Here's the answer...
To really understand the answer to this question, it is important to
recognize the relationship between the money supply and interest
rates. Money is just like any other commodity—its value is determined
by the interplay of supply and demand. If there is a large supply of
money relative to the demand for money, then its value will decrease.
It is also important to recognize that the interest rate represents
the implicit cost of holding money, or its “value”—if you have cash in
your wallet instead of in a bank account, you forego the interest that
you might have collected on that cash had you kept it in you bank
account. Thus the interest rate is a way of finding equilibrium
between the supply and demand of money—it moves up or down as the
money supply moves until money demand exactly equals money supply. If
money supply increases, there is more money available in the economy,
so the “value” of money goes down, and the interest rate goes down.
If the money supply decreases, money becomes more precious, so the
cost of borrowing it (the interest rate) goes up.
It’s also useful to understand the mechanism that the Fed uses for
setting the rates. The Fed does not directly controls interest rate
but rather does so implicitly through the money supply—it buys or
sells government bonds to banks, which affects how much money they are
allowed by law to loan out to their depositors, which in turn
determines the amount of money that is available in the economy as a
whole. (A more detailed description of this process can be found at
http://www.libertyhaven.com/regulationandpropertyrights/bankingmoneyorfinance/fedsets.shtml).
When the Fed wants to increase interest rates, it buys fewer bonds,
which decreases the supply of money in the economy. When it wants to
decrease rates, it increases the money supply.
Now, to answer your question, let’s compare the effects of a drop in
money demand with and without a Fed rate target. If the demand for
money unexpectedly goes down, the interest rate will go down until the
money supply once again matches the money demand (just as with any
other supply/demand relationship, less demand equals a lower price).
In this situation the Fed would not intervene, and so the interest
rate would stay at the lower level, which might effect the performance
of the economy.
Now suppose that the Fed has an interest rate target—this means that
they expand or contract the money supply as needed in order to
maintain a constant interest rate. If money demand goes down, the
Fed, seeing the resultant drop in the interest rate, will want to
raise the rate back to its targeted level. How would it accomplish
this?—By reducing the available supply of money. This would bring the
money supply and money demand system back into equilibrium; the same
interest rate as before the change in demand would now prevail, albeit
with a smaller amount of money in the economy as before. The economy
would remain in the position it was before the unanticipated decrease
in demand.
A little side note:
Economists use several definitions for “money”, but the most typical
definition lumps cash and fairly liquid assets such as checking and
checkable money market accounts (which typically accrue less than
market interest rates) together as money and separates out things like
T-bills and savings accounts, which accrue closer to market interest
rates. A concise explanation of the different measure of the money
supply along with links to historical data can be found at:
http://www.federalreserve.gov/releases/h6/about.htm |
