Money Supply and the Federal Reserve System

Money Supply and the Federal Reserve System.

Money Supply and the Federal Reserve System

Money supply can either positively or negatively affect the economy. For instance, excess money supply in the economy leads to inflation while its scarcity pushed inflation down. It is hard to live in an economy that is devoid of boom and burst. When downturns inflict, the impacts are severe and appalling. Thus, it is everyone’s wish to operate in an economy that is cushioned against the effects of shortages and increase in money supplies. The Federal Reserve System was formed with a view of insuring the economy against harsh economic situations through forging and implementing stable monetary policies.

The Federal Reserve System was formed in 1913 when President Woodrow Wilson signed the Federal Reserve Act into law (Federal Reserve System). The period before the formation of the act was marred with a spate of the financial crisis that eroded the consumers’ confidence towards financial institutions and the economy. People were worried about their investments owing to the constant slumps in the economy (Federal Reserve System). Thus, there was a need to have a mechanism that would ensure stable financial situation. Consequently, economists thought of creating a monetary reserve that would act as a cushion against loss of money invested in banks. As a result, in a time of financial crisis banks would turn to the Federal Reserve for loans that would enable them to continue their operations without interruptions. Therefore, the Federal Reserve Bank (Central Bank of US) was formed to (or “intending to”) ensuring a stable and flexible economy in the face of constant financial crisis. Further, the organization would accomplish its roles through the implementation of sound monetary policies. The institution is composed of 7 central government’s Board of Governors and 12 Federal Reserve Banks in different geographical parts of the US (Federal Reserve System). The Federal Reserve System operates independently and is not subject to the presidential directives, but it works within the national economic policies.

The Federal Reserve System implements monetary policies through constant regulation of the monetary and credit conditions with the aim of ensuring stable interest rates, stable prices of goods and abundant employment opportunities. The above conditions ensure that the economy is not thrown into a crisis. Moreover, the Federal Reserve System is charged with the responsibility of controlling the activities of commercial banks to ensure that the customers are protected against unfair banking financial policies (Federal Reserve System). Customer’s credits rights can be breached by banks when there is a lack of policies to keep the banks in check. Additionally, the Federal Reserve System counters risks that can destabilize the national financial system. Furthermore, the Federal Reserve System provide financial assistance to banks that are in financial crisis. It also facilities coordination between national payment system and the banks and other foreign financial organizations. Banks are required to deposit a minimum amount (required reserve ratio) with the Federal Reserve Bank that acts as an insurance against bankruptcy when the bank is in a financial crisis. The Federal Open Market Committee is charged with the responsibility of developing monetary policies depending on the economic situations in the nation. The Federal Reserve Bank acquires its financing through interests rates advanced to banks and depository institutions, involvement in the open market investments and interest rates from foreign investments in foreign currencies.

  1. Money Supply

Money supply refers to the amount of currency regarding dollar bills and coins and deposits held in banks and depository institutions as directed by the Federal Reserve System and the US Treasury (Federal Reserve System). Money supply can affect the stability of the economy (Friedman 2). Different monetary standards are used to determine the amount of money in the economy. The monetary base is one if the standards used to determine the amount of money in circulation and the reserve balances. The monetary base uses the M1, M2, and M3 criteria to measure the currency circulation in the economy, commercial banks, and depository institutions. M1 measures money as a medium of exchange, M2, considers money as a measure of value and M3 measures money as a close substitute or alternative for items (Friedman 2). Money supply has a direct impact on the economy. Increased money supply in the economy instigates lowering the interest rates. Consequently, there is more investments and spread of wealth among people in the economy. Availability of wealth in the hands of people prompts increased spending that raises production of goods and services, demand for labor, increase in capital goods and a boom in the stock market. The above leads to a buoyant economy until a certain limit are reached where excess money supply leads to inflation. At the stage of inflation, a myriad of measures are taken to control the money supply in the economy (Federal Reserve System). The measures taken try to raise the interest rates to limit the amount of money circulating within the economy. Inflation throws a country into panic causing a hike in prices of goods and services, increased retrenchments that cause increased unemployment and decline in investments (Friedman 7).

Other than monetary base, money supply is determined by some other factors. One of the other factors is the money multiplier. An increase in the value of money multiplier leads to an increase in money supply. Another money supply determinant is the reserve ratio. When the reserve ratio is smaller, the banks have the ability to expand credit hence an increase in money supply. When the reserve ratio is higher, banks lacks the ability to expand the credit hence little money to give out as credit. Additionally, currency ratio is used as another determinant of the money supply. The currency ratio is the ratio of currency demand to the deposit demand. Although it is not easy to ascertain the currency ratio, its value has a direct effect on the money multiplier. Moreover, confidence in banks determines money supply in the economy. When the confidence is high, the amount of money supply is high, and when there is panic, money supply declines. There are other various factors such as time-deposit ratio, the value of money, real income, and interest rates, which all determine money supply in the economy.

  1. Monetary Policy

Monetary policy refers to the action taken by the Federal Reserve Bank (Central Bank of US) to control the amount of money and credit in the US economy (Federal Reserve System). Money supply can determine the near-future economic situation in the nation. That prompt the Federal Reserve Bank to use money supply trends to initiate monetary policies in a bid to tame runaway monetary situations. The main aim of the monetary policy is to prevent an economic situation that can lead to a rise in prices of goods and services, increase in interest rates and high unemployment rate. When such a situation afflicts a nation, its economy suffers a big blow leading to collapse of companies, financial institutions, and massive unemployment. The Federal Reserve System uses some tools to implement monetary policy. The three tools used are open market operations, discount rates, and the reserve requirements (Federal Reserve System).

