How Does the Fed Control the Money Supply?
The Federal Open Market Committee (FOMC) decides the nation's monetary policy. Monetary policy is simply the strategy behind increasing or decreasing the money supply to provide for a stable growth of the economy without fear of inflation or deflation. The Monetary Control Act (MCA) of 1980 authorizes the Fed's Board of Governors to regulate the extension of credit and impose a reserve requirement from 8% to 14% on transaction deposits (checking and other accounts from which transfers can be made to third parties).The Fed may also impose a reserve requirement of any size on the amount depository institutions in the United States owe, on a net basis, to their foreign affiliates or to other foreign banks.
In fact, the Fed even regulates the extension of credit to the stock market. If you trade on margin, you probably know that you are only required to pay for 50% of a marginable stock, bond, mutual fund, or other marginable asset and can borrow the other 50% from your broker. Because the Fed controls this minimum percentage you must pay, the initial 50% amount due shows up as a Fed call on your account when you buy on margin.
There are three tools the Fed uses to conduct monetary policy:
- Changing the reserve requirement
- Changing the discount rate
- Open market operations
Of the three tools, the open market operations are by far the most frequently used to control the money supply. Regardless, we'll look at each of the three methods so you have an understanding of each.
Changing Reserve Requirements
Earlier we talked about how the U.S. banking system is a fractional reserve system meaning they are only required to keep a fraction of each deposit in reserves; the rest is loaned out to others who wish to borrow. This reserve is required regardless of whether the bank is a member of the Fed or not; all banks are subject to it. Because of this fractional reserve system, money is actually created out of thin air.
For example, say the Fed requires a bank to hold 10 cents in reserves for every dollar deposited. In this case, each $1 in assets is only being back by 10 cents or 1/10 of the amount in deposits. If so, the reserve requirement is 10%. With a little math, it's fairly easy to show that the total money created will be ten times the amount or, more specifically, 1/r, where r is the reserve requirement expressed as a decimal. In this example, 10% expressed as a decimal is 0.10 so the total money created will be 1/0.10 = 10 times the amount of money.
In other words, because the banks only need to hold back 10% of each deposit, then the initial deposit will equal 10% of the total loans the bank can make. Therefore, the initial deposit divided by 10% will equal the total loans the bank can make. If the Fed made the reserve requirement 5% of each deposit, the total money in the economy will be 1/0.05 = 20 times the amount.
To show the basic process that occurs, assume the reserve requirement is 10% and a bank takes in $100 in deposits. If so, the bank must hold back $10 in reserves and can loan out the other $90. This $90 will make its way to yet another bank, which will accept it on deposit and hold back 10%, which is $9 (0.10 * $90 = $9). This makes $81 available to be loaned out by the new bank. This process continues as shown in Table 5 below:
Table 5
If you were to continue the table, you would find the total change in deposits would equal $1,000, which is exactly ten times the initial deposit of $100. In addition, the change in reserves will total $100, which is the amount of the initial deposit and the change in loans will be the difference between the two.
So one way the Fed can control the amount of money is to change the reserve requirements of banks. However, this powerful tool is rarely used since small changes in the amount can cause big changes in the amount of money available and therefore have drastic effects on the economy. Therefore, the Fed will only make changes to reserve requirements under extreme conditions. On a similar note, the Fed rarely changes the Fed call percentage for the stock market, as there are just not enough dollars on margin, relative to the monetary base, to make a significant difference in the money supply.
However, the Fed used to actively change its margin requirements to guard against speculative movements in the stock market. They would raise requirements when the market was strong, and lower it when the market trended sideways or downward. Between 1934 and 1974, the Fed changed this margin requirement 22 times but has kept it at a constant 50% since 1974. Let’s now find out more about the Fed’s second weapon for controlling the money supply – changing the discount rate.
Changing the Discount Rate
One of the reasons for the creation of the Fed was to be a central bank or "banker's bank" and make loans to banks in trouble, which was usually a result of unsuitable collateral. If a bank borrows from the Fed, it is known as borrowing from the discount window and the interest rate the bank pays is called the discount rate. It is called the discount rate because banks used to turn over assets on a “discounted” basis to the Fed in exchange for cash.
