Essay about Targeting Of The Money Supply And Interest Rates
The central banks generally attempt to achieve inflation around 2%. Inflation hinges on how much money is in circulation, the money supply. However, the central bank cannot directly control the money supply but rather uses different tools to achieve its target. As the money supply cannot be controlled, other actors tug the number up and down, for which it may differ from its desired state. Interest rates, on the other hand, as one such instrument that influences the money supply, can more easily be altered as they closely relate to the progression of the fed funds rate, which, in turn, orients itself on the federal discount rate (International Monetary Fund,
2012; Schabert, 2005, p. 5).
Say, the Federal Reserve alters the rate at which commercial banks borrow from the central bank, what is called the federal discount rate. As banks are allowed to borrow more cheaply, they can pass the cut on to the clients. More money gets borrowed, the money in circulation increases (Investopedia, 2015).
On the contrary, if the Federal Reserve provides more money to the economy by means of open market operations, the monetary base increases, yet the Fed cannot control how much the bank passes on and to whom. Increasing the monetary base is hoped to lead to a decline in interest rates (International Monetary Fund, 2012), though the relation is not necessarily as intuitive (Schabert,…