Question

1. What are the mechanisms the Fed uses to "control" the creation of money by the banking system?
2. According to Orr, why is the Fed's control over the creation of money "limited"?

Answer 1

1. Fed controls the money supply in banking system in three ways :

Reserve ratio: Banks require to deposit a certaint amount of total deposits with the Fed. By controlling this reserve ratio, Fed controls the monet supply. When reserve ratio increases, ability of the mony creation by the banking systems reduces. Borrowing capacity of the banking system decreases and vice versa.

Discount rate: Banks often borrow from Fed to meet the reserve requirement, whenever there is liquidity crisis. Fed charges an interest rate on this borrowing in the form of discount rate. When Fed raises interest rate, borrowing amount falls and the capacity of money creation also falls. Therefore, Fed controls the money supply in the economy by increasing or decreasing discount rate.

Open market operation: Open market operation is selling and purchasing of governmnet securities. Fed obsorbs money supply by selling treasury securities and bills and buys back the securiies from the private dealers to inject money in the system. The transactiona are made through banking systems.

2. According to Orr, Fed has little control over the money creation due to its lack of transparency. There is a criticism that people should know the process of open market opertion that is conducted by the Fed. Moreover, US economy has expeerienced liquidity trap situation in money system despite tight control of Fed. Liquidity trap is a situation when interest rate is low and savings are high as people choose to put their money in bank instead of bonds. Moneytary policy becomes ineffective in this situation.