For example, say a business has a $1,000 account receivable (an IOU) from a customer due in one year. If the business is scheduled to receive $1,000 in one year, it should be willing to accept less than that today to settle the debt. How much less? It would be an amount that when deposited into a bank at the risk-free rate of interest will grow to a value of $1,000 in one year. If we assume that interest rates are 5%, the business should be willing to accept $1,000/1.05 = $952 today since $952 will grow to $1,000 in one year at 5% interest. In this example, the $952 figure is the “discounted” value.
Businesses could turn these IOUs into their banks and receive a discounted value for it. However, the discounted value would be somewhat less than they would be willing to accept from the customer. For instance, the bank may discount the loan at 7% and give the business $1,000/1.07 = $934 in exchange for the $1,000 debt. They bank would offer less than the $952 the business calculated since there is risk; the bank has no idea who the customer is and must be compensated for that risk.
The banks could take these IOUs to the Fed and rediscount them, just as the business did with the bank, and obtain cash from the Fed. Today, this discount type of loan is not used and the Fed just makes straight loans, which are secured by collateral but the name discount loan has stuck.
In exchange for the loan, the bank pays the discount rate. A high discount rate makes it more expensive for banks to borrow just as high interest rates make loans more expensive for you. Higher discount rates therefore reduce the bank’s desire to obtain the loan (law of demand). As a result, high discount rates reduce the amount of cash available to banks, which increases the interest rates banks charge.
On the other hand, if the discount rate is decreased, banks are more likely to borrow (also the law of demand) which puts more reserves into the banking system. More money supply means banks can charge lower interest rates.
If that’s hard to follow, think of the following analogy. If you run short of cash at the end of the month, you may be willing to borrow from your credit card if rates are very low. If rates are low enough, you may decide to borrow and will consequently have a surplus of cash on hand. Low rates equal increased amounts of cash for you. However, if the interest rate is very high, you will probably not borrow any money from the credit card. Those are the same dynamics occurring with high and low discount rates with the banks.
Notice there is a direct relationship with the discount rate and the overall level of interest rates. In other words, the direction of the changes is the same. For instance, if the Fed lowers the discount rate, interest rates in general will fall. If the Fed raises the discount rate, interest rates will generally rise.
The discount rate the Feds charge is usually somewhat lower than loans banks could otherwise obtain, and perhaps a reason why it is still called a discount loan. On the surface, it seems like banks should borrow all they can from the Fed and increase profits from simply lowering their interest expense. However, the Fed is really a "lender of last resort" and is intended for times of emergencies. If a bank borrows from the Fed, it sends a signal to the Fed that maybe this bank needs to have their boys stop by for a friendly bank audit – something the banks wish to avoid. So while banks rarely use the discount window, it is still an important tool of the Fed since it sends a signal to banks about the direction of interest rates.
If the Fed raises or lowers the discount rate, banks know they are changing monetary policy and usually raise or lower their rates accordingly. If banks do need money to cover short-term liquidity problems, they usually borrow from other banks that have cash surpluses. The interest rate banks charge each other for these loans is called the federal funds rate or fed funds rate and is usually just a little higher than the discount rate.
We’ve now covered the first two methods that the Fed has to control interest rates: Changing the discount rate and changing the reserve requirement. Let’s now take a look at the Fed’s third – and most commonly used tool – open market operations.
Open Market Operations
Changing the reserve ratio and discount rate are not used in daily operations of the Fed and are reserved for more abrupt changes. These tools behave like a zoom focus and allow for quick, major changes. Once the Fed is in the ballpark of its target interest rate, it uses open market operations on a daily basis to "fine-tune" the rates.
Open market operations are simply the buying and selling of government bonds in the open market. If the Fed buys treasury bonds in the open market, they pay for them with cash and receive bonds from investors or banks. The cash is deposited into banks and the money supply is increased. By now you should know that the increased supply of money lowers its value and interest rates fall.
There are other ways to arrive at the same answer, once you start to see the whole picture. How does the Fed entice investors to sell their bonds? They must raise the bid for the bonds. Raising the bid creates a supply of bonds. When the price of bonds rises, the yields (interest rates) fall.
Similarly, if the Fed wants to raise interest rates, they will sell bonds in the open market. By selling bonds, investors and banks will hold the bonds and give up cash. The supply of money in the hands of the public is reduced and its value – the interest rate – rises. How does the Fed get you to buy bonds? By lowering their price, the law of demand says that more people will buy. As the Fed reduces their prices of the bonds, the bond yields (interest rates) rise. On any given day, the Fed is usually buying or selling bonds.
