Interest Rates, Money Supply, and Economic Policies

Macroeconomics studies the overall functioning of an economy and the policies used to manage growth, inflation, and employment. Within this framework, interest rates and money supply are key tools used by central banks to influence economic activity. The U.S. Federal Reserve (FED) plays a fundamental role in the stability of the global financial system by applying various strategies through its monetary policy and fiscal stimulus measures.

1. Interest Rates and Money Supply

1.1 What Are Interest Rates?

Interest rates represent the cost of money and directly affect investment, consumption, and economic growth. They can be classified into different types:

Nominal interest rate: The percentage charged for the use of money, not adjusted for inflation.
Real interest rate: Obtained by subtracting inflation from the nominal rate.
Interbank interest rate: The rate at which banks lend money to each other, such as the Fed Funds Rate in the U.S.
Benchmark interest rate: Set by central banks to influence the economy.

1.2 What Is Money Supply?

Money supply refers to the total amount of money circulating within an economy and directly affects consumption, investment, and inflation. It is classified into:

M1: Includes cash in circulation and demand deposits.
M2: Adds savings deposits and money market accounts.
M3: Includes large deposits and other liquid assets.

Controlling the money supply is a fundamental monetary policy tool used to stimulate or slow economic growth.

2. Fiscal Stimulus

2.1 What Is Fiscal Stimulus?

Fiscal stimulus refers to measures implemented by governments to boost the economy during slowdowns or crises. The goal is to increase spending and investment through:

Tax cuts: To increase the purchasing power of consumers and businesses.
Increased public spending: On infrastructure, healthcare, or direct subsidies to stimulate demand.
Direct transfers: Payments to citizens, such as stimulus checks in the U.S.

2.2 Advantages and Disadvantages of Fiscal Stimulus

✅ Advantages:

Encourages consumption and investment.
Helps reduce unemployment.
Can accelerate economic recovery after a crisis.

❌ Disadvantages:

May increase fiscal deficit and public debt.
Excessive stimulus can lead to inflation.
Effects may be temporary if not combined with structural reforms.

3. Economic Policies of the FED

The Federal Reserve (FED) is the central bank of the U.S. and aims to ensure price stability, full employment, and economic growth. To achieve these objectives, it uses various economic policy tools:

3.1 Expansionary Monetary Policy

Used during periods of recession or slow economic growth, this policy aims to increase liquidity in the economy. Key actions include:

Lowering interest rates: Makes credit cheaper and encourages investment.
Expanding the money supply: Through the purchase of bonds and financial assets, (Quantitative Easing - QE).
Reducing reserve requirements for banks: Allows banks to lend more money.

3.2 Contractionary Monetary Policy

Implemented when there is a risk of high inflation or economic overheating. Measures include:

Raising interest rates: Makes borrowing more expensive and reduces consumption.
Reducing the money supply: Through the sale of bonds in the open market, Quantitative tightening (QT).
Increasing reserve requirements: To curb credit and excessive spending.

3.3 Additional FED Tools

Open Market Operations: Buying and selling U.S. Treasury bonds to regulate liquidity in the economy.
Forward Guidance: The FED communicates its future plans regarding interest rates and monetary policies to influence market expectations.
Liquidity Programs in Crises: During economic crises, the FED may launch financial support programs to prevent massive market failures.

4. Impact of Economic Policies on Markets

The decisions made by the FED and changes in interest rates have a direct impact on financial markets:

4.1 Equity Markets (Stocks)

Low interest rates favor investment in stocks, while high rates can reduce their attractiveness. When interest rates are low, the cost of financing decreases, encouraging companies to borrow to expand their operations and improve profitability. At the same time, investors tend to shift their capital from fixed-income instruments (such as bonds), whose yields decrease with lower interest rates, toward higher-return potential assets like stocks. This increases demand for equities, driving stock prices up.

Conversely, when interest rates rise, borrowing becomes more expensive, limiting companies' growth capacity and reducing their future profits. Additionally, bonds and other fixed-income instruments begin to offer more attractive yields, prompting capital outflows from the stock market into safer investments. As a result, the appeal of equities decreases, and stock prices may decline.

4.2 Bonds

Interest rates affect the profitability of short- and long-term bonds in the following ways:

Short-term bonds: These are more sensitive to immediate interest rate changes set by central banks. When the FED raises rates, newly issued bonds offer higher yields, making existing bonds with lower rates lose value in the secondary market.
Long-term bonds: Their value is more affected by future expectations of inflation and economic growth. When interest rates rise, investors demand higher yields, reducing the price of previously issued bonds with lower rates.
This inverse relationship between interest rates and bond prices is crucial for investors seeking to optimize their portfolios and manage risk based on the economic cycle.

4.3 Currencies

An expansionary monetary policy can weaken the U.S. dollar and strengthen other currencies due to an increase in the money supply. When the FED lowers interest rates and purchases financial assets, liquidity in the system increases, making the dollar less attractive compared to other currencies. This can lead to dollar depreciation, improving the competitiveness of U.S. exports but making imports more expensive. Meanwhile, investors may seek assets in currencies with higher returns, strengthening those currencies against the dollar.

4.4 Inflation and Growth

Excessive stimulus can lead to inflation, while abrupt restrictions can slow down the economy. When the money supply grows too quickly and exceeds an economy’s productive capacity, prices begin to rise, causing inflation. Conversely, if monetary policy is too restrictive, reduced credit availability and lower spending can slow economic growth and increase unemployment.

Additionally, two extreme scenarios must be considered:

Stagflation: Occurs when an economy experiences stagnant growth alongside high inflation. This phenomenon is particularly difficult to manage because conventional monetary policy tools can exacerbate one problem while trying to correct the other. A historical example of stagflation occurred in the 1970s when the oil crisis led to rising production costs and price increases without significant economic growth.
Deflation: The opposite of inflation, characterized by a generalized and sustained decline in prices for goods and services. Deflation can be dangerous as it reduces corporate revenues, discourages investment, and increases the real burden of debt. Japan has experienced prolonged periods of deflation since the 1990s, limiting its economic growth.

5. Conclusion

Interest rates and money supply are key elements in macroeconomics, as they influence consumption, investment, and inflation. Fiscal stimulus plays a crucial role in economic recovery but must be applied cautiously to avoid excessive deficits. Finally, the FED implements various monetary policies to stabilize the economy and mitigate the effects of financial crises.