How does the Fed increase the money supply?
Posted by admin @ Friday, Sep. 19th 2008
theMayne asked:
I understand how the Fed controls the Fed Funds Rate and I understand that injecting money into the system eases credit woes. However, if the Federal Reserve provides banks with more money, how does that money get translated into money in the money supply? Loans are only temporary, but the money supply increases consistently from year to year?
I understand how open market operations work, but what i don’t understand is how it contributes to the money supply. Money held at banks is not part of the money supply, so i don’t see how OMO’s can permanently increase the money supply.
I understand how the Fed controls the Fed Funds Rate and I understand that injecting money into the system eases credit woes. However, if the Federal Reserve provides banks with more money, how does that money get translated into money in the money supply? Loans are only temporary, but the money supply increases consistently from year to year?
I understand how open market operations work, but what i don’t understand is how it contributes to the money supply. Money held at banks is not part of the money supply, so i don’t see how OMO’s can permanently increase the money supply.
Posted in Economics
September 22nd, 2008 at 1:29 pm
The Fed Open Market Committee can purchase Treasury bonds from banks and other holders releasing cash to be circulated in the money supply. The Fed gets the funds for the purchase merely by writing a check ( actually making an electronic bookkeeping entry ) and thus creates money.
September 26th, 2008 at 1:20 am
Yes . The money is created out of thin air.
September 28th, 2008 at 6:46 pm
“…..but the money supply increases consistently from year to year?”
..thus increasing inflationary concerns…..
September 29th, 2008 at 8:21 am
The three policy tools of the Fed to influence the money supply are:
1. changing reserve requirement
2. changing discount rate
3. Open market operations
By changing the reserve requirement, the Fed allows banks to create more loans because they don’t have to keep so much on hand in the vault. When banks issue loans, they literally create money “out of thin air.” I won’t attempt to explain this now, as it can be complicated (at least for me). Here are some links though:
When the reserve requirement ratio (RRR) increases, banks loan less, and the money supply decrease, and vice versa. This is used very rarely because it is so powerful due to the money multiplier effect. I think the last time it was used was in the early 1990s, when the Fed lowered the RRR from 12% to 10% in order to bring economy out of recession.
The second tool used by the Fed is to change the discount rate, the interest rate at which the Fed lends money to insured depository institutions. When the discount rate increase, banks borrow less, and therefore the money supply decrease, and vice versa. This isn’t as important as it used to be because banks can now borrow more easily from each other or find other funds if they are in financial trouble. Borrowing from the fed is usually a last resort.
The third and most important tool of the Fed is open market operations. This is the buying and selling of Treasury bills. When the Fed buys securities, it pays out currency for those T-bills, thus increasing money supply. When they sell them, they rein in the money supply. This tool is used almost daily.
Hoped that helped.