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How the Federal Reserve Manipulates Interest Rates and the Money Supply

Posted by
May 31, 2012

by Robert Wenzel

My post on the eurozone crisis and Ben Bernanke targeting of the Fed Funds rate has resulted in a number commenters asking for specifics on how it’s all done. Below is a quick explanation, for a more detailed explanation I recommend Murray Rothbard’s book, The Mystery of Banking.

The Federal Reserve manipulates interest rates, generally, by buying and selling Treasury bills. When they buy Treasury bills, they add reserves to the banking system. That is they issue a credit to the bank (primary dealer) that they buy the T-bills from. If the bank doesn’t put the credit into excess reserves, the money becomes part of required reserves that the bank lends money out against, which increases the money supply. (The increase in money supply is actually a multiple of the added required reserves–see Rothbard)

When the Federal Reserve sells Treasury bills, the bank (primary dealer) that they sell the T-bills to pays for them with reserves, which drains reserves from the system and decreases the amount of money in the system.

Generally, when the Fed is targeting interest rates, it is doing so to keep interest rates from climbing. This is what occurred during the G. William Miller period I discussed in my earlier post.

During the Miller period, the Fed had to buy huge amounts of Treasury bills to keep rates down. This resulted in a huge increase in reserves, which resulted in exploding money supply, which resulted in soaring prices. Which resulted in higher interest rates. It was a tiger by the tail situation. When Volcker replaced Miller at the Fed, he stopped targeting interest rates and said that instead he would just slow money supply growth (to battle the price inflation)and not care about interest rates. (Rates then soared to double digit levels, some reaching 20% plus, but Volcker was successful in killing the price inflation) …

Continue reading at EconomicPolicyJournal.com…

image: flickr.com/mlcastle