A Lever on Money Supply

What does the Federal Reserve do? Learn about monetary policy and the role of ‘The Fed.’

One bank to rule them all

Central banks are one of the most powerful institutions in a country. They regulate commercial banks and control money supply to ensure a healthy rate of economic growth. With this in mind, central banks keep unemployment low, control inflation, and work toward moderate long-term interest rates. Notice how these objectives seek a balance between an economy on overdrive and one that’s hibernating – moderation is key.

Different countries have different names for their central banks – the Federal Reserve in the US (or the Fed, for short), European Central Bank in the EU, and Bank of Canada in Canada. In any case, they are national authorities which are largely independent to protect them from political pressures. Among the powers and responsibilities of a central bank are the ability to create money, to change interest rates, and to step in should financial institutions collapse. And, with an ever-more globalized world, keeping a country’s currency stable has become an important duty as well.

The lender of last resort

Financial institutions run on trust – that our money is safe in the bank, and that we can retrieve it anytime. Unfortunately, that trust is shaky. If someone tells you your bank is going broke, what would you do? Run straight to the bank and withdraw your money before everyone else does the same and the bank goes bust? Once word gets out, the rumor becomes a self-fulfilling prophecy. Enough people will panic like you, and the bank inevitably runs out of cash.

But that doesn’t mean that the bank has lost depositors’ money. It just means that banks don’t keep 100% of depositors’ cash in their vaults because that’s how banks profit – by lending out excess funds. 

Bank runs are less common nowadays. Thanks to deposit insurance, depositors’ funds are safe regardless of a bank’s cash situation. When all else fails, the Fed can step in as a lender of last resort, propping up banks to avoid a domino effect across the financial system. This happened in 2008, when the US banking system almost collapsed due to the housing crisis.

Controlling the multiplication of money

Banks earn money by loaning out depositors’ cash, keeping only a fraction of all deposits to account for possible withdrawals. Imagine depositing $1000 in a bank. The bank keeps $100 and loans out $900 to Rita. Rita takes the $900, deposits it elsewhere. Her bank keeps $90 and loans out $810 to Janet. Janet takes the $810, deposits it in another bank… and on it goes. From your initial $1000, banks can create up to $10,000 worth of new money.

It’s with this concept of fractional reserve banking that central banks control money supply. Notice how banks keep a constant 10% of deposits in the example? It’s not because they want to. They’re required by law. We call this the reserve requirement, and the Fed moves it up or down as needed. 

If there’s too much money around, the Fed raises the reserve requirement. Banks must retain more of depositors’ cash, so money supply decreases. If the market needs stimulation, the Fed lowers the reserve requirement, hoping to make money more available to consumers to borrow and spend.

Playing with discount rates

Remember that the Fed imposes a reserve requirement on banks. When banks fall short and need extra funds, they can turn to the Fed, which loans them money at an interest rate. We call this the discount rate, and it is the second of 3 traditional tools that central banks use to manage the economy.

When the discount rate is low, banks are incentivized to issue more loans and make up for their reserve shortfall by borrowing from the Fed. If a bank can issue a 5% loan while borrowing from the Fed at 0.25%, the 4.75% difference is a good profit incentive. Banks might react to this low discount rate by issuing more loans, thereby increasing the economy’s money supply. 

In contrast, when the discount rate is high, banks’ profit margins on loans become smaller. This discourages them from borrowing from the Fed, which then reduces the volume of loans they issue. By moving the discount rate up or down, the Fed can influence banks’ loaning behavior and, by extension, the economy’s money supply.

Short-term debt and the quantity of money

Among the Fed’s most used tools is open market operations. Here, the Fed buys and sells short-term government debt to banks in order to adjust money supply and interest rates. By selling government bonds, the Fed receives money from banks, which limits the economy’s money supply. We call this contractionary monetary policy. The Fed can also go the opposite direction and buy back government bonds, thus releasing extra money into the market – an expansionary monetary policy.

