How Will The Fed's Policy Action Change The Money Supply

The Federal Reserve's (also known as the Fed) monetary policy actions exert a powerful influence on the money supply, shaping economic activity, inflation, and overall financial stability. As the central bank of the United States, the Fed utilizes a range of tools to manage the money supply, primarily to achieve its dual mandate of maximum employment and price stability. Understanding how the Fed's policies affect the money supply is crucial for investors, economists, and anyone interested in the intricacies of the financial system.

The Money Supply: A Primer

Before delving into the Fed's policy actions, it's essential to define the money supply. The money supply refers to the total amount of money circulating in an economy at a given time. It's typically categorized into different measures, with the two most common being M1 and M2.

M1: This represents the most liquid forms of money, including:
- Currency in circulation (physical cash and coins)
- Demand deposits (checking accounts)
- Traveler's checks (though less common now)
M2: This is a broader measure that includes M1 plus:
- Savings deposits
- Money market deposit accounts
- Small-denomination time deposits (certificates of deposit, or CDs, under $100,000)

The Fed primarily focuses on influencing M2 as its main target for monetary policy. Changes in the money supply can have significant effects on interest rates, inflation, and economic growth.

The Fed's Monetary Policy Tools

The Federal Reserve employs several key tools to influence the money supply. These tools can be broadly categorized into:

Open Market Operations: This is the Fed's most frequently used and flexible tool. It involves the buying and selling of U.S. government securities (like Treasury bonds) in the open market.
The Discount Rate: This is the interest rate at which commercial banks can borrow money directly from the Fed.
Reserve Requirements: These are the fraction of a bank's deposits that they are required to keep in their account at the Fed or as vault cash.
Interest on Reserve Balances (IORB): The Fed pays interest to banks on the reserves they hold at the Fed.
Quantitative Easing (QE): This is a less conventional tool used during periods of economic crisis or when interest rates are already near zero. It involves the Fed purchasing longer-term government securities or other assets to inject liquidity into the market and lower long-term interest rates.

How the Fed's Policy Actions Change the Money Supply

Now, let's explore how each of these tools affects the money supply:

1. Open Market Operations

Buying Securities: When the Fed buys government securities, it injects money into the banking system. Here's how it works:
1. The Fed purchases securities from banks or other financial institutions.
2. The Fed credits the seller's account with the purchase amount.
3. The bank now has more reserves, which it can lend out.
4. As banks lend out these reserves, the money supply expands through the money multiplier effect.
The money multiplier is a crucial concept. It signifies the potential increase in the money supply for each dollar increase in reserves. The multiplier effect arises because when a bank lends out its excess reserves, the borrower deposits that money into another bank. This second bank then has more reserves to lend out, and the process continues. The money multiplier is calculated as:
```
Money Multiplier = 1 / Reserve Requirement Ratio
```
For example, if the reserve requirement ratio is 10% (0.1), the money multiplier is 10. This means that each dollar increase in reserves can potentially lead to a $10 increase in the money supply.
Selling Securities: Conversely, when the Fed sells government securities, it drains money from the banking system.
1. Banks or other financial institutions purchase the securities from the Fed.
2. The Fed debits the buyer's account.
3. The bank now has fewer reserves, limiting its ability to lend.
4. As banks reduce lending, the money supply contracts.
Open market operations are a powerful and flexible tool because the Fed can conduct them on a daily basis and in relatively small increments, allowing for precise control over the money supply.

2. The Discount Rate

Lowering the Discount Rate: When the Fed lowers the discount rate, it makes it cheaper for commercial banks to borrow money directly from the Fed.
1. Banks are more willing to borrow from the Fed when the rate is lower.
2. This increases the amount of reserves in the banking system.
3. Banks can then lend out these additional reserves, expanding the money supply.
4. Lowering the discount rate can also signal to the market that the Fed is pursuing an expansionary monetary policy, encouraging more lending activity.
Raising the Discount Rate: When the Fed raises the discount rate, it makes borrowing from the Fed more expensive.
1. Banks are less willing to borrow from the Fed.
2. This reduces the amount of reserves in the banking system.
3. Banks reduce lending, and the money supply contracts.
4. Raising the discount rate can signal a contractionary monetary policy, discouraging lending.
While the discount rate can influence the money supply, it is typically less impactful than open market operations because banks generally prefer to borrow from each other in the federal funds market (the market where banks lend reserves to each other overnight) rather than directly from the Fed. The federal funds rate is a key benchmark that the Fed targets through its open market operations.

3. Reserve Requirements

Lowering Reserve Requirements: When the Fed lowers reserve requirements, it allows banks to lend out a larger portion of their deposits.
1. Banks have more excess reserves.
2. The money multiplier increases (as seen in the formula above).
3. Banks expand lending, leading to a significant increase in the money supply.
Raising Reserve Requirements: When the Fed raises reserve requirements, it forces banks to hold a larger portion of their deposits in reserve.
1. Banks have fewer excess reserves.
2. The money multiplier decreases.
3. Banks reduce lending, causing the money supply to contract.
Historically, changes in reserve requirements were a significant tool, but in recent decades, the Fed has rarely used them. Adjusting reserve requirements can be disruptive to bank operations, so the Fed prefers to use open market operations as its primary tool for managing the money supply.

