How does Federal Reserve Control the Money Supply?

Federal Reserve or simply “the Fed” is an independent entity whose main goal is to provide the nation with a safer, more flexible, and more stable monetary and financial system. It is the central bank of the United States that influences the monetary policy by controlling the money supply and cost of money in able to give the economy full employment, low inflation rate, and stable prices. Manipulating money supply is a very powerful tool use by the Fed to stabilize the economy. So how does the Federal Reserve control the money supply? The Fed uses three different methods to increase or decrease the amount of money supply in the economy. The first method is by conducting open market operations, which affects the federal funds rate. In open-market operations, the Fed buys and sells government securities in the open market. If the Fed wants to increase the money supply, it buys government bonds. This supplies the securities dealers who sell the bonds with cash, increasing the overall money supply.

Conversely, if the Fed wants to decrease the money supply, it sells bonds from its account, thus taking in cash and removing money from the economic system. Open-market operations are the most important tool that the Fed can use to influence the money supply. Perfect example was during the recession of 2007 – 2009. The primary tool that the Fed used early during the current crisis was to cut the Federal Funds rate. The Fed initially conducts open market operations by buying and selling short-term Treasury instruments and then later on widened the range of securities to include agency and mortgage-backed bonds. The Fed had raised rates to 5.25% in June 2006 and rates remained at that level until the first rate cut (to 4.75%) in September 2007. The Fed continued to cut rates six more times until rates were at 2% in April 2008. The Fed then paused until the Lehman crisis and then cut rates twice in October 2008 and once again in December 2008 when rates reached the current target range between 0% to 0.25%. The Fed relied on rate cuts to heal the damage in the financial markets.

The second method the Fed use to alter the money supply is by changing short-term interest rates. By lowering (or raising) the discount rate that banks pay on short-term loans from the Federal Reserve Bank, the Fed is able to effectively increase (or decrease) the liquidity of money. Lower rates increase the money supply and boost economic activity; however, decreases in interest rates fuel inflation, so the Fed must be careful not to lower interest rates too much for too long. Finally, the Fed influence money supply by modifying reserve requirements. Reserve requirement is the amount of funds banks must hold against deposits in bank accounts. By lowering the reserve requirements, banks are able loan more money, which increases the overall supply of money in the economy. Conversely, by raising the banks’ reserve requirements, the Fed is able to decrease the size of the money supply.

Banks and other depository institutions (savings institutions, credit unions, and foreign banking entities) are required to hold a portion of their deposits as reserves. Depository institutions may hold reserves either as vault cash or as deposits with Federal Reserve Banks. Effective December 28, 2000, depository institutions were required to hold a reserve requirement of 3 percent against their first $42.8 million in net transaction accounts (demand and other checkable deposits) and 10 percent against their net transaction accounts above $42.8 million. At present, there is no reserve requirement on time and savings deposits. In relation to the recession of 2007-2009, the Fed has seldom employed changes in reserve requirements to enact monetary policy, because open market operations are a much more precise tool.