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Do You Know How The Fed Pumps Up The Money Supply? |
By:
Kalinda Rose Stevenson, PhD |
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Do You Know How The Fed Pumps Up The Money Supply?
by Kalinda Rose Stevenson, PhD
Have you seen the news reports that the Federal Reserve has "pumped" money into the economy? Have you wondered exactly what that means? How exactly does the Fed "pump" more money into the system?
Controlling the amount of money in the system is one of the most important functions of a government. Money is never simply personal. It is a matter of government policy. The more you understand how governments increase and decrease the amount of money available, the more you will be able to control your personal economy.
In the United States, the central bank is the Fed, or Federal Reserve. Every nation has an equivalent central bank. These banks monitor current economic conditions and respond if the central banks want to heat up or cool down the economy.
You might hear that the Fed is "pumping money" into the economy to calm fears of an economic panic. At other times, you will hear that the Fed will "drain money" from the system, to cool it down. Although the news media uses such language, they don't explain exactly how the Fed increases or decreases the amount of money.
First, let's make clear that Fed does not pump more money into the system by printing more currency. Currency is not the same as money.
The Fed can control the money supply with several methods.
One method is to change the reserve requirements of banks. The "reserve" is the percentage of customer deposits that the bank must not loan out. In other words, a bank must keep a certain percentage of its deposits on "reserve."
If you deposit $1,000 in the bank, the bank makes money by loaning out most of your $1,000 to other customers. However, the bank cannot loan the full $1,000 amount.
The Federal Reserve sets the reserve requirements for banks. The banks must keep 3-10% of customer deposits on reserve. This means that the bank needs to keep on reserve only 3-10% of your $1,000. With a 10% reserve, the bank must keep $100 on reserve. That means it can loan out the remaining $900. With a 3% reserve, the bank must keep only $30 on reserve. It is allowed to loan out the remaining $970.
The Fed can use the reserve requirements to control the amount of money banks have available to loan. If the Fed wants to increase the amount of money in the economy, it reduces the reserve requirements. If it wants to decrease the amount of money, it increases reserve requirements. This is how the Fed "pumps" money into the system and "drains" money from the system.
With a lower reserve requirement, the bank has more money to loan. With a higher reserve requirement, the bank has less money to loan. This is the difference between loaning out 97% of its deposits with a 3% reserve rate and 90% of its deposits with a 10% reserve rate. The changes in reserve rates increase and decrease the money supply.
So, the reserve requirement is one way that the Fed controls the amount of money in the economic system. This is why it is not exactly accurate to claim that the Fed "pumps" more money into the system. The banks are the ones pumping more money into the system, and they do that because the Fed reduced the reserve requirement.
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Article Source: http://www.statssheet.com/articles/article55175.html |
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