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How the Federal Reserve Increases Money Supply

To understand how the Federal Reserve increase money supply, it is important to first understand the meaning of money supply, which we will think of as: money which is available (in the economy) for use.

Second, you must remember the three parties that influence the money supply:

  1.  The Federal Reserve
  2. Banks
  3. Households that deposit money

It will be easier to understand money supply if you remember that the word “reserve” implies not available to use, so it will help to notice when “reserve” appears as we’re talking about decreasing the money supply.

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The Inverse Relationship between Bond Prices and Bond Interest Rates

Bonds are considered less risky forms of investments than stocks, as the former does not have the same volatility as the latter has. It represents a promise to pay when the indebted entity, the bond issuer, borrows money from a buyer of the bond, the bondholder. Bonds are used by the government and private companies to finance desired projects. The interest rate of a bond is fixed when it is first issued. The payment comprises of two parts – the fixed bond interest rate or coupon and the final amount to be paid upon maturity. The fixed coupon rate may be annually or every 6 months depending on the type of bond. Bonds can be adversely affected by prevailing economic conditions such as rising interest rates.

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What is a Bond and How do Bonds Work?

A bond refers to a debt security that pledges to make regular payments for a specified period of time. If you are wondering what a security is, it is a claim or entitlement on the issuer’s future assets or income. If you buy a bond, you are simply lending money in return for interest payments which the borrower or bond issuer makes periodically during the loan term. At the time of loan maturity, the bond issuer pays the principal or original amount of the debt to the lender or bond holder. When to pay the periodic payments of the interest and the date of maturity are based on the terms of the bonds agreed upon by both holder and issuer. Bonds are commonly issued by governments and corporations. They do so to raise capital so they can finance their projects or business expansions.  The major bond classifications include the US Treasuries, corporate bonds, municipal bonds, and agency bonds. US Treasuries are those issued by the US Department of Treasury while corporate bonds are offered by corporations that have investment grade ratings. Local governments like states and cities can also issue municipal bonds. Government-sponsored enterprises like Freddie Mac and Fannie Mae can also offer agency bonds. Aside from these, there are also high-yield bonds, asset-backed securities, mortgage-backed securities, and collateralized debt obligations (CDO).

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