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. 

  1. required reserve rate is lowered: The Fed can lower required reserve rate which raises the multiplier effect of high powered money (cash). The cash stays in the banks and each dollar can support more loans/demand deposits. In our example, it the required reserves went from 20 percent to 10 percent, bank ACM would only need to hold $10,000 in reserves for the initial injection of $100,000.  The other $90,000 would be loaned out so at each stage in the multiplier chain, the banks would be loaning out more funds and the eventual increase in the money supply would be larger.
  2. discount interest rate decreases: The Fed can lower the discount rate and lower the costs for banks holding low excess reserves which will lower the excess reserve rate.  If the Fed lowers the discount rate, or sets a lower federal funds target, this can be accomplished if the Fed injects funds into the system which will drive down the price of those funds - interest rates.  To see how it could increase the level of cash in the system, we can turn to the next Fed tool - open market operations. 
  3. publics' holding of cash changes: The Fed can raise confidence in banking system which will lower public's desire for holding cash. If you look at the high-powered money the Fed can inject into the system, a dollar in the hands of an individual is simply a dollar of money supply.  A dollar in reserves at the banks, however, can support some multiple expansion of checking accounts.  For example, when the required reserve rate was 10 percent, the $100,000 cash injection the system ultimately resulted in a $500,000 increase in checking account balances.  Thus if the Fed can move dollars from people's pockets to banks, this will increase the money supply.  In the Great Depression, one of the real problems was people lost confidence in the banks and took their cash out of the banks, a pattern that caused the money supply to decrease.  When people want cash, the reserves in the banks fall which creates a bigger drop in demand deposits.  The result is a net decrease in the money supply.  For this reason you would expect every Christmas season the money supply would decrease as consumers want to hold more cash.  To offset this the Fed will need to get more cash into the system.  The same will happen as the Fed attempts to offset the public's hoarding of money at the turn of the millennium.  
  4. open market purchases: this is the Fed's primary tool of monetary policy.  The Fed can buy or sell government securities.  Let's look at the situation when the Fed wants to increase the money supply.  The Fed will contact its broker and announce it wants to buy $100,000 of government securities.  To make life easy we will assume the securities the Fed buys are sold by Herschel Perot who deposits the cash in his bank - ACM National Bank.  The original balance sheet of the bank appears below.

ACM National Bank's Initial Balance Sheet

Assets   Liabilities  
Securities $500,000    
Reserves   Checking deposit $5,000,000
Actual $1,000,000 Saving deposit $0
Required $1,000,000 Net Worth $500,000
Excess $0 *    
Loans $4,000,000    
Total $5,500,000 Total $5,500,000

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.

Diagram 2
Fed Policy Tools

Tools Goal: Increase Money Supply Goal: Decrease Money Supply
Discount rate lower raise
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

MSout.gif (2252 bytes)

Appendix:  Fed control of the money supply: An algebraic approach

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.