OK could someone decribe to me ‘briefly’ how cutting interest rates increases inflation. Since I always viewed inflation as an increase in the supply of money…I would think the biggest cause of inflation would be budget deficits that require additional Gov’t Debt.
you’re bang on - an increase in teh money supply increases inflation. So if you cut rates, people borrow more money, thus increasing the money supply. More money equates to more demand for products leading to higher inflation. Remember when gov’ts borrow debt, it actually decreases the money supply. for instand, i buy a government bond for $1000 - that is i give the govt my $1000. Well, in the economy now there is $1000 less money floating around, helping curb inflation.
The fed doesn’t actually “cut” interest rates with open market operations, it reduces the target fed funds rate. It does this by buying government bonds on the open market. Buying bonds adds $$$ to the economy, increasing the supply of money, decreasing the cost of money (interest rates), and increasing the equilibrium price level. (expansionary monetary policy) If the fed SOLD bonds on the open market, it would be taking money OUT of the economy. This would lead to a reduced supply of money, higher interested rates, and lower price levels. (restrictive monetary policy)
One note: only the Fed can change the supply of money, through OMO.
Where do they get the money to buy gov’t bonds in the open market? Are they just printing more cash thereby adding to the supply?
Basically… Monetarists advocate a steady growth rate in the money supply, rather than just dumping cash into the market (as has been done lately).
But is that what happens when they buy gov’t bonds. Printing more money.
Not physically printing more money, they are creating more money however. The term that I have heard lately is “The Fed has injected $$$$$$$$ into the financial system.”
this should give a good overview of money creation and the Federal Reserve http://www.econbrowser.com/archives/2007/09/money_creation.html