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In 1971, the dollar officially became a fiat currency. (Before that, international treaties required the dollar to be convertible into gold.) With a fiat currency, there is no practical or legal constraint on the size of the money supply. That is, there’s no constraint on the amount of money in circulation. Under those conditions, the Fed conducted monetary policy by managing the size of the money supply.
Managing the Money Supply
Suppose, for the moment, that the money supply consists entirely of bills and coins people keep at home or on their person, and suppose also that all transactions involve the exchange of cash. How much people are willing to pay for something will depend on how much physical cash they have with them. In this scenario, suddenly enlarging the money supply by handing every adult a stack of bills will accomplish two things: first, it will stimulate spending, which will increase economic activity and thereby create jobs, reducing unemployment. And second, the cash giveaway will raise prices, because stimulating spending shifts demand curves for all sorts of products to the right.
The real-world money supply includes more than just bills and coins, but the same point still holds: an expansion of the money supply stimulates economic growth and lowers unemployment, but it is inflationary. Conversely, shrinking the money supply (perhaps by imposing a one-time tax on everyone) will lower prices but will slow the economy and increase unemployment. Monetary policy focused on the size of the money supply will therefore seek to strike the right balance between unemployment and inflation by growing or shrinking the money supply as needed.
Money Creation
What economists mean by the money supply is not simply all the bills and coins in people’s pockets. There are different measures of the money supply, but the M2 money supply (the most important measure) consists essentially of the following:
- All notes (bills) and coins in the physical possession of firms or households—that is, excluding notes and coins stored in bank vaults
- All savings and checking account balances, nationwide
- Certain other highly liquid (readily accessible) holdings, such as small-denomination certificates of deposit (CDs).
Intuitively, the M2 money supply represents the sum total of all purchasing power handily available to firms and households.
Consider, again, a simplified scenario. Alex has $1,000 in cash, which we will suppose represents the entire monetary base (no one else has any cash). Alex deposits this $1,000 in a bank savings account. The bank keeps $100 in its vault but lends the remaining $900 to Blaine. How big is the money supply at this point? Alex has $1,000 in a savings account, and Blaine is holding $900 in cash, so by the M2 definition, the money supply stands at $1,900. (The $100 in the bank vault is excluded.) If Blaine puts the $900 in a bank account, the bank may keep $90 in its vault and lend the other $810 to Cameron. Now the M2 money supply has grown to $1,000 + $900 + $810 = $2,710. Thus the bank has not quite tripled the money supply by the simple act of extending loans to a couple of its customers.
Suppose now that the bank continues the practice of re-lending and re-re-lending money deposited with it, always setting aside 10 percent of a deposit as vault reserves, so that the amount lent out is less each time. The size of the money supply will approach $1,000 times \(1/0.10 = 10\), or $10,000. In general, if banks’ reserve ratio is \( rr\), meaning that banks consistently hold back a fraction rr of any deposit and lend the rest out, then the money multiplier is \(1/rr\). This is the number that, multiplied by the monetary base, gives the size of the money supply after the banks are done lending and re-lending.
Limited Reserves
In the real world there are many banks, each making their own choices about whom to lend to, and how much. But every bank needs to hold back some fraction of deposits, so that when depositors want to make withdrawals, the bank has cash on hand to give them. In its capacity as overseer of the banking system, the Fed established a certain minimum fraction as the reserve requirement. (Here we skip over some complicating details that don’t matter for our purposes.) Banks obeyed that requirement but did not maintain any additional (excess) reserves beyond what was required. This was what is known as a limited reserves environment. Under those conditions, the reserve requirement imposed by the Fed could be dialed up or down to decrease or increase the size of the money multiplier (higher rr for a lower multiplier, lower rr for a higher multiplier), and thereby increase or decrease the size of the money supply. In short, the reserve requirement became a tool for conducting monetary policy. To increase the money supply, lower the reserve requirement. To decrease the money supply, raise the reserve requirement.
The traditional picture also included open market operations. This term refers to the Fed’s buying or selling of Treasury bonds in order to add money to the money supply or to draw money out of it. When the Fed buys T-bonds, it pays for them in cash, thereby putting that cash into general circulation and hence adding it to the money supply. When the Fed sells T-bonds, it receives cash in payment, thereby taking that money out of circulation and hence subtracting it from the money supply.
