Federal Reserve and Money Supply

BUS305-0602B-01

Economics in a

Global Environment

Unit 5, Individual Project 2

“The Federal Reserve and the Money Supply”

By: Daniel Loran

Instructor

Professor Albert Alexander

Abstract: In this project, I will describe three ways the Federal Reserve can change the money supply, then discuss what changes would be made if there was an economic inflation, and economic recession. Finally, I will discuss the current condition of the economy in the United States, and what tools I would suggest using at the next meeting of the Federal Reserve based upon the data and trends.

I. Three Ways in which the Federal Reserve can change the Money Supply:

The three methods used by the federal reserve [Fed] to change the money supply in the country are

• Open Market Operations; and,

• Changing Reserve Limits on Banks; and,

• Changing the discount rate to banks. (pp. 646)

In Open Market Operations, the FED gives and takes back available money to the economy through its purchase of government bonds. When the FED buys bonds, such as a 100 million dollar bond, that money goes into the bond seller’s bank. The banking system can then loan that amount, minus the reserve requirement, to other consumers. To entice consumers to borrow that money, banks lower interest rates on loans. Consumers borrow the money, and then purchase and produce with the money. Conversely, when the FED sells bonds back into the economy, the reverse holds true. When the economy must cough up the money to buy the bonds from the FED, then that is money that cannot be used any longer by the firms or consumers to produce nor to loan and invest. It is money returned ‘out of the system’. Interest rates rise, to compensate for the lost revenue of making loans on money, and spending decreases due to less money.

When the FED changes the reserve requirement, the percent of reserve the Banks simply cannot spend or loan to consumers is raised or lowered. If a bank has 10 billion on ‘reserve’ with the FED, the bank may be restricted from lending or using a percentage of those funds, usually around 10%. If the FED increases or decreases that percentage level, the amount of ‘available balance’ to the bank is inversely adjusted. Less in the piggy, means more to lend. This generates more money in the economy.

The third method to be used by the FED is by the changing of the discount rate. The discount rate is the interest the FED charges to the banking system to borrow money from the FED to subsequently loan to consumers and investors. When the rate is lower than the rate of borrowing from the economy lenders, the banks go to the FED to get their loans, instead of each other. This is another way to draw money out of the FED and into the general economy. When the FED raises the interest it will charge on any lending of money, the banks then borrow from each other, or the economy lenders. This money that is loaned to the banks is no longer available in the economy for use by non-bank investors and consumers. (fn 1,)( pp. 648).

II. Adjustments of the tools during recession and inflation:

For the next two analysis of this project, the following chart I created will be used as a visual aide. The chart was re-created from one given in the text (fn.1)(pp.654, fig. 28.7):

First, when an economy is growing to quickly, that is called “overheating” (fn.1)(pp. 657).

To combat a rapidly rising GDP and Inflation, the FED can [1]: sell bonds on the market, which will decrease the money supply in the economy, decrease output of goods to consume, and lower prices. The overall effect of this action is to decrease the GDP. And, [2]: raise interest rates, which when done, causes banks to borrow money from the economy lenders, rather than the FED, and this in turns decreases the overall money supply with the same results as bond selling. Or, [3]: Increase the