Question

Discuss our fractional reserve system and the process by which the Fed changes the money supply.

Answer 1

Fractional reserve system is the system of banking, where a fractional amount as a fixed percentage of the deposits is kept as required reserve and remaining deposits as excess reserves are disbursed as loans to the borrowers. It facilitates a creation of money as loan issued by one bank is the deposit in another bank and that bank also maintains the fractional reserve and disburses the remaining amount as loans. It creates money in the economy. It is based on money multiplier that is calculated by the following formula.

Money multiplier = 1/required reserve ratio

Fed changes money supply using different tools. One of the tool is open market operations. With the help of it, Fed buys or sells the government securities and money supply is controlled. When Fed sells the government securities, then it sucks the excess reserve and banks are unable to give loans. Hence, money supply is controlled and reduced. With the change in required reserve ratio also, money supply is changed by Fed. A higher reserve ratio means, lower money supply and vice versa.