Now, you may think there is money to be made if we knew whether they were buying or selling. If they are buying, we can expect interest rates to fall and vice versa and could take appropriate positions (such as with interest rate futures contracts) and make guaranteed money. Well, that's true, if we knew. In order to prevent this, the Fed establishes target increases or decreases in the interest rate and then buys and sells bonds so that it's not readily apparent as to what they are doing. It is the net effect of the buys and sells that count. Nonetheless, there are groups of people, known as Fed watchers, who constantly monitor the Fed's actions and try to make money by predicting the direction of interest rates.
In essence, the Fed controls the money supply by starting with bank reserve requirements. Keep in mind that the reserve requirements (fractional reserve banking) create a multiple of the available amount of money. Then by adjusting the discount rate (which influences the federal funds rate) and using open market operations, they can fine-tune their control over how much money is available for reserves. Once the bank reserves are met, the rest of the money is available for loans.
Regardless of which of the three methods the Fed uses, whenever they are increasing the money supply, it is known as an "easy" monetary policy or "expansionary." In other words, they are making money "easy" to obtain, which should expand the economy. Conversely, if they are reducing the money supply, it is known as a "tight" policy or "contractionary." When money is tight, it's hard to find (it’s in “tight supply”) and the economy contracts.
Open market operations are the Fed’s most commonly used tool for controlling the money supply. Regardless of which tool they choose, it takes time for it to work its way through the system, which are called “policy lags.”
Policy Lags – Fed Acts Fast But Response Is Slow
Whenever the Fed makes changes in the money supply, they inevitably take time to work through the economy. This can be especially tough in a recession. The Fed can give the incentive for consumers to spend, but that doesn't mean that people necessarily will, especially if their confidence is shaken about the recovery.
In fact, monetary policy is often compared to pulling and pushing on a string. If you pull on a string, changes occur immediately. Likewise, if the Fed pulls on the string (pulls money out), economic contractions can occur quite rapidly. However, if the Fed tries to push on the string, it will take some time to get the opposite effect. The Fed can easily reduce the money supply but it is often much tougher to create buying pressure.
The Fed's effects on the economy can be difficult to determine for many reasons. First, we have been assuming there is one interest rate, when actually there are many. There are Treasury bills, notes, and bonds with maturities ranging from 30 days to 30 years. Each group has its own interest rate. Further, there are CD rates (Certificates of Deposit), prime rate, mortgage rates, broker call rate, commercial paper and numerous other rates that affect the decisions we make.
If the economy is sluggish, the Fed may buy bonds, which creates cash in the hands of the banks. Because of the extra cash, banks find it easier to meet the reserve requirements and therefore have more money to lend either to customers or to other banks (fed funds). The Fed's actions will certainly reduce short-term rates but may have little, or even the opposite, effect on long-term rates.
There are a couple of reasons long-term rates may not be immediately affected. First, the demand for investment guides long-term rates. In other words companies will respond to demand and produce more if the interest rates allow. They do not borrow just because interest rates seem low. Interest rates are relative. A firm may be very eager to borrow at 20% – if it can make 25% on the project. So just because rates are falling does not necessarily mean that firms will start borrowing. They must wait for consumer demand to appear.
Second, if investors fear inflation from the additional dollars being injected into the economy, it is quite possible to see longer-term rates actually rise since the nominal bond yields take into account expected inflation. If people expect inflation, they will demand a higher interest rate on the bonds. It is the longer-term rates that are most meaningful to firms so the Fed's actions are questionable as to their immediate impact on the economy and long-term rates.
It is important for any nation to have price stability; that is low inflation. Money is just a representation of goods and services and is otherwise a worthless piece of paper. The reason price stability is so important is that one of the functions of money is to act as a store of wealth – a representation of goods and services – and inflation destroys that value. If money just represents goods and services, why not use a barter economy and trade only the goods and services? Why use money in the first place? The reason money is important for any nation to advance it that it reduces transaction costs. Lower costs benefit buyers and sellers and results in more trade. Under a barter system, the nation must create numerous exchange rates, which can get complicated quickly!
For example, on a simple island economy, you may have the following exchange rates: 10 pineapples for a duck, 4 ducks for a hammock, and 15 hammocks for a canoe. Anyone care to guess how many pineapples it takes to trade for a canoe? You can see that it takes a lot of time and energy (and algebra) to expand an economy under a barter system. The time spent trying to exchange goods and services adds to transaction costs, which makes things more expensive and results in less economic growth.
