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Economics: How the Fed Changes the Money Supply


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About this Lesson

  • Type: Video Tutorial
  • Length: 10:06
  • Media: Video/mp4
  • Use: Watch Online & Download
  • Access Period: Unrestricted
  • Download: MP4 (iPod compatible)
  • Size: 108 MB
  • Posted: 03/29/2010

This lesson is part of the following series:

Economics: Full Course (269 lessons, $198.00)
Economics: Banking, Spending, Saving and Investing (19 lessons, $30.69)
Economics: The Creation of Money (4 lessons, $7.92)

In this video lesson on economics, you'll learn about how the Fed (Federal Reserve) changes the money supply. Taught by Professor Tomlinson, this lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

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We have seen how banks, in their pursuit of profit, create money. Banks make loans so that they can earn interest. When they make loans, they create checking accounts and checking accounts are part of the money supply. However, the Fed is really running this whole show. Because it is the Fed that determines how much reserve a bank has to hold against its checking accounts.
For instance, whenever a bank offers a new checking account, every dollar in checking has to be backed with ten cents worth of reserves whether cash in the vault or deposits at the Fed. Since the Fed gets to determine this reserve ratio, and the Fed gets to determine how much reserves are actually available to the banking system, it is the Fed that is really driving the process even though banks are making the decision about how many new checking accounts to create as they make loans.
Let us think now about how the Fed can use its power to influence the money supply. There are three important policy tools that the Fed uses as it seeks to increase or decrease the money supply at any given time.
The first policy tool is the required reserve ratio itself. That is, the Fed can decide whether the banks have to hold ten cents in reserves or twenty cents in reserves of fifty cents in reserves for every dollar in checking that the banks offer. Consider an extreme case: what if a bank had to hold 100 percent reserves? That is, suppose for every dollar that the bank offers in checking accounts, the bank has to hold a dollar in cash in its vault. If this is the case, banks cannot create any new money. That is, if I make a deposit in my bank, and the bank gives me credit in my checking account, the bank has to hold my cash in the vault and cannot lend it out. In this case, the bank is unable to create new money, and there is no money multiplier.
Now, the Fed is not going create such an extreme case because the Fed like the banking system to have the latitude to create new money or to create fewer loans in response to changes in the demand for money. So, the Fed would not create such an extreme case. Suppose that the Fed does change the reserve requirement. Say it changes it from 12 percent to 10 percent as it did in the early 1990's. When the Fed does that, banks suddenly find that they do not need all of the reserves that they are holding in their vaults and then they immediately lend out the excess. That is, if they want to make a profit, they immediately make new loans so that they can earn interest. Whenever the reserve requirement shrinks, the money multiplier expands. That is, banks need to hold less of what is deposited there so they can make more new loans anytime they receive new reserves. When the required reserve ratio goes up, banks are not able to make as many new loans, and therefore the money multiplier is smaller. When the required reservation shrinks then banks are able to lend out more money because more of every new deposit is excess.
Now, the required reserve ratio, because it affects the money multiplier, is a very powerful tool, and the Fed rarely changes it. The Fed has increased the required reserve ratio as it did in the early 1980's in order to reduce the money supply precipitously in the environment when there was a lot of inflation. So, an increase in the reserve requirement shrinks the money supply very fast. In the early 1990's, the Fed lowered the reserve requirement because the economy was in a recession and the Fed wanted to make credit easier to get so that business would expand. In the required reserve ratio change is the least frequently used policy tool of the Fed because it is the most powerful. For the same reason that you do not go get a sledgehammer to swat a fly, the Fed doesn't change the reserve requirement when it wants to make small adjustments in the money supply.
The second tool that the Fed uses is historically interesting, but not so important nowadays and that is changes in the discount rate. The Fed makes discount loans to ensure depositories. That is, any bank, credit union, or savings and loan that has insurance through the Federal Deposit Insurance corporation or one of the other federal depository insurers is able to go the Fed and borrow money when it needs it. Now, in the early days, the Fed operated as the lender of last resort. That is, whenever a bank was finding people withdrawing money rapidly, and there was a liquidity crunch and in danger of failing, the Fed would lend this institution money at a very low interest rate in order to prevent its failure and help to protect the money supply. However, nowadays, banks have other places they can go to borrow when they need it. They can borrow from one another through what is called the Federal Funds Market. Or they can use some of the treasury bills that they hold, and sell them in order to get cash.
