Fed's Control of the Money Supply
The money supply contains coins and currency in the hands of the public, controlled by FED, and deposits accounts controlled by the interaction of the households and firms that use money and the banks that create money. At this point we have discussed the structure of the Fed and the money creation process in the banking system. It is now time to put the two together to see how the Fed can alter the money supply.Fed control of the money supply
The money supply (M1) can be increased if the coins and currency in circulation increase or the checking account balances (demand deposit) increase. There are four ways that this can happen.
ACM National Bank's Initial Balance Sheet
After the Fed purchase of the bonds from Mr. Perot and his deposit of the cash into his bank, ACM National Bank's balance sheet is:
ACM National Bank's books after a $100,000 infusion of cash
Assets Liabilities Securities $500,000 Reserves Checking deposits $5,100,000 Actual $1,100,000 Saving deposits $0 Required $1,020,000 Net Worth $500,000 Excess $80,000 Loans $4,000,000 Total $5,600,000 Total $5,600,000
This should look very familiar. It is in fact the first two stages of the money creation process that we examined earlier and you will recall the results. The increase of $100,000 cash into the system will result in an increase in the money supply of $500,000. Now you know why the Fed uses this policy to manage the money supply. If the Fed wants to increase the money supply it will buy government securities, while if it wants to decrease the money supply it will sell government securities.
Although all of the above are policy tools of the FED, Open Market Operations tend to be the favored tool. Their popularity stems from the fact that the decisions are reversible, flexible, and timely. The Fed's tools are summarized in Diagram 2 below.
Fed Policy Tools
|Tools||Goal: Increase Money Supply||Goal: Decrease Money Supply|
|Required reserve rate||lower||raise|
|Open market operations||but securities||sell securities|
How do we show the Fed's policies in the money market where interest rates are set? If the FED increases the money supply, then the money supply curve shifts outward. The outward shift could be accomplished by a reduction in the discount rate, open market purchases, or lower required reserve rates.
Increase in Money Supply
Those with some algebra skills can look at the situation one more time - this time with the help of some simple algebra. The derivation of the results can be found in An algebraic perspective, so here we will simply provide a summary of the assumptions and the conclusions. In the simple model the public holds no cash and the banks hold no excess reserves, while in the extended model the public holds cash and the banks hold excess reserves.
A simple model
The results of the simple model are captured in the equations below. The change in the money supply equals 1 divided by the required reserve rate. If the required reserve rate is 20 percent, as it was in the first example, then the money multiplier would be 1/.2 = 10/2 = 5. It should be no surprise that the money supply increased by $500,000 since this would satisfy the equation below.
D Money Supply = D Deposit Accounts
D Deposit Accounts = [1/rr] *D Reserves
An extended model
D Money Supply = [( cd + 1 ) / (cd + rr + re ) ] D Reserves
Here things are a bit more complicated, but the logic is the same. The money supply (M1) can be raised if the coins and currency in circulation increase or the checking account balances (demand deposit) increase. This can happen if:
The Fed can control the money supply by its ability to affect the variables and parameters on the right hand side of the two equations. It's now time to turn our attention to what impact the change in the money supply has on the economy - what we will call the monetary transmission mechanism.