What You Should Know About Money Supply for the Series 7 Exam

Changes in money supply can affect rates of economic growth, inflation, and foreign exchange. Knowing about monetary policy can help you for the Series 7 and predict how certain securities will fare and how interest rates will change.

When the money supply is eased, interest rates in general decrease. The Fed can ease the money supply by

  • Buying U.S. government securities in the open market

  • Lowering the discount rate, reserve requirements, and/or Regulation T

Occasionally, the Fed has to tighten the money supply. When the money supply is tightened, interest rates across the board increase. The Fed can tighten the money supply by

  • Selling U.S. government securities (pulling money out of the banking system)

  • Increasing the discount rate, reserve requirements, and/or Regulation T

The Federal Reserve Board

The Federal Reserve Board, or the Fed, has the authority on behalf of the U.S. government to lend money to banks; it determines the interest rate charged to banks for these loans. The rate the Fed charges impacts the rates banks charge each other and their public customers. Because banks charge customers higher rates than the Fed charges banks, the Fed policy affects consumers as well:

Fed $ banks $ customers $

The Fed has a few tools in its arsenal to help control the money supply. Here’s what you need to understand about these tools for the Series 7:

  • Open market operations: The tool the Fed uses most often, open market operations are the buying or selling of U.S. government bonds or agency securities to control the money supply. If the Fed sells securities, it pulls money out of the banking system; if the Fed purchases securities in the open market, it puts money into the banking system.

  • The discount rate: This value is the rate that the 12 Federal Reserve Banks charge member banks for loans. If the discount rate increases, the money supply tightens; by contrast, if the discount rate decreases, the money supply eases.

  • Reserve requirement: The reserve requirement is the percentage of customers’ money that banks are required to keep on deposit in the form of cash. In line with the theory of supply and demand, if the Fed increases the reserve requirement, banks have less money to lend to customers, so interest rates increase.

  • Regulation T: Reg T is the percentage that investors must pay when purchasing securities on margin. Regulation T is currently set at 50 percent, and it doesn’t change very often. If the Fed raises the rate, investors have less cash, which tightens up the money supply.

Interest rate indicators

The Series 7 designers expect you to recognize some signs that interest rates have increased or decreased. If the following values are high, the money supply will tighten up. The money supply is subject to supply and demand the same way securities are, so if interest rates increase due to the tightening of the money supply, you can assume that those increases will occur across the board.

  • Reserve requirements: This value, controlled by the Fed, is the percentage of bank deposits that may not be loaned to customers.

  • Discount rate: The discount rate is the interest rate that the Fed charges to member banks for loans. The discount rate is the lowest rate for all loans.

  • Fed Funds rate: The Fed Funds rate is the interest rate that banks, broker-dealers, and financial institutions charge each other for loans. If one bank doesn’t have enough money to meet the reserve requirements, the bank can borrow money from another bank that has excess reserves. In most cases, a Fed Funds loan is a loan between banks, usually overnight. It’s the most volatile of all interest rates.

  • Call loan rate (broker loan rate): This value is the interest rate that banks charge brokerage firms for customers’ margin accounts. When customers borrow money from a broker-dealer to purchase securities on margin, the broker-dealer in turn borrows money from a bank to cover the loan that it made to the customer.

  • Prime rate: This value is the interest rate that banks charge their best customers for loans.

Easy money and tight money yield curves

Yield curves are graphic representations of bond yields as compared to the amount of time until maturity. Visualizing the different yield curves can really help you answer multiple choice questions about yield curves:

  • Normal (easy money) yield curve: This is the type of yield curve that you’d expect; the yields on long-term debt securities are higher than the yields on short-term debt securities. If you’re going to tie your money up for a year, you may be happy with a 6 percent yield, but if you’re tying your money up for 30 years, you may want a yield of 8 percent.

    image0.jpg
  • Inverted (tight money) yield curve: This curve is the opposite of what you’d expect. In a tight money yield curve, short-term debt securities are actually paying higher yields than long-term debt securities. Not cool.

    image1.jpg
  • Flat yield curve: When you plot this situation out on a graph, the yields on long-term and short-term debt securities are pretty much the same.

The following question tests your yield curve knowledge.

During a period of tight money, when the yield curve is inverted, which of the following securities is likely to have the highest yield?

(A)    T-bills
(B)    Commercial paper
(C)    T-notes
(D)    AA-rated corporate bonds

The correct answer is Choice (B). Because you’re dealing with an inverted yield curve and tight money, short-term debt securities have higher yields than long-term debt securities. The two short-term debt securities listed are T-bills and commercial paper, so if you pick T-bills, you’re on the right track. However, because T-bills are issued by the U.S. government and are considered very safe, they’d have lower yields than commercial paper.

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