Category: 

What is the Relationship Between the Federal Reserve and Money Supply?

Article Details
  • Written By: Jess Rhodes
  • Edited By: Melissa Wiley
  • Last Modified Date: 12 October 2019
  • Copyright Protected:
    2003-2019
    Conjecture Corporation
  • Print this Article
External Resources

The U.S. Federal Reserve and money supply in the country are closely linked. The Federal Reserve affects the country’s monetary supply by changing decisions in open market operations and affecting interest rates through the discount rate and reserve requirements. All three decisions directly influence the amount of money that banks have to offer as loans to the public, thus affecting the money supply.

The Federal Reserve’s responsibilities include conducting U.S. monetary policy, keeping stability in the financial system, and providing financial assistance to depository institutions. The Federal Reserve also calculates the U.S. money supply, publishing reports for the public. While these responsibilities influence and affect the money supply, they do so indirectly and with occasionally unpredictable outcomes.

Open market operations are the most commonly used connector between the Federal Reserve and money supply. Conducting open market operations entails purchasing or selling government securities, including treasury notes, bills, and bonds. Purchasing securities increases the money available in the bank, thus increasing the monetary supply and the ability of banks to lend money. Selling securities deducts money from the bank’s reserve, thus decreasing the amount of money available for loans and the national money supply.

Ad

The Federal Reserve and money supply are also connected via the discount rate, although this is not as commonly used as open market operations. The discount rate is the interest rate that the Federal Reserve charges banks for borrowing federal funds. If this interest rate increases, banks cannot afford to borrow as much from the Federal Reserve. They can then borrow from other institutions, or they have less money to offer in loans, decreasing the supply of money. If the Federal Reserve decreases the interest rate, banks can borrow more, thus increasing the supply of money.

Reserve requirements also connect the Federal Reserve and money supply, although this tactic is rarely used in the U.S. Reserve requirements are the mandated reserve funding level that banks and other depository institutions must maintain, set by the Federal Reserve. This is usually set as a percentage of their dealings. Higher reserves means less money can be in circulation, and lower reserves mean that more money can be distributed as loans.

One additional way the Federal Reserve and money supply can be connected is through deliverance of preemptive news about future changes in the above rates or procedures. Through news reports, therefore, the Federal Reserve can persuade market participants toward certain actions. When institutions include potential monetary policy into their strategic plans, greater benefit can be achieved.

Ad

Recommended

Discuss this Article

Post your comments

Post Anonymously

Login

username
password
forgot password?

Register

username
password
confirm
email