When the money supply is changed, interest
rates also change. In fact, an increase or decrease in short-term
rates is what the Fed is trying to achieve in authorizing its
open market operations.
Supply and demand
As reserves increase and the money supply
expands, the interest rate known as the
federal
funds rate
drops. That’s the rate that banks charge
each other for very short-term, overnight loans.
A drop in the federal funds rate results
in an immediate drop in the
prime
rate.
That rate determines the interest rate banks charge
on consumer and business loans. And when the cost of borrowing
drops because the supply of money increases, demand for borrowing
increases.
The opposite happens when reserves decrease
and the federal funds rate goes up. The prime rate increases,
the price of borrowing increases, and demand for loans decreases.
Reduced borrowing slows spending, which in turn puts the brakes
on economic expansion.
While the federal funds rate may change in
response to supply and demand without Fed action, it always changes
when the Fed buys and sells.
The spread rule
The spread, or difference, between the federal funds rate and the prime rate is three percentage points, though that’s custom rather than law. For example, if the fed funds rate is 2.25%, the prime rate is 5.25%. If the former is raised to 2.50%, the latter will go to 5.50%. It’s not a written rule, but a rule of thumb.
