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Dr. Kalinda Rose Stevenson
How The Fed Controls The Money Supply
Welcome back!
Have you seen the news reports that the Federal Reserve has “pumped” money into the economy? Have you wondered exactly what that means? How exactly does the Fed “pump” more money into the system?
Controlling the amount of money in the system is one of the most important functions of a government. Money is never simply personal. It is a matter of government policy. The more you understand how governments increase and decrease the amount of money available, the more you will be able to control your personal economy.
In the United States, the central bank is the Fed, or Federal Reserve. Every nation has an equivalent central bank. These banks monitor current economic conditions and respond if the central banks want to heat up or cool down the economy.
Although the news media use this type of language, they don’t explain exactly how the Fed increases or decreases the amount of money. What does the Fed do when the media report that the Fed is “pumping money” into the economy to calm fears of an economic panic? What does it do to “drain money” from the system, to cool it down?
Before we figure out what it means, let’s establish clearly what it does NOT mean. The Fed does not pump money into the system by printing out more currency. Currency is not equivalent to money.
The Fed has several tools it can use to decrease or increase the amount of money in the system.
The first tool the Fed uses is to adjust the reserve requirement of banks. The “reserve” is the portion of customer deposits that the bank must keep. It cannot loan all of its deposits.
If you have ever wondered how banks make money, they make it by loaning out customers deposits to other customers. However, the bank cannot loan out all of its deposits. If you deposit $1,000 in the bank, the bank loans most, but not all, of your $1,000 to other customers.
The Federal Reserve sets the reserve requirements for banks. Typically, the reserve ranges from 3-10% of its deposits. So, with your $1,000 deposit, the bank needs to keep on reserve only $30 with a 3% reserve and $100 with a 10% reserve. The bank is free to loan out whatever is left after the reserve requirement. With a 3% reserve the bank can loan out $970 of your money. With a 10% reserve, the bank can loan out only $900.
If the Fed wants to increase the money supply, it can reduce the reserve rate. If the Fed wants to decrease the amount of money in the system, it increases the reserve requirements. This simple example demonstrates how the process works, and how the Fed pumps money into and drains money out of the system by changing the reserve requirements.
When the bank has to keep 10% of its deposits on reserve, it can loan out only 90% of its deposits. When the bank has to keep only 3% of its deposits on reserve, it can loan out 97% of its deposits to customers. With a lower reserve, more money is available. With a higher reserve, less money is available. .
It is a bit misleading to claim that the Fed “pumps” money into the system. In fact, the Fed allows the banks to “pump” more money into the system, because the Fed has reduced the reserve rate. The lower the rate, the more money the banks can pump into the system. The ability of the Fed to change reserve requirements is one powerful tool Fed uses to control the amount of money in the economy.
By Kalinda Rose Stevenson, Ph.D.
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