In response to problems in financial markets and a slowing...

In response to problems in financial markets and a slowing economy, the Federal Open Market Committee (FOMC) began lowering its target for the federal funds rate from 5.25 percent in September 2007 . Over the next year, the FOMC cut its federal funds rate target in a series of steps. Economist Price Fish back of the University of Arizona observed, "The Fed has been pouring more money into the banking system by cutting the target federal funds rate to 0 to 0.25 percent in December 2008 " What is the relationship between the federal funds rate falling and the money supply increasing? How does lowering the target for the federal funds rate "pour money" into the banking system?

Key Concepts

Banking System Liquidity

This concept involves the ease with which banks can meet their short-term obligations. When the central bank lowers the federal funds rate through actions like open market operations, it increases bank reserves, boosting liquidity. This enhanced liquidity means banks have more funds to lend, which 'pours money' into the banking system and helps stimulate economic activity.

Open Market Operations

These are the primary tools used by central banks to manage the money supply and influence the federal funds rate. By buying or selling government securities on the open market, central banks inject or withdraw liquidity from the banking system. Buying securities increases the reserve levels of banks, lowering interest rates and increasing the money supply.

Money Supply

The money supply refers to the total amount of monetary assets available in an economy at a specific time. It includes physical currency, deposits, and other near-money assets. When the money supply increases, it typically leads to greater liquidity and potentially lower borrowing costs, which can stimulate economic activity.

Federal Funds Rate

This is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight. It plays a crucial role in monetary policy by influencing overall interest rates, borrowing costs, and economic activity. Adjusting this rate affects the cost of money in the economy, making financial institutions adjust their lending and borrowing behavior accordingly.

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