This focus on money supply and interest rates has its foundations in Irving Fisher’s Quantity Theory of Money[20]. Fisher suggests that any change in money supply creates an equivalent change in price levels:

 

money supply × velocity of money = general price of goods × volume of transactions in the economy

 

Velocity of money, which is how fast money changes hands in an economy, can play an influential role too. Are people spending enthusiastically, or are they holding tight to their funds? The former amplifies any changes in money supply, while the latter dampens it.

This formula has since been debated, adapted, and modified. Economists still argue about its specifics, but what we can take from this is that money supply usually has a direct effect on inflation and is, therefore, a good tool for controlling it.

A new frontier for monetary policy

The 2008 financial crisis was so dire that the Fed lowered discount rates to zero to encourage spending. But, even at that point, the Fed’s traditional expansionary measures failed to revive the economy. It had to look for other tools.

Enter quantitative easing. Instead of just buying short-term government bonds, the Fed started purchasing longer-term assets. This allowed it to influence both in the short term and longer term. The Fed also gained the ability to target certain industries. By buying mortgage instruments, it could help lower interest rates, specifically for homebuyers.

As a result of quantitative easing, the Fed effectively funneled large swaths of cash into bank reserves. On top of that, it started paying interest on bank reserves. This encouraged banks to keep a fat cushion of cash that they would have otherwise eagerly loaned out pre-2008. In fact, bank reserves have never looked the same since then. Some economists fear what might happen should banks start loaning out their large reserves, imagining unprecedented levels of inflation. Banks have yet to do so, and economists are keeping a close watch.

Powerful but not almighty

The 2008 financial crisis revealed the limits of the Fed’s toolkit. Efforts to jumpstart an economy in crisis only goes so far when interest rates are already at rock bottom. That’s why the Fed resorted to unconventional measures like quantitative easing and paying interest on bank reserves.

But sometimes the challenge is in even deciding what to do. The Fed must address realities on the ground, but it doesn’t always have a clear or full picture of something as complex as the US economy. Economists can have different takes on a situation, and they can all be correct. It’s just that none of them has a full view, and they all come from different angles. 

The early signs of inflation, for example, may be interpreted as a spike in demand. To keep things in check, authorities may reduce money supply. However, time may paint a different picture. Perhaps increased costs in the supply chain led to cost-push inflation. In hindsight, the Fed knows what it should have done, but the solution isn’t always obvious while things are still unfolding.

Cooperation, not competition

Humans enjoy comparing things. Fiscal and monetary policy are not immune to this sort of comparison. Fiscal policy generally has a more direct impact on consumers in the form of new jobs and direct payments from the government. But discretionary fiscal policy involves significant legislative and implementation delays. Help does not always come fast enough.

Another thing to note is that fiscal policy lies in the hands of politicians who may or may not be as well-versed in economic policy compared to members of the Fed. But that’s not to say that the Fed has never messed up. Even Ben Bernanke, former chair of the Fed, admitted that the Great Depression was worsened by the institution’s policies[21].

Monetary policy offers relatively quick action from experts whose sole job is to monitor the health of the economy. Fiscal policy, meanwhile, has more impact on citizens, and is more effective during severe economic downturns. Ultimately, both have their roles to play, and an economy that uses both wisely is better equipped for growth and stability.

Does the Fed affect you?

The Fed works closely with financial institutions, but do their tools actually affect consumers? Of course, society as a whole experiences the flow-on effects of a healthy economy. But besides that, the ripples of the Fed’s policies do reach consumers, primarily in the form of interest rates.

When the Fed tweaks interest rates, this will reflect in the rates we get charged on our credit cards, auto loans, and mortgage payments. For instance, someone looking to buy a house needs to prepare a bigger budget for buying into the market as interest rates are going up.

Higher interest rates also mean higher interest on government bonds and savings accounts – assuming you partake in either. Stock investors may observe the stock market being shaky for some time, but the market adjusts eventually, so there’s no cause for panic.

All in all, the Fed’s policies, whether expansionary or contractionary, will affect you. How it does depends on where you stand financially. Are you more of a borrower or a lender? What ends up being favorable for one will inevitably hurt the other.

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