How The Fed Controls The Money Supply - By: Kalinda Rose Stevenson, PhD, Posted on: 2007-08-28

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?

One of the fundamental functions of government is to control the money supply. The more you understand how governments control the amount of money in the economic system, in a global economy, the better you can take control of your own personal economic system.

Every nation has its own central bank. One of the functions of a central bank is to respond to current economic situations to either cool down or heat up the economy. In the United States, the central bank is the Federal Reserve.

The news media use colorful language to say that the Fed is "pumping money" into the economy to calm fears of an economic panic. In other situations, the media refer to actions of the Fed intended to "drain money" from the system. Even though the media report that the Fed "pumps" money or "drains" money, they don't explain clearly how the Fed does this. How exactly does the Fed increase or decrease 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."

Banks make money by loaning out customer deposits to other customer deposits. This means that if you deposit $1,000 in the bank, the bank loans most of your money to other customers. However, the bank is not allowed to loan out the full $1,000.

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.

If the Fed wants to increase the money supply, it can reduce the reserve rate. If the Fed wants to decrease the amount of money in the system, it increases the reserve requirements. This simple example demonstrates how the process works, and how the Fed pumps money into and drains money out of the system by changing the reserve requirements.

When the bank has to keep 10% of its deposits on reserve, it can loan out only 90% of its deposits. When the bank has to keep only 3% of its deposits on reserve, it can loan out 97% of its deposits to customers. With a lower reserve, more money is available. With a higher reserve, less money is available. .

So even though the media talk about the Fed "pumping" more money into the economy, this language is a bit misleading. The banks do the "money-pumping" when the Fed allows banks to loan out a higher percentage of its deposits. This is one way the Fed controls the amount of money in the economic system.

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Kalinda Rose Stevenson, Want to discover how investors use money? Find out how in a real estate investing book about the world's most popular board game. How would you like a www.accesstoprivatemoney.com">private money investor for huge projects?

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