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When QE is carried out, the Federal Reserve prints money and buy government bonds in an effort to pour extra money into the economy. This causes financial institutions for instance banks to lowered their cost of borrowing. Why do these institutions decide to lowered down their interested rate just because they gain more money from the FED? From my reading, when the FED bought bonds, the price of the bonds become higher and the yield become less. How bonds yield and its price affect the interest rates of banks is what I don't understand?

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  • $\begingroup$ This is what a textbook might say, but this is not what happened. Money supply did not increase (see research.stlouisfed.org/fred2/graph/?g=2LOF for example) and the funds did not find their way to the real economy. They are still within the Fed. $\endgroup$ – Kiwiakos Dec 1 '15 at 10:38
  • $\begingroup$ When Fed buys bonds banks gets money for return and this lead to increase in money supply. Do you want to say when Fed buy bonds, banks does not get nothing? $\endgroup$ – Neeraj Dec 1 '15 at 11:09
  • $\begingroup$ @Kiwiakos: M1 && M2 are usually tracked by investors. You'd better have a look at [research.stlouisfed.org/fred2/series/M1SL] or [research.stlouisfed.org/fred2/series/M2SL] and check how the slope gets steeper since 2008. nice counter-argument :), isn't it? $\endgroup$ – owner Dec 1 '15 at 11:15
  • $\begingroup$ M2 is the same as MZM. M1 is too narrow for me, but in any case if you want to talk about trends you should take logs. Look also at MB which reflects QE1,2,3: research.stlouisfed.org/fred2/graph/fredgraph.png?g=2LT2 The base doubled with QE1 and then increased by further 40% by QE2 and then another 40% by QE3. The change of the money in the 'real economy' barely registered. The effect is not as big as you make it. The fact that we had zero inflation also confirms it IMO. $\endgroup$ – Kiwiakos Dec 1 '15 at 13:59
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Put it simply, the interest rate depends on the forces of demand and supply of money. When the Fed buy bond, it increases the money supply into the economy. To induce the people to borrow more money bank reduces their own interest rate, otherwise, people won't have any incentives to borrow more. The interest rate is reduce to such level again equilibrium is reached in the market ( or demand gets equal to the supply).

Interest Rate Determination

Further, increase liquidity in the market also reduces the cost of borrowing money in the money market. A good example is LIBOR (London Interbank Offered Rate). It not only reduces bank own borrowing cost but many loans and contracts are directly tied to LIBOR. Any change in LIBOR has direct impact on the trillions of contract tied to it.

Similar to opposite happen when Fed reduces the money supply via selling bonds.

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  • $\begingroup$ i agree. cheers. $\endgroup$ – owner Dec 1 '15 at 11:24

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