The Federal Reserve Bank uses monetary policy to affect the way people shift their holdings between savings and spending. Monetary policy refers to the Fed's ability to change the money supply and control interest rates, largely by buying or selling Treasury securities in large quantities. Money, as in ordinary currency, is not interest-bearing, but is necessary to carry our daily transactions.The challenge for the Fed is to ensure that the demand for money is roughly equal to its supply. Holding money reflects an opportunity cost, because money held as ordinary currency does not earn interest income the way interest-bearing securities do. When the Fed senses imbalances between the supply of and demand for money, it uses monetary policy to bring about an equilibrium. The equilibrium interest rate is the interest rate at which the supply of money is equal to the demand for money.
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How Monetary Policy Works
The math underlying bond pricing is designed to ensure that as the price of a bond increases, its interest rate (or yield) decreases. The interest rate is the yield required to induce investors to assume the market and interest rate risks implicit in the bond's pricing and invest in that bond. When the Fed sells Treasury securities, it lowers the money supply by taking liquidity out of the general money supply and replacing it with Treasury securities. When the Fed buys Treasury securities, it pours currency back into the money supply by buying bonds from investors. If the Fed senses that money supply is high relative to demand, it sells Treasury securities. This would cause the price of Treasury securities to decrease, as the supply of Treasury securities increases relative to demand. The decrease in bond prices is associated with an increase in interest rates. As equilibrium is met, the interest rate represents the equilibrium interest rate.