So, since they do not have to borrow from the Fed, banks do so very infrequently for the same reason you do not want to borrow from your parents. You get a good interest rate, but they are going to ask you a lot of nosy questions. The Fed comes in and audits banks that borrow from it because if you are borrowing from the Fed, that is a bad sign. It means that other people will not lend you money.
So, discount loans, although they were important in the early days of the Fed, nowadays, are less important. In fact, the discount rate, which the Fed changes every so often, is viewed as largely symbolic. Increases in the discount rate signal to the financial markets that the fed is tightening the money supply, but since few banks are borrowing at that rate, it is not especially important as a policy tool.
The final tool that the Fed uses is what is called open market operations. Open market operations refers to the purchase and sale of government securities. The Fed holds about $400 billion worth of US government debt and it can buy and sell government debt, as it wants to change the money supply. This is the most frequently used policy tool of the Fed. In fact, every business day, the agents of the Fed are in the financial markets buying and selling government securities to change the money supply.
So, you see that all of the tools of the Fed operate on two different directions in creating money. Either they change the amount of reserves that are available to the banking system by lending banks more reserves, or by providing money to people who deposit in banks, thereby creating reserves, or they change the reserve requirement giving banks more room to create loans with the given amount of reserves.
Let us look, finally, at how these policy tools show up on the balance sheets, first to the Fed and then to the banks. Look at the Feds balance sheet. The assets of the Fed include the government debt, and the liabilities of the Fed include the reserve deposits of banks. So the Fed has reserve deposits over here that it owes to the banks that have made them, and the Fed over here has assets such as treasury bills and loans that the banks owe to the Fed. When the Fed does a discount loan, what happens is the Fed gets an asset over here and the liability is an increase in bank reserves. So, banks now have more reserve credit at the Fed. When the Fed does an open market operation, say the Fed buys a government security, then the Fed acquires treasury bills, and whenever it writes a check to some trader in the public, and that trader deposits it in his bank, then the bank gets reserve credit at the Fed.
Let's see now how this actually creates money by looking at a bank balance sheet that we did earlier. Suppose the Fed buys a government security from some trader; that is, the Fed writes a check for $1000 to you whenever you sell a treasury bill to the Fed. You take the check to your bank and deposit it. So, the bank now gives you credit in your checking account for that $1000 check that you deposited from the Fed. When the bank presents it to the Fed, the bank gets $1000 in reserve credit.
Now, the bank does not have to hold all of that money, and if the reserve requirement is only 10 percent, the bank can lend out 90 percent, which it does. It creates a loan for $900 and that $900 loan is created in the form of a new checking account for somebody, say, person number two. This is the step at which the bank actually creates money. The open market operation pumps new reserves into the banking system and gives the banks more room to create more money. Of course, then, the person who got that loan immediately spends it, and the reserves flow to another institution setting up a multiplier process.
So, that is the way that the Fed works. Now, the multiplier process may not be as strong in practice as it is in our theories for three reasons. First, banks may not want to lend out all of the reserves that they are able to. That is, even though they can lend out 90 percent, they may only lend out 80 percent and keep 10 percent in access reserves. Banks do this if they cannot find high quality loans or if they are afraid that the economy might turn down and they get stuck with a bunch of non-performing loans. A second concern is households may not choose to put all of the money in the bank.
Suppose that whenever you get this check from the Fed, you go in and cash it, but you do not put it all in your checking account, you hold it in currency instead. As long as it is outside the banking system it doesn't count as bank reserves and that limits the number of new accounts that banks can create.
Finally, there is another concern that keeps the Fed from having such tight control over the money supply. That is that there are things that count as near money, repurchase agreements, large CD's, savings accounts over which the Fed does not have nearly as much control. The reserve requirement is directly aimed at checking accounts, and these near monies, these other kind-of liquid ways of storing wealth may increase or decrease without as much direct control from the Fed. When that happens, then people may change their shopping behavior using mediums that the Fed is not directly controlling, and that limits the Fed's ability to as tightly fine tune economy as it might like.
Money: Banking, Spending, Saving, and Investing
The Creation of Money
How the Fed Changes the Money Supply Page [2 of 2]

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