MONETARY POLICY FEDERAL RESERVE

HOW THE FED’S INTEREST RATES AFFECT CONSUMERS

How the Federal Reserve Manages Money

Supply
By MARY HALL Updated July 14, 2021

Reviewed by MICHAEL J BOYLE

Fact checked by MICHAEL LOGAN

Throughout history, free market societies have gone through boom-and-bust cycles. While
everyone enjoys good economic times, downturns are often painful. The Federal Reserve was
created to help reduce the injuries inflicted during the slumps and was given some powerful
tools to affect the supply of money. Read on to learn how the Fed manages the nation's
money supply.

The Evolution of the Federal Reserve

When the Federal Reserve System was established in 1913, the intention wasn't to pursue an
active monetary policy to stabilize the economy. Economic stabilization policies weren't
introduced until John Maynard Keynes' work in 1936. Instead, the founders viewed the Fed as
a way to prevent money supply and credit from drying up during economic contractions,
which happened often prior to 1913.
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One way in which the Fed was empowered to insure against financial panics was to act as the
lender of last resort. That is, when risky business prospects made commercial banks hesitant
to extend new loans, the Fed would lend money to the banks, thus inducing them to lend
more. (To learn more, see: The Federal Reserve.)

The function of Fed has grown and today it primarily manages the growth of bank reserves
and money supply in order to promote a stable expansion of the economy. The Fed uses three
main tools to accomplish this:

1. By setting bank reserve requirements [1]

2. By setting the discount rate [2]
3. Via open market operations [3]
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How The Federal Reserve Manages Money Supply

Reserve Ratio
A change in reserve ratio is seldom used, but is potentially very powerful. The reserve ratio is
the percentage of reserves a bank is required to hold against deposits. A decrease in the ratio
allows the bank to lend more, thus increasing the money supply. An increase in the ratio has
the opposite effect. [1]

Discount Rate
The discount rate is the interest rate the Fed charges commercial banks that need to borrow
additional reserves. The Fed sets this rate, not a market rate. Much of its importance stems
from the signal the Fed sends when raising or lowering the rate: if it's low, the Fed wants to
encourage spending and vice versa. [2]

As a result, short-term market interest rates tend to follow the discount rate's movement. If
the Fed wants to give banks more reserves, it can reduce the interest rate it charges, thereby
inducing banks to borrow more. Alternatively, it can soak up reserves by raising its rate and
persuading the banks to reduce borrowing.
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Open Market Operations

Open market operations consist of buying and selling government securities by the Fed. If the
Fed buys back securities (such as Treasury bills) from large banks and securities dealers, it
increases the money supply in the hands of the public. Conversely, the money supply
decreases when the Fed sells a security. The terms "purchase" and "sell" refer to actions of the
Fed, not the public. [3]

For example, an open market purchase means the Fed is buying, but the public is selling.
Actually, the Fed carries out open market operations only with the nation's largest securities
dealers and banks, not with the general public. In the case of an open market purchase of
securities by the Fed, it is more realistic for the seller of the securities to receive a check drawn
on the Fed itself. When the seller deposits this in their bank, the bank is automatically granted
an increased reserve balance with the Fed. Thus, the new reserves can be used to support
additional loans. Through this process, the money supply increases. (For related reading, see:
Open Market Operations vs. Quantitative Easing.)

The process does not end there. The monetary expansion following an open market operation
involves adjustments by banks and the public. The bank in which the original check from the
Fed is deposited now has a reserve ratio that may be too high. In other words, its reserves and
deposits have gone up by the same amount. Therefore, its ratio of reserves to deposits has
risen. To reduce this ratio of reserves to deposits, the bank may extend more loans.

When the bank makes an additional loan, the person receiving the loan gets a bank deposit,
increasing the money supply more than the amount of the open market operation. This
multiple expansion of the money supply is called the multiplier effect. 

The Bottom Line

Today, the Fed uses its tools to control the supply of money to help stabilize the economy.
When the economy is slumping, the Fed increases the supply of money to spur growth.
Conversely, when inflation is threatening, the Fed reduces the risk by shrinking the supply.
While the Fed's mission of "lender of last resort" is still important, the Fed's role in managing
the economy has expanded since its origin.
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ARTICLE SOURCES

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Related Terms
The Reserve Ratio Explained
The reserve ratio is the portion of reservable liabilities that commercial banks must hold onto, rather than
lend out or invest. more

Monetary Theory Definition

Monetary theory is a set of ideas about how changes in the money supply impact levels of economic
activity. more

Federal Open Market Committee (FOMC) Definition

The Federal Open Market Committee (FOMC) is the branch of the Federal Reserve System that determines
the direction of monetary policy. more

What Is Credit Easing?

Credit easing is used to relieve a market going through turmoil. Credit easing happens when central banks
purchase private assets such as corporate bonds. more

Primary Dealer
A primary dealer is a pre-approved financial institution that is authorized to make business deals with the
U.S. Federal Reserve. more

Federal Reserve System (FRS) Definition

The Federal Reserve System is the central bank of the United States and provides the nation with a safe,
flexible, and stable financial system. more
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