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The Money Supply and

the Federal Reserve System

Standard measures of the money supply


Monetary base
The monetary base is defined as the sum of currency in circulation and
reserve balances (deposits held by banks and other depository institutions
in their accounts at the Federal Reserve).

M1
Currency held outside banks + demand deposits + travelers checks + other
checkable deposits

M2
M1 + savings accounts + money market accounts + other near monies

The Federal Reserve System

The Federal Reserve System (also known as the


Federal Reserve, and informally as the Fed) is the
central banking system of the United States. It
was created on December 23, 1913, with the
enactment of the Federal Reserve Act, largely in
response to a series of financial panics,
particularly a severe panic in 1907. Over time, the
roles and responsibilities of the Federal Reserve
System have expanded, and its structure has
evolved.

The Fed's Structure


The Federal Reserve System consists of a sevenmember board of directors in Washington, D.C., and
12 regional banks, each controlled by its own directors.
These regional institutions, owned by commercial
banks within their jurisdictions, only do business with
the Treasury and their member banks, not with the
public at large.
They do not lend money for automobiles or homes,
and their main assets are U.S. government securities
(such as Treasury bonds).

The Fed's Operations


Even though the Constitution authorizes the
government to "coin money," it would be
impractical to control its supply by speeding up or
slowing down the printing presses.
After all, if enough were printed it would soon be
worthless.
It is also impractical to tie the value of paper
money to precious commodities such as gold or
silver, since the supply of these commodities does
not always keep pace with economic growth.

The Federal Reserve System manages the money supply in


three ways:

Reserve ratios
Banks are required to maintain a certain proportion of their
deposits as a "reserve" against potential withdrawals. By varying
this amount, called the reserve ratio.
the Fed controls the quantity of money in circulation.
Suppose, for example, it orders banks to hang on to an extra 1
percent of their deposits. They would then have 1 percent less to
lend.
One percent may not sound like a lot, but it translates into billions
of dollars that are siphoned out of the economy.

Discount rate
When banks temporarily overcommit themselves,
they occasionally have to borrow from the Fed to
secure the necessary funds to meet their reserve
requirements. The interest rate charged for these
loans is the discount rate, and it too affects the
money supply
If the Fed raises the discount rate, banks cannot
afford to borrow as heavily as before and have to
curtail their lending and raise their own interest
rates. That results in less money flowing into the
economy

Open-market operations
By far the most important of the Fed's activities are open-market
operations, the buying and selling of government securities.
The process works this way: If the Fed decides to increase the
money supply, its open-market manager buys back treasury
securities from private dealers, paying for them by simply
crediting their bank accounts.
It does not transfer any actual cash. (This power distinguishes it
from all other financial institutions and gives it its clout.) The
dealers' banks now have more money to lend, and these loans
ultimately find their way into more banks, which pass a portion
of them on to additional borrowers.
The Fed's initial purchase thus has a multiplier effect as money
ripples throughout the economy.
Of course, the process is reversed when the Fed sells off some of
its securities, because it in effect deducts the price from the
purchasers' accounts, leaving their banks with fewer deposits.


The Fed and the Political System

On paper the Federal Reserve System appears to


be relatively autonomous, since it receives its
operating revenues from its constituent banks,
not from congressional appropriations, and
since its governors, once in office, cannot be
dismissed by the president.
The governors' long terms mean that an
occupant of the White House cannot expect to
pick a majority of the governors.

Fed creation of Congress


Yet the Fed is also the creation of Congress, which takes a strong interest
in its work and can always amend its charter. Furthermore, as a practical
matter, the Fed's officers have to interact daily with senior executives in
the Treasury Department, the OMB, and other agencies.
Some political economists go even further: They detect a political
monetary cycle (PMC), during which the Fed relaxes monetary policy in
the months before a presidential or congressional election, hoping that
business will pick up and thus make the incumbent president's party
shine in the eyes of the electorate.
As soon as the campaign ends, however, it tightens the screws again to
hold down inflation. According to this interpretation, the Fed
rhythmically starts and stops the economy for partisan purposes. If true,
the existence of a PMC would suggest that the Fed is at least indirectly
accountable to the people, as democratic theorists hope.

Looking for a Hero


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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