The
Federal Reserve implements
monetary policy by manipulating the
money supply.
There are different kinds of
money in the economy. The main categories are
- M1: Currency, Traveler's checks, Demand Deposits (checking accounts)
- M2: M1 + small Savings deposits, Money market mutual funds
- M3: M2 + Large deposits, repo[?] (Repurchase agreements)
When money is deposited in a bank it can then be loaned out to another person. If the inital deposit was $100 and the bank loans out $100 to another customer the money supply has increased by $100. However, because the depositer can ask for the money back, banks have to maintain minimum reserves to service customer needs. If the reserve requirement is 10% then in the earlier example the bank can only loan out $90 and thus the money supply increses only to $190. This relationship between increase in money supply and reserve requirement is expressed as:
m = 1 / RR
where
m = money multiplier
RR = reserve requirement
The Federal Reserve has two main mechanisms for manipulating the money supply. It can sell treasury securities. When it sells treasury securities it reduces the money supply (because it accepts money in return for a promise to pay in the future). It can purchase treasury securities. When it purchases treasury securities it increases the money supply. Finally, the Federal Reserve can adjust the reserve requirement. The reserve requirement is indirectly related to the money multiplier as show above.
When the money supply increases interest rates go down. When interest rates go down businesses and consumers have lower cost of capital and can increase spending and capital improvement projects. This helps the economy. Conversely, when the money supply falls the interest rates go up and reins in the economy. The Federal reserve increases interest rates to combat
inflation.
See also: Monetary policy of Sweden