  1. Open Market Operations

The federal uses the open market operations to impose monetary policy by selling and buying government securities. The term open market operations mean that the Federal Reserve System does not choose whom to trade with during the sale of securities (Federal Reserve System). The market is open for all hence the buyer is determined by the ability to meet the set prices. Through open market operations, Fed can expand or contract the Fed reserves and subsequent money supply. When Fed purchases securities, it causes an increase in the reserves and an increase in money supply in the same amount as the increase in reserve (Federal Reserve System). That helps to increase the amount of money supply in the economy. Purchase of securities happens when there is a decline of money in the economy. The sale of securities decreases the amount federal reserves and decreases the amount of money supply in the economy. When there is an excess supply of money in the economy, Fed sells the securities to reduce the amount of money in circulation. Open market operations are used interchangeably within several days since Fed does not wish to increase or decrease the reserves permanently. The increase and decrease in the reserves influence the overnight lending rates at which banks borrow reserves from one another. The open market operations are the most preferred monetary policy tool due to its precision in indicating the amount of credit available in the economy. Moreover, it is flexible and predictable than any other monetary policy tool used by Fed. The Federal Open Market Committee directs Fed on the open market options to take depending on the economic situation as presented by the financial and the stock exchange market trends. The committee decides the short-term decisions for engaging in the open market operations.

  1. Discount Rates

This is another tool used by Fed to control the money supply in the economy. The discount rates refer to interest rates charged on the loans advanced to the commercial banks and other depository institutions by the regional Federal Reserve banks (Federal Reserve System). All commercial banks are required to make a certain reserve with the Federal Reserve Bank called the reserve ratio. In the course of operation, a bank may experience financial crisis thus fail to meet the required reserve ratio as required by Fed. Consequently, the bank will result in borrowing to make up for the deficit. The bank can borrow from other banks or directly from the Federal Reserve banks. When the bank borrows from the Federal Reserve Bank, a discount rate is charged. When the discount rates are lowered, banks are encouraged to borrow from the Federal Reserve, and that increases the amount of money available in banks to lend other banks, businesses, and individuals (Federal Reserve System). Availability of money increases spending and investment in the economy.  When the discount rates are increased, the interest rates rises affecting the lending and borrowing trends hence lowering money supply in the economy. Increasing or lowering the discount rates, therefore, affects the commercial bank’s reserve rates and the subsequent interest rates. Ultimately, increase or decrease in the discount rates by the Federal Reserve banks affects the amount of money circulating in the economy (Federal Reserve System). The discount rates are increased to discourage constant borrowing from the Federal Reserve Banks. On the other hand, the discount rates are lowered when the Federal Reserve banks want to encourage increased borrowing. The discount rates either are raised or lowered depending either on the shortage in money supply or excessive money supply in the economy. Discount rates are used as a complement to the open market operations when the Federal Reserve banks want to control monetary situations in the economy effectively.

  1. Reserve Requirements

A reserve requirement refers to an amount of cash that the commercial banks are supposed to deposit with the Federal Reserve Bank (Federal Reserve System). The amount acts as a cover against financial crisis for the commercial banks. Fed can increase the reserve requirements for commercial banks and depository institutions. Increasing the reserve requirements ultimately leaves the banks with small amounts of money to lend fellow banks, businesses, and individuals. Consequently, money supply is limited leading to declining in its circulation. Similarly, when the reserve requirements are lowered, commercial banks and depository institutions are left with a huge amount of money enough to lend to other banks, business, and individuals. Availability of money increases its circulation in the economy.  The reserve requirements changes are subject to approval by the Board of Governors. It is only through the instruction of the Board of Governors that Fed can either lower or increase the number of reserve requirements. The reserve requirements are meant to ensure that customers’ money is available upon request (Federal Reserve System). The reserve requirements can be raised when the economy is undergoing recession to avert financial crisis as a result of panic. It is also used to curb inflation when there is an excess supply of money in the economy. Evidently, the expansion and contraction of the reserve requirements are meant to ensure stable employment and to reduce inflation. A shortage in money supply can prompt a bank to borrow from the Central Bank. As a result, the Federal Reserve Bank is referred to as the “lender of the last resort.” When all the other commercial banks and depository institutions can’t manage to support a bank during a financial crisis, the Federal Reserve Bank steps in to offer the assistance using the reserve requirements deposited by the bank in it.

  1. Fiscal Policies

Fiscal policies are measures taken by the government to control its spending and tax rates to influence the economy. The government implements fiscal policies through budgetary adjustments, unlike the monetary policies, which are implemented by the Federal Reserve banks. Both the fiscal and monetary policies work in conjunction to influence the economy towards a particular goal (Friedman 8). For instance, when the government lowers tax, more money is left in the hands of the consumers. The increase in money supply leads to increased investments, high employment, and rise in the income. When there is a shortage of money in the economy, the government might decide to increase its spending in a bid to restore parity in the money supply.

Money supply is an important element in determining the future of an economy. Putting in place sound monetary measures can help adjust situations that might adversely affect the economy.


Works Cited

Federal Reserve System. Monetary Policy Basics. Federal Reserve Education. N.d. Accessed 9 Feb. 2017.

Friedman, Benjamin. “Monetary Policy for Emerging Market Economies: Beyond Inflammation Targeting.” Microeconomics and Finance in Emerging Market Economies, vol. 1, no.1, 2008, pp. 1-12.


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Money Supply and the Federal Reserve System

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