Question

Please briefly explain the reason why the Fed cannot precisely control the money supply in the economy. (hint: use “monetary base”, “currency-deposit ratio” and “money multiplier” in your explanation.)

Answer 1

The monetary base is the total of all currency in circulation and reserves held by banks. The Fed can directly influence the monetary base and the monetary base influences the money supply. To understand how the money supply process works, the Fed's balance sheet must be introduced. In this lesson, only several items are introduced. In lesson 13, you will learn all the major components of the Fed's balance sheet. The Fed's liabilities are the currency in circulation and bank reserves. Currency in circulation - the Federal Reserve Notes the public is holding, i.e. U.S. money. This does not include vault cash at banks, because vault cash is already counted as bank reserves. Let's keep this example and lesson simple. Bank reserves - reserves held at the Fed or in a bank vault. The required reserve ratio is the percentage of total deposits that banks must hold. If a bank bank holds reserves above this amount, then it is called excess reserves. The important thing to notice is bank reserves are assets to the bank, but liabilities to the Fed. The money the public is holding is an asset to them, but a liability to the Fed. The two major assets the Fed has are government securities and discount loans. When the Fed increases its assets, the monetary base increases. When the Fed decreases its assets, the monetary base decreases. The first and direct method to change the monetary base is through open market operations. Open market operations occur, when the Fed buys and sells financial securities. Usually the Fed buys and sells U.S. government securities. When the Fed buys U.S. government securities, it is called an open market purchase. The Fed's assets increase, causing the monetary base to increase. The Fed can also sell U.S. government securities, which is called an open market sale. The Fed's assets decrease, causing the monetary base to decrease. For example, the Fed buys a $10,000 T-bill from your bank. The transaction is listed below:

Your Bank Assets Liabilities -$10,000 T-bill +$10,000 Deposit at the Fed The Fed Assets Liabilities +$10,000 T-bill +$10,000 Bank reserves

The Fed buys the T-bill by using a Fed check. When the bank sends the check to the Fed, the Fed increases the reserves at your bank. There is no money behind the Fed check; its more like adding more numbers in a bank's accounting books. The bank's reserves increase and your bank will make a loan to someone, so the bank can earn interest. The Fed's assets increase, the monetary base increases, and the money supply increases. The second example, the Fed buys one T-bill from you for $10,000, using a Fed check. You deposit the Fed check at your bank.

You Assets Liabilities -$10,000 Treasury Bill +$10,000 Demand Deposit (Checking) Your Bank Assets Liabilities +$10,000 Fed Reserve Deposit +$10,000 Demand Deposit The Fed Assets Liabilities +$10,000 T-bill +$10,000 Bank reserves

The money supply increased, because you traded the T-bill for a demand deposit. It makes no difference if the Fed buys U.S. securities from the public or a bank. The Fed's assets increase, causing the monetary base to increase. Your bank's reserves increase and your bank can make loans to earn interest. Then the money supply increases. If the Fed sells U.S. government securities, the opposite occurs. The Fed's second asset is loans. The Fed can extend loans to banks, which helps the banks survive liquidity problems. The Fed loans are called discount loans. The interest rate the Fed charges for these loans is called the discount rate. The Fed does not use loans to influence the monetary base. Instead, the Fed relies on open market operations, because the Fed has complete control over how much securities it wants to buy and sell. With discount loans, the banks determine if they want to borrow from the Fed or not. The Fed cannot force a bank to accept a loan. However, if the Fed makes more discount loans, the Fed's assets increase, causing the monetary base and money supply to increase. For example, a bank asks the Fed for a loan of $1 million.

The Bank Assets Liabilities Reserves at Fed +$1 million Loan from Fed +$1 million The Fed Assets Liabilities Loan to institution +$1 million Bank reserves +$1 million

The bank's reserves increased by $1 million, and now the bank can make more loans, which will increase the money supply. When the bank repays the Fed loan, the Fed's assets decrease, the monetary base decreases, and the money supply decreases. The transaction is listed below:

The Bank Assets Liabilities Reserves at Fed -$1 million Loan from Fed -$1 million The Fed Assets Liabilities Loan to institution -$1 million Bank deposit at Fed -$1 million

In this next example, the Fed increases the monetary base, which causes the money supply to increase. The money supply is created through multiple deposit expansion. This means when the Fed increases the monetary base by $1, then the amount of checkable deposits will increase by more than $1. Checkable deposits are one component of the M1 definition of money, so the money supply increases by more than $1. The Fed wants to increase the money supply, so the Fed buys a $10,000 U.S. T-bill from you. You take the Fed check and deposit it at your bank.