How Fed Discount Rate Changes Impact the Money Supply

What happens to the money supply when the Fed reduces the discount rate?

• A. The money supply decreases
• B. The money supply remains unchanged
• C. The money supply increases
• D. The money supply increases temporarily

Answer: (C)

When the Federal Reserve (the Fed) reduces the discount rate, it lowers the cost at which banks can borrow funds from the Fed. This encourages banks to take out more loans since they can access cheaper money. When banks receive these loans, they typically lend more to consumers and businesses, thereby increasing the amount of money circulating in the economy. As a result, the overall money supply increases. The reduction in the discount rate effectively signals that the Fed is adopting a more accommodative monetary policy stance, which is aimed at stimulating economic activity. This makes it cheaper for banks to borrow, which in turn increases liquidity in the banking system and fosters lending. Consequently, the increase in bank lending leads to a greater money supply, as the additional loans create new deposits through the money multiplication effect. Thus, a decrease in the discount rate by the Fed is directly associated with an increase in the money supply in the economy.

When the Federal Reserve (the Fed) makes a move to reduce the discount rate, it sets off a cascade of effects throughout the economy. You might be wondering, "What exactly happens to the money supply when this occurs?" Well, the crux of the matter is that the overall money supply increases. Simply put, when banks can borrow money at a lower cost, they’re more likely to tap into those funds.

Think of it this way: Imagine you find a coupon that cuts the cost of your favorite coffee from $5 to $3. You’re more likely to treat yourself and buy that coffee more often, right? Similarly, when the Fed lowers the discount rate, banks feel empowered to borrow more because access to money becomes cheaper. As banks take out these loans, they increase their lending to consumers and businesses—after all, providing loans is how many banks make their profits.

Now, here’s where it gets a bit more technical but stick with me. When banks lend out the money they’ve borrowed, it leads to new deposits being created through what's known as the money multiplication effect. With each loan made, new dollars get circulated into the economy. You start realizing just how interconnected these financial systems are.

Now, think about the larger economic picture for a second. A reduction in the discount rate typically sends a clear signal. It means the Fed is adopting a more accommodating monetary policy stance. The aim? To stir the economic pot, if you will! When borrowing costs go down, businesses are encouraged to invest and expand, while consumers feel more comfortable taking out loans, whether for cars, homes, or education. This increased activity is like a shot of espresso for the economy—a jolt of energy that stimulates growth and boosts spending.

But what does all of this mean for you as a student preparing for the Western Governors University (WGU) ECON5000 C211 Global Economics for Managers Practice Exam? Well, understanding these dynamics can be a game-changer. This knowledge equips you with the tools to interpret financial news and understand government action's impact on the economy. While it might seem abstract, you can think of the discount rate as a rudder steering the economic ship. When the Fed lowers that rate, the ship turns towards more growth and activity.

So, the next time the Fed tweaks the discount rate, remember that it isn't just numbers on a page. It's an entire process that shapes lending, business investment, and your very own wallet. By grasping how these economic principles work, you’re not just studying for an exam; you’re building a lens through which to view the world economically. And who knows? That knowledge might just turn you into the next great economic thinker or savvy manager!