Banking

The money supply is defined as the total amount of currency plus deposits held by the public.

The first is through open market operations. The second is by changing the reserve requirement. The third is through changing the federal funds interest rate. Each of these actions in some way affects the total amount of currency or deposits available to the public.

Open market operations are a form of monetary policy, meaning that the Fed directly affects the money supply. Open market operations are the sale and purchase of government bonds issued and regulated by the Fed. When the Fed sells government bonds, the public exchanges currency for bonds, thus resulting in a shrinking of the money supply. When the Fed purchases government bonds, the Fed exchanges currency for bonds, thus resulting in an increase in the money supply. Open market operations are the most common tool that the Fed uses to affect the money supply. In fact, almost every weekday government bonds are bought and sold in New York City.

The second way that the Fed can influence the money supply is through changing the reserve requirements. This is a form of fiscal policy because the Fed is working with the finances of banks to affect the money supply rather than with the money supply directly. We learned earler that the money multiplier shows how much an initial deposit increases the money supply after loans are made and redeposited. Recall that the money multiplier is one over the reserve requirement. Thus, if the reserve requirement is decreased, banks are required to hold fewer reserves and can then make more loans. This in turn repeats the cycle of loan to deposit, resulting in an increase in the money supply. For a given initial deposit, a smaller reserve requirement will result in a larger money multiplier, and thus in a larger change in the money supply.

There are a number of safeguards built into the US banking system. The first is the Federal Deposit Insurance Corporation. The FDIC insures individual deposits up to $100,000 in the case of a bank collapse. This measure is supposed to inspire confidence in the public that the money it deposits in a bank will not be lost, despite unforeseen events. A second safety measure is a system of bank checks and audits by the government to ensure that prudent banking practices are being observed. These are simply very detailed examinations of bank records and dealings. The third safeguard is the regular verification that banks' holdings meet reserve requirements. In this way, banks are prepared to pay depositors as needed and may be able to avoid a bank failure. The fourth safety measure is that banks are limited in the investments that they may make with deposited funds. Banks not only earn money from interest on loans, but they also invest money in bonds and stocks. By regulating the amount of risk that a bank can undertake in its investments, the government ensures that depositors' money will be relatively secure, even in the case of poor economic conditions. In all, the government regulates the actions of banks in such a way as to maintain the US banking system as one of the safest and most open in the world.