Transaction costs are also high under a barter system because people must find someone who wants their goods in exchange for the goods they want, which in economics is called a double coincidence of wants. If you have pineapples and want a canoe, you need to find a canoe maker who wants pineapples. If he wants 15 hammocks instead of pineapples, you will need 60 ducks in order to trade for 15 hammocks so will need to find someone with ducks who wants pineapples. If so, you can trade 600 pineapples for 60 ducks, trade the 60 ducks for 15 hammocks and trade the 15 hammocks for one canoe. The barter system is truly and inefficient way of doing business. One of the functions of money is to reduce such headaches and provide an efficient medium of exchange.
Think how much easier the transactions would be if quoted in dollars. If we knew the dollar prices of pineapples, ducks, hammocks and canoes, we would not need to find other traders to conduct transactions. We could go straight to the canoe maker and pay with cash. Whether he uses that cash to buy hammocks, ducks or pineapples is irrelevant since the cash is a representation of goods and services. This is yet another function of money in that it serves as a unit of account and gives a standard measure of value in an economy.
To see how this works, assume a pineapple costs $1. Under the barter exchange rates given previously, this means that a duck should cost $10, hammocks $40 and canoes $600. Notice now how much easier it is to find relative values using money. With pineapples at $1 and canoes at $600, we can immediately see that a canoe is worth 600 pineapples. Likewise, it takes 60 ducks to buy one canoe ($600/$10 = 60). Notice how these prices are not so apparent under a barter system.
Further, in this simple economy with only four goods, it takes six prices in order to conduct transactions. We need the price of pineapples per duck, pineapples per hammock, pineapples per canoe, ducks per hammock, ducks per canoe and, finally (whew!), hammocks per canoe. If this simple economy grows to just a meager 100 goods, it is a mathematical fact that you would need 4,950 different prices to conduct transactions. Imagine the difficulty of running an economy with hundreds of thousands of products and services with each requiring its own exchange rate against all other products.
It should now be apparent that it is far more efficient to have everything quoted in a standard unit such as dollars. If you know how much something costs in dollars, you immediately know the exchange rates for all the other goods. A standard currency makes markets more efficient – unless the currency is not stable.
If the value of a dollar fluctuates too much or is subject to great inflationary risks, the transaction costs become unclear and it is difficult, and far less efficient, for businesses to raise capital. As the costs increase, economic activity decreases. For example, say you have money to invest in a one-year bond and are willing to accept 5% more purchasing power at the end of the year in exchange. If interest rates are 5% and expected inflation is 3%, you should be willing to accept a nominal bond yield of 8%.
If inflation rises as expected, you will have 5% more purchasing power at the end of the year. Now assume that inflation is expected to be somewhere 3% and 20%? How willing are you to invest now? Because of the great uncertainty, you will command a very high yield in order to invest, and may even decide to not invest at all. As the expected inflation rises, bond yields rise, businesses invest less, and this can lead to an overall breakdown in the economy. Inflation distorts the value of money.
As inflation becomes more unpredictable, consumers spend more time trying to protect their wealth, rather than investing and producing. If expectations for inflation are high, investors move their capital into more speculative investments such as gold, art or other hard assets that act as a store of wealth. With fewer funds available for investment, the interest rate is driven higher and fewer firms are able to invest and produce, which adds further declines in the economy.
High inflation also challenges the credibility of the government. A government that continuously dilutes the currency so as to create high inflation will lose the confidence of investors. High nominal interest rates will not even attract investor capital under erratic inflationary environments.
For example, around 1992, the country of Nigeria offered an investment with a seemingly high 36% annual interest rate that could be rolled over for a five-year period. Remember, though, that is the nominal rate and includes a premium to "cover" the expected inflation. The U.S. exchange rate at that time was roughly 10 Naira per dollar. A U.S. investor could have taken $10,000, converted it to 100,000 Naira and invested it for a five-year span at 36% interest per year. At the end of the five years, the investor would have indeed collected many Naira, but would he be better off? To be exact, the account would have grown from 100,000 to over 465,000 Naira, which would make the $10,000 investment worth $46,500 – assuming the exchange rate stayed the same. However, during that five-year period, runaway inflation took the exchange rate from 10:1 to over 920:1 making the initial $10,000 investment worth less than $500 after five years. Would you have invested the following five years even with a sizeable inflation premium?
