Key Concepts of the Federal Reserve System and Money Supply
Overview of the Federal Reserve System
- The Federal Reserve (Fed) is the central bank of the United States, pivotal for monetary policy and economic stability.
- It manages government borrowing and regulates private banks, influencing the money supply and aggregate demand.
Federal Reserve's Role
- Government's Bank: Manages accounts for the U.S. Treasury and oversees government bond issuance.
- Banker's Bank: Regulates banks, lends them money, and manages payment systems.
- Money Supply Regulation: Can control money supply without physically printing money by manipulating reserves in bank accounts.
The U.S. Money Supply
- Money includes any widely accepted means of payment. Key components:
- Currency: Paper bills and coins in circulation.
- Total Reserves: Assets held by banks at the Fed.
- Checkable Deposits: Money in checking accounts accessible for transactions.
- Savings and Other Deposits: Less liquid forms of money, including savings accounts, money market mutual funds, and certificates of deposit (CDs).
Definitions of Money Supply
- Monetary Base (MB): MB = ext{Currency} + ext{Total Reserves}
- M1: M1 = ext{Currency} + ext{Checkable Deposits}
- M2: M2 = M1 + ext{Savings Deposits} + ext{Money Market Funds} + ext{Small-Time Deposits}
Functions of Money in the Economy
- Liquid Assets: Can be quickly converted into cash or easily used for transactions.
- Major forms include currency, checkable deposits, and various account types.
Key Concepts in Banking
- Fractional Reserve Banking: Banks hold a portion of deposits in reserve and lend out the remaining amount.
- Reserve Ratio (RR): Ratio of reserves to deposits, indicating the fraction of deposits banks must hold.
- Example calculation: If a bank has $100 reserves for every $1000 of deposits, RR = rac{100}{1000} = 0.1 or 10%.
Money Multiplier Effect
- The Money Multiplier (MM) effect indicates how money supply can increase relative to initial reserves:
- MM = rac{Deposits}{Reserves} = rac{1}{RR}
- Example: With a reserve ratio of 10%, the multiplier is MM = rac{1}{0.1} = 10.
- Initial reserves of $1000 can lead to a total money supply of 1000 imes 10 = 10,000.
- Open Market Operations: Buying/selling government bonds to influence money supply and interest rates.
- Buying bonds increases bank reserves and boosts money supply; selling has the opposite effect.
- Interest on Reserves: The Fed pays interest on reserves held by banks at the Fed, impacting their lending behavior and reserve management.
Open Market Operations Explained
- The Fed's primary method of influencing money supply:
- Buying Bonds: Increases money supply by raising bank reserves, leading to more loans and increased aggregate demand.
- Selling Bonds: Reduces money supply by lowering bank reserves.
Interest Rate Influence
- The Fed's actions in open market operations also affect interest rates:
- Lower demand for bonds increases prices and subsequently raises interest rates when bonds are sold.
- By adjusting the federal funds rate, the Fed sets a key indicator of monetary policy effectiveness.
Conclusion
- The Federal Reserve plays a crucial role in regulating the economy via its monetary policy tools, particularly through the manipulation of money supply, which ultimately impacts interest rates and overall economic health.
