The Federal Reserve and the Money Supply - Online Tutor, Practice Problems & Exam Prep

The Federal Reserve controls the money supply through monetary policy, primarily using open market operations, discount policy, and reserve requirements. Open market operations involve buying and selling U.S. Treasury securities, directly influencing bank reserves and the money supply. A lower discount rate encourages banks to borrow more, increasing the money supply, while adjusting the reserve ratio affects how much banks can lend. Understanding these mechanisms is crucial for grasping how monetary policy impacts economic stability and aggregate demand.

Money Supply:Discount Policy and Required Reserves

Now, let's see how the Fed controls the money supply by applying discount policy, adjusting the reserve requirement, and going through open market operations. So, the Fed controls the money supply in the United States using monetary policy. Right? So, that's what we're getting to in this section is that they use monetary policy by adjusting maybe interest rates or the reserve ratio or buying and selling securities; they're going to control the amount of money available in the public. Okay? So let's start here with discounts policy and reserve requirements. I want to make a note that these are not used as often. I would say, in order of what's used, I would say open market operations is used the most often. Discount policy, second. And then rarely will they adjust the reserve ratio. Okay? So let's start here with discount policy and reserve ratio, and then we'll spend a little more time on the open market operations.

So, discount policy, this is where they set the discount rate. And remember when we define discount rate, this is the rate at which banks borrow from the Fed. Okay? So, the Fed is going to have, short-term loans that they give to the banks. And it's going to be based on this discount rate, okay? So, the higher the discount rate is, the less likely the fewer loans the banks are going to take, right? The fewer loans the banks are going to take from the Fed, which leads to a lower money supply, right? Because they're not taking as many loans and what you have to think about is when the banks have the money, it's in the hands of the public. When the Fed has the money, it's not in the hands of the public. So they tighten the money supply by not loaning stuff out and they loosen the money supply. They make it bigger by loaning out money to the banks, and then to the public from the banks. So a lower discount rate, well, the lower the rate goes, the more loans the banks are going to take because they can make a profit by loaning that out at a higher rate to the public, right? To the general public. So more loans equals a higher money supply. Right? And this is just how we saw in our example where we were following, the loans going through the deposits. And then, I'm getting loaned out again and the deposits and it was increasing the money supply through that.

So this is one way they can affect it by changing the something they do much less often because it has a lot of implications within the economy is adjusting the reserve ratio. So they can set another thing the Fed does is set the reserve ratio. What is the required reserves that, that a bank has to keep on deposits, right? The amount of reserves banks must hold on their deposits. These are the reserves. So the more reserves they have to have, well that's money they can't lend out, right? If the reserve ratio is higher, then they have less money to loan. Right? Fewer loans again. But this one's to the general public. Okay? Because the banks still are considered the public because we're talking about the Fed as part of the government. And then, the public, the general public being the banks, and then the consumers, right? So the banks are going to be making fewer loans to consumers because they have to hold more in reserves. So the more that the banks have to hold in reserves, the less they can loan out which ends up making a lower money supply again here. Right? And this follows that same logic that we saw through the banks. The loans going through Clutchtopia and to the different, through the different banks and increasing the money supply through that money multiplier. So a lower reserve ratio means they have to hold less in reserves so they can make more loans leading to a higher money supply through that same logic.

So let's go through a quick example here just so we can see. The checkable deposits in this case. Let's say in the first scenario, we've got 100,000,000 in checkable deposits and the reserve ratio is 10%. That means that the banks required reserves are equal to 100,000,000 in deposits times 10%, well, they're required to hold 10,000,000. Right? The required reserves are 10,000,000 so they can loan out their excess reserves. And those excess reserves are equal to the 100,000,000 in deposits minus the 10,000,000 that are required; they're able to loan out 90,000,000 and that's going to be increasing the money supply through that money multiplier process we've been through. And in our other example here on the right-hand side, now let's say the Fed says, okay. You only have to hold 8% in reserves. Well, that means from the 100,000,000 in checkable deposits, they only have to hold 8% now which is 8,000,000. So they have an extra 2,000,000 to play with, right? Before they had 10,000,000 they had to hold on to by law. Now they only have to hold on to 8,000,000. So the 100,000,000 minus the 8,000,000 in this case, gives us 92,000,000 that they can loan out. Right? So by having those greater loans, the lower ratio adds to the money supply through that process, right? The lower reserve ratio. Cool. So those are the less common things that the Fed does. Let's go through the open market operation.

