Central banks use several different methods to increase or decrease the amount of money in the banking system. These actions are called monetary policy. While the Federal Reserve (commonly known as the Fed) could print paper money at its discretion in an attempt to increase the amount of money in the economy, this is not the measure used, at least not in the United States. United.
The Federal Reserve Board, which is the governing body that manages the Federal Reserve System, oversees all national monetary policy. They are often referred to as the Central Bank of the United States. This means that they are generally held responsible for controlling inflation and managing short and long term interest rates. They make these decisions to strengthen the economy, and controlling the money supply is an important tool they use.
Key points to remember
- Central banks use several methods, called monetary policy, to increase or decrease the amount of money in the economy.
- The Fed can increase the money supply by lowering banks’ reserve requirements, which allows them to lend more money.
- Conversely, by increasing bank reserve requirements, the Fed can decrease the size of the money supply.
- The Fed can also change short-term interest rates by lowering (or increasing) the discount rate banks pay on short-term Fed loans.
Modification of minimum reserves
The Fed can influence money supply by changing reserve requirements, which typically refer to the amount of funds banks must hold against deposits in bank accounts. By lowering reserve requirements, banks are able to lend more money, which increases the overall supply of money in the economy.
Conversely, by increasing bank reserve requirements, the Fed is able to reduce the size of the money supply.
How do central banks get money into the economy?
Changing short-term interest rates
The Fed can also change the money supply by changing short-term interest rates. By lowering (or increasing) the discount rate that banks pay on short-term Federal Reserve loans, the Fed is able to effectively increase (or decrease) the liquidity of the currency.
While the Fed can directly influence a market rise, it is more often held responsible for market declines than increases.
Lower rates increase the money supply and stimulate economic activity; however, interest rate cuts fuel inflation, so the Fed must be careful not to cut interest rates too low for too long.
In the post-economic crisis of 2008, the European Central Bank kept interest rates at zero or below zero for too long, which negatively impacted their economies and their ability to grow. healthy way. Although he did not bury any country in economic disaster, he was seen by many as a model of what not to do after a large-scale economic downturn.
Conduct open market operations
Finally, the Fed can affect the money supply by conducting open market operations, which affects the fed funds rate. In open trades, the Fed buys and sells government securities in the open market. If the Fed wants to increase the money supply, it buys government bonds. This provides liquidity to the stock brokers who sell the bonds, thereby increasing the overall money supply.
Conversely, if the Fed wants to decrease the money supply, it sells bonds from its account, thus taking liquidity and withdrawing money from the economic system. The adjustment of the federal funds rate is a much anticipated economic event.