4. Interest on Reserve Balances (IORB)

Raising IORB: When the Fed raises the interest rate it pays on reserve balances, it incentivizes banks to hold more reserves at the Fed and lend less to consumers and businesses.
1. Banks earn more by keeping their money at the Fed.
2. This reduces the amount of money available for lending.
3. The money supply may grow at a slower pace, or even contract.
Lowering IORB: When the Fed lowers the interest rate it pays on reserve balances, it incentivizes banks to lend more and hold fewer reserves at the Fed.
1. Banks earn less by keeping their money at the Fed.
2. This increases the amount of money available for lending.
3. The money supply may grow at a faster pace.
IORB is a relatively new tool that gained prominence after the 2008 financial crisis. It allows the Fed to influence the money supply without drastically altering the level of reserves in the banking system. It is an important tool for controlling the federal funds rate when there are abundant reserves in the banking system.

5. Quantitative Easing (QE)

QE and the Money Supply: During periods of economic crisis or when interest rates are near zero, the Fed may employ quantitative easing (QE). QE involves the Fed purchasing longer-term government securities or other assets (like mortgage-backed securities) to inject liquidity into the market.
1. The Fed purchases these assets from banks and other financial institutions.
2. This increases the reserves of the banks.
3. QE aims to lower long-term interest rates, stimulate lending, and boost economic activity.
4. QE can substantially increase the money supply, especially M2.
QE is a less conventional tool and is typically used when other monetary policy tools are proving insufficient. While QE can be effective in stimulating the economy, it can also lead to concerns about inflation if the money supply grows too rapidly.

The Impact of Fed Policy on the Economy

The Fed's actions to influence the money supply have far-reaching effects on the economy:

Interest Rates: Changes in the money supply directly affect interest rates. An increase in the money supply tends to lower interest rates, making it cheaper for businesses and consumers to borrow money. Conversely, a decrease in the money supply tends to raise interest rates, making borrowing more expensive.
Inflation: The money supply has a strong relationship with inflation. If the money supply grows too rapidly relative to the growth of the economy, it can lead to inflation, where prices of goods and services rise. The Fed aims to keep inflation under control by carefully managing the money supply.
Economic Growth: Changes in the money supply influence economic growth. Lower interest rates (resulting from an increase in the money supply) can stimulate investment and consumer spending, leading to economic growth. Higher interest rates (resulting from a decrease in the money supply) can slow down economic activity.
Employment: The Fed's dual mandate includes maximum employment. By influencing economic growth, the Fed's actions on the money supply also affect employment levels. Stimulating economic growth can lead to job creation, while slowing down economic activity can lead to job losses.
Asset Prices: Changes in the money supply can also affect asset prices, such as stock prices and real estate prices. Lower interest rates can make these assets more attractive to investors, driving up their prices.

Challenges and Considerations

While the Fed has powerful tools to influence the money supply, managing it effectively is not without its challenges:

Lags: There are often lags between the Fed's policy actions and their effects on the economy. It can take several months or even quarters for changes in the money supply to fully impact interest rates, inflation, and economic growth. This makes it difficult for the Fed to fine-tune its policies.
Unpredictable Behavior of Banks and Borrowers: The money multiplier effect assumes that banks will lend out their excess reserves and that borrowers will be willing to borrow. However, banks may choose to hold onto excess reserves if they are uncertain about the economic outlook, and borrowers may be reluctant to borrow if they are pessimistic about the future. This can weaken the impact of the Fed's policies.
Global Factors: The U.S. economy is increasingly interconnected with the global economy. Global economic conditions, exchange rates, and international capital flows can all influence the money supply and the effectiveness of the Fed's policies.
Inflation Expectations: Inflation expectations play a crucial role in determining actual inflation. If people expect inflation to rise, they may demand higher wages and prices, leading to a self-fulfilling prophecy. The Fed must carefully manage inflation expectations to maintain price stability.
The Zero Lower Bound: When interest rates are near zero, the Fed's ability to stimulate the economy through conventional monetary policy is limited. This is known as the zero lower bound. In such situations, the Fed may need to resort to unconventional tools like quantitative easing.

Conclusion

The Federal Reserve's policy actions exert a profound influence on the money supply, shaping the course of the U.S. economy. By utilizing tools like open market operations, the discount rate, reserve requirements, IORB, and quantitative easing, the Fed aims to achieve its dual mandate of maximum employment and price stability. Understanding how these tools affect the money supply is crucial for anyone seeking to navigate the complexities of the financial system.

However, managing the money supply effectively is not without its challenges. Lags, unpredictable behavior of banks and borrowers, global factors, inflation expectations, and the zero lower bound can all complicate the Fed's efforts. Nevertheless, the Fed remains a critical player in the economy, constantly adapting its policies to meet the evolving challenges of the economic landscape.