Federal Reserve System and the Money Supply
Federal Reserve System changes the money supply using three tools, namely open market operations, adjustments in the levels of bank reserve requirements and modifications in the Feds discount rates. Open market operations consist of sale and purchase of outstanding U.S. treasuries by the Federal Reserve System in the in U.S.As open securities market. Purchase of outstanding securities from public directly increases bank reserves and the money supply. Conversely, sale of outstanding securities to households, businesses and governments reduces money supply. Open market operations alter the money supply by at least the amount of the open market transaction. Secondly, Federal Reserve System can increase reserve requirements to reduce money supply and lower reserve requirements to increase money supply. Finally, the Fed can opt for discount rate alterations. Rise in discount rate raises banks required working reserves while a fall in discount rate lowers desired working reserves making more money available for lending and increasing the money supply.
An economy that is growing too quickly can become susceptible to high rates of inflation and requires a lowering of money supply. To lower money supply using all the three aforementioned tools, the Fed will sell outstanding securities in the open securities market, increase bank reserve requirement and increase the Feds discount rate. When securities are sold, money, in the form of cash or check, leaves the money supply and is turned over to the Federal Reserve System. Rise in reserve requirements and discount rate will make less loanable money available to banks, which can then decrease the money supply through less lending.
During a recession an economy is slumping and the Federal Reserve System will undertake steps to increase the money supply. It will accomplish this through purchase of outstanding securities in the open securities market, decreasing bank reserve requirements and Feds discount rate. When securities are purchased, money, in the form of cash or check, enters the money supply from Federal Reserve System. Decline in reserve requirements and discount rate will make more loanable money available to banks, which can then increase the money supply through lending.
Presently, the U.S. economy is recovering from a turbulent recession and Feds reserve requirements and discount rates are at all time lows. These changes were made to enable the economy to cope with recession. With the economy well on its way to recovery, Federal Reserve System should not opt for any further lowering of interest rates and reserve requirements. Conversely, it should begin to chalk out strategies for increasing them in its next meeting. Though the rates should to be increased immediately to avoid short-circuiting the recovery, their future hikes should be on the agenda of the next meeting. Secondly, it must stop purchase of U.S. treasuries and terminate the program wherein risky securities could be traded for safe U.S. treasuries. To sum up, at the next meeting I would start planning for reversals in open market transactions, discount rate and reserve requirements that were prevalent in the society but did not insist on the modifications immediately. This approach will ensure provision of sufficient recovery time to the economy while removing threats of inflation due to all the increased money supply.