Money Supply, Monetary Policy, and Fiscal Policy on the SIE

By Steven M. Rice

When you are studying for the Securities Industry Essentials (SIE) exam, you need to be able to follow the money. When conducting securities analysis understanding the money supply and monetary policy are important concepts to mater.

The money supply heavily affects the market. If the money supply is higher than average, interest rates go down, people borrow more money, and people spend more money. That all sounds great, but the situation can lead to some negatives, such as higher inflation and the weakening of U.S. currency in relation to foreign currency. The Federal Reserve Board (the Fed or FRB) has to do a balancing act to help the economy grow at a slow and steady rate. This section deals with how the money supply affects the market and the tools that the Fed uses to control the money supply.

The Fed controls the monetary policy but the fiscal policy is controlled by government politicians (the House, the Senate, and ultimately signed by the President). The monetary policy is typically included in budget decisions and includes how much the U.S. government will borrow (and how), how much it will spend (and on what), how much money will be raised through taxes, and so on.

To put it in a nutshell so to speak, you can think of it like this:

  • Monetary policy = money supply, interest rates
  • Fiscal policy = borrowing, spending, taxes

Influences on the money supply

Changes in money supply can affect rates of economic growth, inflation, and foreign exchange, so knowing a bit about monetary policy can help you predict how certain securities will fare and how interest rates will change. Take a look at the following table to see what easing and tightening the money supply can do.

Effects of Easing and Tightening the Money Supply

Category Easing the Money Supply Tightening the Money Supply
Economy Easy money helps the U.S. avoid or get out of a recession. Consumers can borrow money at lower interest rates. The economy slows down because people aren’t spending as much money; the rate of small business failure increases.
Market As a result of lower interest rates, investors have more money to invest and can purchase more goods. Additionally, businesses don’t have to pay as much interest to borrow money, which increases their profits. Both elements can lead to a bullish market. High interest rates hurt the market because investors don’t have extra money to spend. Additionally, corporations have to pay higher interest on loans and, therefore, report lower earnings. The market becomes bearish.
Inflation Lower interest rates lead to higher inflation. If companies see that customers are spending money freely, they raise their prices. A tighter money supply helps curb high inflation.
Strength of the U.S. dollar The U.S. dollar weakens. U.S. exports increase because foreign currency strengthens (people can trade fewer units of foreign currency for more dollars); therefore, buying U.S. products is cheaper for foreign consumers. However, the U.S. dollar loses value when purchasing foreign goods, so foreign imports decrease. The value of the U.S. dollar rises in relation to foreign currency. The U.S. dollar is subject to supply and demand, so if our money supply is tight, the value of our currency increases. Because the U.S. dollar is strong, importing foreign goods is cheaper for U.S. companies. However, U.S. exports decline because buying U.S. goods becomes more expensive for foreign companies.

When the money supply is eased (resulting in easy money), 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 (although changing Reg T isn’t likely)
  • Printing U.S. currency

Occasionally, the Fed has to tighten the money supply. (Remember, the Fed wants the U.S. economy to grow at a slow, steady pace.) When the money supply is tightened (resulting in tight money), 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’s toolbox

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. You probably remember the chairman of the Fed (currently Jerome Powell) coming on TV to announce an increase or decrease in the discount rate (the rate the Fed charges banks for loans) and what a big deal it was. 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 (through credit card fees, mortgage loans, auto loans, and so on):

Fed $ → banks $ → customers $

The Fed has a few tools in its arsenal to help control the money supply (the preceding section explains the effects of tightening and easing the supply). Here’s what you need to understand about these tools for the SIE:

  • Open market operations: Besides the printing of money, this is the tool the Fed uses most often. Open market operations are the buying or selling of U.S. government bonds or U.S. government agency securities to control the money supply. Open market operations are performed by the Federal Open Market Committee (FOMC). 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.

Exchange rates

Exchange rates are the rates at which one currency can be converted into another. As you can imagine, exchange rates are constantly changing as the value or currency in different countries appreciates, stays the same, or depreciates. Some investors even speculate in foreign currencies hoping to be able to purchase a foreign currency when its value is low with the hope that it appreciates so that they can sell it at a higher value. Certainly, many things can affect the value of a currency, such as a change in a country’s social policies, taxing policies, economy, government, and so on.

You can assume for SIE exam purposes that the value of the U.S. dollar and foreign currency go in opposite directions. The exchange rate is considered a floating rate because it changes constantly.

U.S. balance of payments

The U.S. balance of payments (BoP) is an accounting of the United States’ economic transactions between us and the world over a given period of time (typically quarterly or annually). The balance of payments may show a deficit (more money flowing out of the U.S. than in) or a credit (more money flowing into the U.S. than out). As such, the value of our currency (strong or weak dollar) greatly affects our balance of trade and thus the U.S. balance of payments.

If the U.S. dollar is strong in comparison to other currencies, it will be cheaper for us to buy foreign goods and services. Thus, more money will likely be going out of the United States.

If the U.S. dollar is weak in comparison to other currencies, it will be cheaper for foreign corporations, governments, individuals, and so on to purchase U.S. goods and services. As such, more money will be flowing into the United States.