achieve its three objectives of maximum employment, price stability, and moderate interest rates, the Federal Reserve controls the money supply, and the money supply changes the interest rates. Increasing the money supply is like pouring gas on the campfire. Why do they want to control the interest rate? Because it directly influences the demand for money, which affects how the economy grows.

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