In the SparkNote on money and interest rates we learned about the money supply. Initially we defined the money supply as the total amount of currency held by the public. While this definition is correct, it is incomplete. In the previous section, we learned that through a fractional reserve banking system, the money supply increases. Thus, the money supply is better defined as the total amount of currency plus deposits held by the public. All available money, either in terms of currency or demand deposits, is thus accounted for.
Initially, money supply was introduced as a vertical line that was only affected by Fed policies. While it is true that the Fed has the majority of the control over the money supply, our new definition of money supply indicates that the public has so me control as well, albeit unwitting: the public has the power to make deposits and take out loans. We will work through how both the Fed and the public affect the money supply through their actions.
There are three basic ways that the Fed can affect the money supply. 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 the se 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 bon ds, 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 suppl y directly. We learned in the section on the purpose of banksthat the money multiplier shows how much an initial deposit increases the money supply after loans are made and redeposited. Recall that the money multiplie r 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.
The third way that the Fed can influence the money supply is through changing the federal funds interest rate. This is also a form of fiscal policy because the Fed is working with the finances of banks to affect the money supply rather than with the mone y supply directly. We learned in the section on the purpose of banks that banks make deposits, withdrawals, and loans from banks' banks that are usually branches of the Fed. When a bank makes many loans, its reserves get d epleted to near the absolute required minimum. If a customer makes a withdrawal, banks must either recall a loan or take out a loan to pay the withdrawal while still maintaining the necessary reserves. If the Fed increases the federal funds interest rate, banks will be less likely to borrow money from the Fed and will thus be more weary of making loans to ensure that they have the necessary reserve requirements. Thus, if the federal funds interest rate is higher, banks make fewer loans, the money multi plier is not fully utilized, and the change in the money supply for a given initial deposit is smaller.