Series 79: Money Supply, Interest Rates, And The Markets

Taken from our Series 79 Top-off Online Guide

Money Supply, Interest Rates, and the Markets

The performance of financial markets is linked to the performance of the economy as a whole, so it stands to reason that changes in interest rates, the money supply, or the inflation rate will have a significant impact on markets.

When the Fed pursues an expansionary policy, interest rates drop. As already explained, lower interest rates spur businesses to increase investment and consumers to make large purchases on credit. This activity spurs economic production, which boosts corporate earnings, and common stocks and other equity investments generally increase in price. Lower interest rates also make stocks relatively more attractive, because bonds and other debt securities will offer low rates of return. Prices of already-issued bonds will rise, however, because of the inverse relationship between interest rates and bond prices. Lower interest rates in the United States also tend to lower the foreign exchange value of the dollar, which boosts exports by making American-produced goods relatively less expensive.

In contrast, a contractionary policy causes higher interest rates, which leads to reduced borrowing and spending by businesses and consumers. Total economic output declines, putting pressure on corporate earnings and leading to lower stock prices. Higher interest rates also make other investments more attractive relative to stocks. The dollar rises against other currencies, making foreign goods less expensive. Higher interest rates also lead to lower bond prices. (The reasons for this relationship are explained later, but in short, if a given bond pays a lower interest rate than the prevailing market rate, the price of the bond will have to decline to entice anyone to buy it.)

For all these reasons, markets typically react favorably when the Fed announces an intent to lower the target federal funds rate. At the same time, predictions about the Fed’s actions are usually built into market prices b

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