Money Supply:Open Market Operations

Alright. So now let's go through the open market operations. So what are open market operations? This is when the Fed buys and sells US Treasury Securities. Generally, it's US Treasury Securities such as bonds or more likely treasury bills, which are short-term treasury investments. They buy and sell them with the public. And when I say public, it's not like you can call up the Fed and say, hey, let me buy some treasury securities. No, they're dealing with banks in this case. They're dealing with the banks, and the banks are part of the public in this idea. Okay? So, the Fed having money is taking money away from the public. The Fed giving money to banks is money going into the hands of the public. And remember, everything we're focused on here is how much money is in the money supply. Okay? So the Federal Open Market Committee, right? FOMC, they're the ones that handle the open market operations. And they do this most often to deal with the money supply because it gives them the most control. They get the most control over the money supply because they can set the volume of purchases and sales. Okay. So think about it. They can buy or sell \$100,000,000 in US Treasury securities, or they can do \$200,000,000, \$500,000,000. They can do \$50,000,000, \$20,000,000. The size of the open market operation is totally up to them. So it gives them a lot more control over how they're going to adjust the money supply. Another great benefit of doing open market operations is that they're easily reversible. If they make an open market operation and they see that it's having negative impacts, well, they can do the opposite and just immediately cancel out what was happening. Such as, if they buy \$20,000,000 in US Treasury securities from the banks, and then they see that things aren't going so well. Well, they can just sell them back to the banks, get the \$20,000,000 back, and reverse what just went through. And they can be quickly executed, right? There's not a whole bunch of administrative burden going on here. The committee makes a decision and they make it happen. Okay? So there are 2 things they can do. They can either buy or sell US Treasury Securities. Okay? So if they're buying US Treasury Securities, think about the Fed. Okay? In this situation, the Fed is going to be like the government. We're going to think about the Fed as being like the government and the banks being like the public. The ones who have the money in the public would be in the money supply. If the money is in the Fed, well, it's not in the money supply. So if they're buying US Treasury Securities, we have the Fed buying. So they're going to give to the banks. What are they giving to the banks? If they're buying US Treasury Securities, they're giving the banks money, and they're getting treasury securities in return. Right? So in this situation, who's getting the money in this case? The banks, right? The banks are getting the money. So when the Fed buys US securities, there's more money in banks. And when the banks have the money, that's like the public having the money. So there's more money supply. Okay? The money supply is higher when they buy US securities. And this is where a lot of students get tripped up because you have to follow the logic of who's getting the cash and who's getting the securities. When the Fed gets the securities, well, they're paying out cash to the public. Okay? And then it's the opposite in the second situation. I'll do it here in blue. So Fed and banks. Again, in this case, I'll do it a little further down so we have space. Now in this case, they're selling treasury securities. So what is the Fed giving to Banks and what are Banks giving to the Fed? In this case, the Fed is giving the Banks treasury securities, right? The Fed is selling treasury securities and they're getting money from the banks. So who has the money now? Do the banks have the money or the Fed? The Fed has the money in this case, right? The Fed is going to have the money so there's less money in the banks because now they have treasury securities instead of the dollars. And when there's fewer dollars in the banks, that's less money supply. Okay? So this is the idea. The fed is trying to control the supply of money, which is that M1 that we talked about, right? The currency in circulation plus the checkable deposits. This is them controlling that amount that's in the public, okay? And we're going to see why they want to control that amount when we go to the graphs and we kind of see the demand for money and the supply for money on the graph. But for now, it's important to just understand how they conduct the open market operations. And it's as simple as buying and selling US securities. Okay? So when we're studying monetary policy, it's important to think like this. The Fed, we're going to say as the government. Now, they're not exactly the government, but we're just going to say it like that. They're the Central Bank of the US and they're going to be the insiders, right? They're not part of the public and then the public is going to be banks and of course, consumers as well. Right? Consumers. But mostly, the Fed is only going to be dealing with banks, right? With the the Fed is mostly just going to be dealing with the banks, and going through these operations with the banks. It's not like you can call up the Fed yourself. Okay? So the Fed is the government and the banks are the public. Oh, we're seeing who has the money. Does the Fed get the dollars or do the banks get the dollars? So the money supply is the money in the hands of the public. Okay? So when the money is in the hands of the public, it's in the money supply. It's circulating. And that's what we're concerned with is how much is in the money supply and how is that affecting the markets, alright? So that's about it here. Let's go ahead and move on to the.

Here’s what students ask on this topic:

How does the Federal Reserve use open market operations to control the money supply?

The Federal Reserve uses open market operations (OMOs) to control the money supply by buying and selling U.S. Treasury securities. When the Fed buys securities, it pays banks, increasing their reserves and thus the money supply. Conversely, when the Fed sells securities, banks pay the Fed, reducing their reserves and the money supply. This method is preferred because it offers precise control over the money supply and is easily reversible. The Federal Open Market Committee (FOMC) decides the volume of these transactions, allowing for quick adjustments to economic conditions.

What is the discount rate and how does it affect the money supply?

The discount rate is the interest rate at which banks borrow short-term funds directly from the Federal Reserve. A lower discount rate encourages banks to borrow more, increasing their reserves and the money supply. Conversely, a higher discount rate discourages borrowing, reducing bank reserves and the money supply. This tool is less frequently used compared to open market operations but is still significant in influencing the availability of money in the economy.

What are reserve requirements and how do they impact the money supply?

Reserve requirements are regulations set by the Federal Reserve that determine the minimum amount of reserves a bank must hold against its deposits. A higher reserve requirement means banks must hold more money in reserve, reducing the amount they can lend out, which decreases the money supply. Conversely, a lower reserve requirement allows banks to lend more, increasing the money supply. This tool is used less frequently due to its broad impact on the banking system.

Why are open market operations considered the most effective tool for controlling the money supply?

Open market operations are considered the most effective tool for controlling the money supply because they offer precise control and are easily reversible. The Federal Reserve can quickly buy or sell U.S. Treasury securities in varying amounts to adjust the money supply as needed. This flexibility allows for rapid responses to changing economic conditions, making OMOs a preferred method for implementing monetary policy. Additionally, the transactions can be executed swiftly with minimal administrative burden.

How do changes in the reserve ratio affect the money supply?

Changes in the reserve ratio directly impact the amount of money banks can lend. A higher reserve ratio means banks must hold a larger portion of their deposits as reserves, reducing the funds available for lending and thus decreasing the money supply. Conversely, a lower reserve ratio allows banks to hold fewer reserves, increasing the funds available for lending and thereby increasing the money supply. This tool is used sparingly due to its significant impact on the banking system.