Microsoft Word - Money, Banking, and Int Finance(scribd).docx

Money, Banking, and International Finance

formula. Furthermore, the short-term interest rates for other credit instruments rise. Finally, the
banks’ reserves fall, and bankers grant fewer loans that shrink the money supply.

Treasury Bill Market

Figure 1. The Federal Reserve increases the money supply by purchasing T-bills

Treasury Bill Market

Figure 2. The Federal Reserve decreases the money supply by selling T-bills

The Fed can only control the growth rate of the money supply or short-term interest rates,
but not both at the same time. For example, the Fed increases the M1 money supply by 3%.
Consequently, the Fed keeps buying T-bills until the M1 money supply expands by 3%.
However, short-term interest rates fall. The Fed cannot prevent the falling interest rates because
it focused on the money supply. On the other hand, the Fed wants to reduce the short-term