A similar situation has been happening recently in Turkey. In the middle of 1995, one U.S. dollar would buy about 50,000 Turkish Lira; today in October 2001, it will buy nearly 1.6 million Turkish Lira. As a consequence, the Turkish government pays nearly 70% interest on a 3-month treasury. So why aren't investors flocking for the high rate of return? That's because they don't have the confidence that the currency is under control. Part of Turkey's problem is due to the government's abandonment of currency "support" in the open market.
Many countries buy and sell their currency in the open market to keep it in a specific, narrow range of exchange rates, which is something the Turkish government did until recently. Regardless of the cause, once the people lose faith in the government's ability to stabilize their currency, inflation rates can run rampant. The chart below shows the exchange rate of Turkish Lira per U.S. dollar for a one-year period starting in October 2000. Looking at Figure 2, it is quite evident at which point the Turkish government announced their decision to no longer support their currency in the open market:
Figure 2
How bad can inflation get? Extreme inflation is called hyperinflation and probably the worst case in history was observed in Hungary after World War II. For nearly one year starting in August 1945, prices rose at an astounding rate of 19,000% per month! That's just over 18% per day. If the U.S. experienced this type of inflation, something that cost $1 today would cost $1.18 tomorrow, $191 by the end of the month, and $1.7 x 1026 by the end of the year, which is simply a scientific notation that represents the number 17 followed by 25 zeros – a number far too big to even name. What caused this inflation? The Hungarian government printed money to help finance the large government expenditures during the war. In effect, hyperinflations act as a severe tax where the government gains at the expense of the bondholders because the government is paying back the loans with cheaper dollars.
It should be noted that general inflations do not necessarily always benefit the borrower, as many believe. Many incorrectly think that if inflation destroys the value of the dollar, then the borrower is always paying back the loan to the lender with cheaper dollars and always getting the better end of the deal. However, if inflation is expected to be 3%, the bond buyer receives a 3% inflation premium on the yield. If inflation turns out to be greater than 3%, then, it is true that the borrower (bond seller) will benefit at the lender's (bond buyer's) expense.
However, there will certainly be times when the reverse is true and inflation turns out to be less than expected. Under these conditions, a borrower will lose because they initially sold the bond too cheaply; that is they offered too high of an inflation premium. Because inflation premiums are never systematically overstated or understated, it is incorrect to say that general inflations always benefit borrowers. It comes down to how the resulting inflation compared to the expectations and they are above and below these expectations about half the time. However, hyperinflations are, by definition, runaway inflation and the lenders are almost never properly compensated for this risk.
Hyperinflations can be self-perpetuating. For instance, if the government prints an additional 5% more paper money, eventually the price levels will rise by 5%. Once this happens, the government has lost its purchasing power and increases the production of money further. If they raise it by 10%, they have more purchasing power – until the price levels rise by 10%. Eventually people realize the currency loses its value quickly and spend money faster and faster before they lose their purchasing power.
One of the ways to protect money under hyperinflations is to buy hard assets such as jewelry, cars, houses, etc. that maintain a relative value even though they may command higher dollars in the future. For example, if you pay $100,000 for a house and price levels double in one year, your house is now worth $200,000. If you sell for this price, your purchasing power is effectively still $100,000. Notice that if you just held the $100,000 in cash, its value would cut in half and effectively be worth $50,000.
Therefore, under hyperinflations, people have the incentive to spend money faster and faster and faster. In other words, hyperinflations increase the “velocity” of money. In the equation M*V = P*Q we can see that both M (money supply) and V (velocity) are increasing which is why the price levels rise so quickly. Hyperinflations are like an economic suicide game of "hot potato" where each consumer passes the excess cash to the next person before it is worthless. The cash changes hands through the purchase of goods and services, yet the production of those goods and services have not been increased. There is clearly a very long line of excess cash and the way to get rid of the line is to raise the price. The name of the game is to get rid of the cash and the velocity spins out of control.
Perhaps the most well known hyperinflation occurred in Germany after World War I, although not nearly as severe as the Hungarian episode. The acceleration in spending (velocity) was confirmed by employers paying employees twice during each day so they could spend their money before it was nearly worthless by the time the afternoon's wages were paid! Other interesting stories of this period include patrons at German pubs who would buy two beers at a time so as to avoid a price increase between the first and second one. Hyperinflations are a true economic chaos.
It's rather strange that the government's ability to print money is what gives it value – just as long as they don't do it.