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Here is an oversimplified example:

The Fed decides to increase the money supply $100,000. So it prints more money and purchases government securities, making more money available to your local bank. Let’s say you want to purchase a house for $300,000, but you only have $30,000. Someone needs to lend you $270,000 or you aren’t getting the house. You go to your local bank, and because or fractional reserve banking, they can lend you $270,000, instead of just the $100,000 they actually have.

Now, these examples aren’t actual ratios used in American banking. This is just for example purposes. God save us if we the Federal Reserve could actually influence interest rates with just $100,000.

My friend asked me about how any of this effects the interest rates. It is classic supply and demand. So far, we’ve talked about the supply-side of the equation. Interest rates come from the demand side. Interest rates are determined by the demand for the money that the Federal Reserve is putting into the market. In theory, an increased money supply results in more money in your local bank’s reserves, allowing them to lend you more money at lower rates. When the Federal Reserve then sells their securities (shrinking the money supply), your local bank no longer has access to easy money and neither do you. This is when you’ll find higher interest rates on loans.

Ron Paul supporters will say that the Federal Reserve has an unconstitutional grip on our economy. They’ll make a call for the good ol’ days of “The Gold Standard“. While this system had it’s merits, it is long overdue for being given a final resting home. It is an antiquated system that no longer serves or honors modern economies. I’ll cover more about the flaw of the Gold Standard in a future article here on Words Cause.

So far, we have a simple formula for the money supply. The Federal Reserve Bank prints more money and spends it on assets, increasing the money supply and lowering interest rates. When it wishes to increase interest rates, it sells assets, reducing the money supply and increasing interest rates.

There is something very important to note about how this system works. The Federal Reserve is buying and selling assets. This is the single most important aspect of this system. The Federal Reserver cannot buy fruit cakes to increase the money supply. The fruit cakes will be eaten or will spoil and the Fed will have nothing to sell back later. Obviously, this would result in a very serious problem, and this is largely were the Ron Paul supporters bring up the Gold Standard.

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