No Such Thing as a Free Lunch: Principles of Economics (Part 123)

The Federal Reserve ranks among the most transparent central banks. We publish a summary of our balance sheet every week. Our financial statements are audited annually by an outside auditor and made public. Every security we hold is listed on the website of the Federal Reserve Bank of New York.

Janet Yellen

The Money Supply and the Federal Reserve System

(Part F)

by

Charles Lamson

How the Federal Reserve Controls the Money Supply

To see how the Fed controls the money supply in the U.S. economy we need to understand the role of reserves. As we have said, the required reserve ratio (a central bank regulation that sets the minimum amount of reserves that must be held by a commercial bank) establishes a link between the reserves of the commercial banks and the deposits (money) that commercial banks are allowed to create.

The reserve requirement effectively determines how much a bank has available to lend. If the required reserve ratio is 20 percent, each $1 of reserves can support $5 in deposits. A bank that has reserves of $100,000 cannot have more than $500,000 in deposits. If it did it would fail to meet the required reserve ratio.

The money supply is equal to the sum of deposits inside banks and the currency in circulation outside of banks. Reserves provide the leverage that the Fed needs to control the money supply.

If the Fed wants to increase the supply of money, it creates more reserves, thereby freeing banks to create additional deposits by making more loans. If it wants to decrease the money supply, it reduces reserves.

These three tools are available to the Fed for changing the money supply: (1) changing the required reserve ratio; (2) changing the discount rate; and (3) engaging in open market operations. Although (3) is almost exclusively used it to change the money supply, an understanding of how (1) and (2) work is useful in understanding how (3) works. We thus begin our discussion with the first two tools.

The Required Reserve Ratio

One way for the Fed to alter the supply of money is to change the required reserve ratio. This process is shown in Table 2. Let us assume the initial required reserve ratio is 20 percent.

TABLE 2

In panel 1, a simplified version of the Fed's balance sheet (in billions of dollars) shows that reserves are $100 billion and currency outstanding is $100 billion. The total value of the Fed's assets is $200 billion, which we assume to be all in government securities. Assuming there are no excess reserves---banks stay fully loaned up (actual reserves are equal to required reserves)---the 100 billion dollars in reserves supports $500 billion in deposits at the commercial banks. [Remember from part 121, the money multiplier = 1/required reserve ratio = 1/20 = 5. Thus, $100 billion in reserves can support $500 billion dollars ($100 billion * 5) in deposits when the required reserve ratio is 20 percent]. The supply of money [M1, or transactions money (physical currency, demand deposit, traveler's checks, and other checkable deposits] is therefore $600 billion: $100 billion in currency and $500 billion in (checking account) deposits at the commercial banks.

Now suppose the Fed wants to increase the supply of money to $900 billion. If it lowers the required reserve ratio from 20 percent to 12.5 percent (as in panel 2 of Table 2), then the same $100 billion of reserves could support $800 billion in deposits instead of only $500 billion dollars. In this case, the money multiplier is 1/.125, or 8. At a required reserve ratio of 12.5 percent, $100 billion in reserves can support $800 billion in deposits. The total money supply would be $800 billion in deposits plus $100 billion in currency, for a total of $900 billion.

Put another way, with the new lower reserve ratio, banks have excess reserves of $37.5 billion. At a required reserve ratio of 20 percent, they needed $100 billion in reserves to back their $500 billion in deposits. At the lower required reserve ratio of 12.5 percent, they need only $62.5 billion of reserves to back their $500 billion of deposit, so the remaining $37.5 billion of the existing $100 billion in reserves are "extra." With that $37.5 billion of excess reserves, banks can lend out more money. If we assume the system loans money and creates deposits to the maximum extent possible, the $37.5 billion of reserves will support an additional $300 billion of deposits ($37.5 billion * the money multiplier of 8 = $300 billion). The change in the required reserve ratio has injected an additional $300 billion into the banking system, at which point the banks will be fully loaned up and unable to increase their deposits further:

For many reasons, the Fed has tended not to use changes in the reserve requirement to control the money supply. In part, this reluctance stems from the era when only some banks were members of the Fed and, therefore, subject to reserve requirements. The Fed reasoned that if it raised the reserve requirement to contract the money supply, banks might choose to stop being members. (Because reserves pay no interest, the higher the reserve requirement, the more the penalty imposed on those banks holding reserves.) This argument no longer applies. Since the passage of the Depository Institutions Deregulation and Monetary Control Act in 1980, all depository institutions are subject to federal requirements.

It is also true that changing the reserve requirement ratio is a crude tool. Because of lags in banks' reporting to the Fed on their reserve and deposit positions, a change in the requirement today does not affect banks for about 2 weeks. (However, the fact that changing the reserve requirement expands or reduces credit in every bank in the country makes it a very powerful tool when the Fed does use it.) 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 489-491*

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