Friday, November 15, 2013

Fed Economist Explains How the Fed Controls the Money Supply

Daniel L. Thornton, economist at the St. Louis Fed, does a great job of very succinctly explaining how the Fed controls the money supply---and even does a good job of explaining how banks placing funds back at the Fed as excess reserves counters Fed monetary base expansion. My bold:
The Fed controls the supply of money by increasing or decreasing the monetary base. The monetary base is related to the size of the Fed's balance sheet; specifically, it is currency in circulation plus the deposit balances that depository institutions hold with the Federal Reserve. The Fed has essentially complete control over the size of the monetary base.

The primary way the Fed controls the monetary base is through open market operations: buying or selling securities. To increase the monetary base, the Fed buys securities from any party and pays with a check. That check, written on the Fed, is deposited by a bank in its account with the Fed, thereby adding to its reserves and increasing the monetary base. The same process works for decreasing the monetary base: The Fed sells securities, getting a check from a bank in exchange. When the check is deposited, the bank's balance at the Fed decreases.

The total supply of money (M1) consists of currency held by the public and checkable deposit balances of banks and other depository institutions. The money supply and the monetary base are linked by reserves, i.e., vault cash and deposit balances held at Federal Reserve banks. While the Fed's control over the size of the monetary base is complete, its control over the money supply is not. One major reason for this is banks can choose to hold the additional base money (i.e., deposit balances with the Federal Reserve banks) supplied by the Fed as excess reserves.

1 comment:

  1. Regarding the final sentences, Bob has shown us that when incentivized to do so, they will. And as he has noted, what happens when the incentive goes away is still a matter for conjecture, but it likely won't be pretty.

    In the coming years, this will bear repeating.