Category: Economy

Q: What does “too many dollars chasing too few goods” mean?

A: Imagine if all the banks in the United States simultaneously placed an extra $500,000 in every bank account. Most people would probably rush out to spend a good bit of this money. Let’s say most of them decided to buy a new car. Unfortunately, carmakers would not have enough cars to satisfy everyone. The likely response by carmakers would be to raise their prices. In other words, too many dollars (people with “extra” money) chasing too few goods (cars).

 

Q: How would we end up with too many dollars in the economy?

A: Essentially, the Federal Reserve serves as the monetary authority in the United States and controls the amount (or supply) of money in the economy. If the Fed miscues, for instance, we could easily end up with too much money in the economy.

 

Q: How does the Federal Reserve control the amount of money in the economy?

A: The term “control” has to be qualified. For example, if the Fed wants to increase the supply of money, it can simply have more money printed (at the U.S. Mint). But that’s unlikely because it would be the best way to make sure too many dollars are chasing too few goods.

Instead, the Fed tries to influence the amount of money through interest rates. Currently, the Fed “targets” the short-term interest rate called the federal funds rate. The idea is this: if the Fed can keep interest rates low, there will be more money in the economy, and if the Fed can send interest rates higher, there will be less money in the economy. This policy is supposed to work through bank lending. Banks will lend more money when interest rates are low (because the price of credit is lower) and less money when they are high (because the price of credit is higher).

 

source: http://www.heritage.org/Research/Economy/wm526.cfm