Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Easy Money

What it is:

Easy money is a phrase that often refers to the presence of low interest rates. In the context of the Federal Reserve, easy money is a method of helping the economy expand by increasing the money supply.

How it works (Example):

Let's assume policymakers feel employment is too low and interest rates are too high. The Federal Reserve could enact expansionary monetary policy and encourage economic growth by doing one or all of these three things:

  • Direct the Federal Open Market Committee (FOMC) to purchase U.S. Treasuries on the open market
  • Lower the reserve requirement
  • Lower the discount rate

Each of these choices creates easy money and creates a chain reaction. For example, when the FOMC (an agent of the Federal Reserve) purchases U.S. Treasuries in the open market, it gives money to the sellers. The sellers deposit these payments at their local banks. Because the Federal Reserve requires banks to maintain a certain percentage of these deposits in reserve, the banks are free to lend most of these new deposits to other bank customers and earn interest. These customers in turn deposit the loan proceeds in their own bank accounts, and the process continues indefinitely. Thus, every dollar of securities that the Federal Reserve buys increases the money supply by several dollars.

Likewise, if the Federal Reserve lowers the reserve requirement, the bank doesn't have to keep as much of its assets in cash and thus more of a bank's deposits become available for lending. This increase in the supply of available funds lowers the price of those funds (i.e., the lending rate), making debt cheaper and more enticing to borrowers.

Additionally, if the Federal Reserve lowers the discount rate, it becomes cheaper for banks to borrow money from the Federal Reserve, thus making it cheaper for banks to access funds they can in turn lend to customers.

Why it Matters:

Ultimately, the goal of easy money is to stimulate an economy. Many economists agree that the Federal Reserve is the most important political tool a government has to do this, because in the end, each of a monetary policy's chain reactions affects the everyday financial decisions of the citizens of the economy... whether they should buy a car, save more money, or expand or start a business. These decisions have a global effect, considering that the U.S. is the largest economy in the world.
 

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