How The Fed Controls The Money Supply

Recent news reports announce that Federal Reserve has "pumped" money into the economy, without making clear what this means. Do you know how the Federal Reserve "pumps" money into the economy?

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.

Every nation has its own central bank. One of the functions of a central bank is to respond to current economic situations to either cool down or heat up the economy. In the United States, the central bank is the Federal Reserve.

You might hear that the Fed is "pumping money" into the economy to calm fears of an economic panic. At other times, you will hear that the Fed will "drain money" from the system, to cool it down. Although the news media uses such language, they don't explain exactly how the Fed increases or decreases the amount of money.

First, let's make clear that Fed does not pump more money into the system by printing more currency. Currency is not the same as money.

The Fed has several tools it can use to decrease or increase the amount of money in the system.

One method involves the reserve requirements for banks. A bank must keep a portion of its deposits on reserve. In other words, the bank can only loan out a percentage of its deposits as loans. The percentage it cannot loan out is the reserve.

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. The banks must keep 3-10% of customer deposits on reserve. This means that the bank needs to keep on reserve only 3-10% of your $1,000. With a 10% reserve, the bank must keep $100 on reserve. That means it can loan out the remaining $900. With a 3% reserve, the bank must keep only $30 on reserve. It is allowed to loan out the remaining $970.

This example demonstrates that the Fed can control the amount of money banks can loan by changing the how much the banks must keep on reserve. When the Fed wants to "pump" money into the system, it reduces the reserve requirements. The same process works in the opposite direction. The Fed can "drain" money from the system if it increases 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.

Article Source: http://mylilpeanut.com

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