it's simply supply and demand. When you lower the interest rate, you increase the demand for money. in order to keep in equilibrium you have to increase the supply to meet those demands. Why provide an increase in demand if you aren't going to supply that demand.

Here's my understanding.

Lowering interest rates doesn't technically necessitate an increase in the money supply, and the money supply would increase anyway, but based on human nature there's a 99% chance that the lower rates will lead to it increasing even faster.

When you borrow money from the banks, one of two things happens, or both:
A) the Federal Reserve creates new money out of nowhere
B) the bank you're borrowing from creates new money out of nowhere via "fractional reserve lending"

If this seems screwed up, it's cause that's the way the monetary system is. It's a scam. That's why Dr. Paul introduces a bill to change it every year.

It just does.

Think of the interest rate as the price of money over time. When the interest rate is lowered, that makes money "cheaper" and more abundant.

No?

Think of it this way: you are more likely to take your money out of non-liquid accounts more quickly if you aren't making much money (i.e. interest - which is dictated indirectly by the Federal Interest Rate) on those accounts.

A low interest rate means you are "paid" less to keep cash locked up in bank accounts. This means you are more likely to place that money into bank accounts that make the money more available for you to purchase goods, services or securities.

Uh...no?

A low interest rate makes you want to spend money (or at least make it available for spending), not stow it away in some long-term account that you can't reach, and isn't making you that much money anyway.

No?

Are you more likely to take a loan from me at 4% interest or 5%? More likely means more money available to be spent on goods, services, or securities.

So, when interest goes down, money goes up.

I'm with Jellio, it seems like the total amount of dollars in the world stays static when loans are made. Only when new money is issued does the amount of dollars change.

The value of those dollars, of course, changes over time but the number of them shouldn't. Right?

Its pretty straight forward. Most of this is spelled out above, but here is some more detailed information.

1) The Federal Reserve makes loans to private banking institutes. The rates that they give these loans out at are the rates that the reserve is lowering or raising.

2) All accredited banks and lending institutions are required to keep a certain percentage of deposited funds available on hand. This limits the amount of loans they can give out.

3) By borrowing money from the federal reserve, private banks can have more money on hand to cover deposits, and can make more loans to consumers. Banks also make loans to each other to make sure they are covered in case of large losses, and that they always have enough money on hand to cover the right percentage of deposits. The rates that they loan to each other are based on the federal rates, usually plus a constant.

4) More loans to consumers means more purchasing power. In other words, there is more money in supply via private loans.

5) BAM! Inflation.

You've heard about all these record losses the banking institutions have had, right? Billions, upon billions of dollars. You've also heard about the amount of money the Fed is making available to these banking institutions...to keep things liquid, right? Again, BILLIONS of dollars. Now where do you think all that money is coming from? Well, we're borrowing it, the same way all those McDonald's managers who bought million dollar homes did. Only the Fed is borrowing it from China. All our wealth is going overseas. We're selling ourselves...

Part of it is called the multiplier effect.

Money supply can be defined in strict terms as a) the money on deposit in demand accounts at banks plus b) the amount of currency (physical coins and bills) in circulation.

People and businesses can either a) save or b) spend their money. When you lower interest rates, spending becomes more attractive than saving.

When you spend your money, the money goes to whoever you bought something from. They in turn use your money to pay their suppliers and workers, or to save it in reserve. The suppliers and workers do the same, ad infinitum. All of it ultimately flows through bank accounts, increasing money supply.

The problem: if you make more money available, you may not have more goods and services available, and you get price increases - inflation. Raising interest rates has the exact opposite effect - saving becomes more attractive, there is less money to spend, so prices go down.

Kevin L. - Good show for bringing up the multiplier effect! I should have mentioned that!