The Federal Reserve and the Money Supply - Video Tutorials & Practice Problems
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Money Supply:Discount Policy and Required Reserves
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now let's see how the Fed controls the money supply by applying discount policy, adjusting the reserve requirement and going through open market operations. So the Fed controls the money supply in the United States using monetary policy. Right? So that's what we're getting to in this in this section, is that they use monetary policy by by adjusting maybe interest rates or the reserve ratio or buying and selling securities. They're going to control the amount of money available in the public. Okay. So let's start here with discount policy and reserve requirements. I want to make a note that these are not used as often, I would say in order of what's used. I would say open market operations is used the most often discount policy. Uh second, and then rarely will they adjust the reserve ratio. Okay, so let's start here with discount policy and reserve ratio and then we'll spend a little more time on the open market operations. So discount policy, this is where they set the discount rate. And remember when we define discount rate, um this is the rate at which banks borrow from the Fed. Okay. So the Fed is going to have um short term loans that they give to the banks and it's going to be based on this discount rate. Okay, so the higher the discount rate is the less likely the less loans, uh the banks are going to take, the less loans the banks are going to take from the Fed, which leads to a lower money supply. Right? Because they're not taking as many loans and what you have to think about is when the banks have the money, it's in the it's in the hands of the public, when the Fed has the money, it's not in the hands of the public. So they tighten the money supply by not loaning stuff out and they loosen the money supply, They make it bigger by loaning out money to the banks and then to the public from the banks. So a lower discount rate. Well, the lower the rate goes, the more loans the banks are going to take because they can make a profit by loaning that out at a higher rate to the public right to the general public. So more loans equals a higher money supply. Right? And this is just how we saw in our example, where we were following the loans going through the deposits and then them getting loaned out again and the deposits and it was increasing the money supply through that. So this is one way they can affect, it is by changing the discount rate. Um something they do much less often because it has a lot of implications within the economy. Is it just the reserve ratio so they can set another thing the Fed does is set the reserve ratio. What is the required reserves that uh, that a bank has to keep on deposits? Right? The amount of reserves. Banks must hold on their deposits, these are the reserves. So the more reserves they have to have, Well, that's money, they can't lend out. Right. If the reserve ratio is higher, then they have less money to loan, right less, we'll say less loans again, but this one's to the public to general public. Okay. Because the banks still are considered the public, because we're talking about the Fed as like part of the government and then um the public, the general public being the banks and then the consumers. Right? So the banks are going to be making less loans to consumers because they have to hold more in reserves. So the more that the banks have to hold in the reserves, the less they can loan out, which ends up making a lower money, a lower money supply again here. Right? And this follows that same logic that we saw through the banks, the loans going through clutch Topia and and to the different um through the different banks and increasing the money supply through that money multiplier. So a lower reserve ratio means they have to hold less in reserves so they can make more loans Leading to a higher money supply through that same logic. So, let's go through a quick example here, just so we can see the checkable deposits in this case, let's say in the first scenario, we've got 100 million in checkable deposits and the reserve ratio is 10%. That means that the banks required reserves Are equal to 100 million in deposits, times 10%. Well, they're required to hold 10 million, write the required reserves are 10 million. So they can loan out their excess reserves, And those excess reserves are equal to the 100 million in deposits minus the 10 million that are required. They're able to loan out 90 million and that's going to be increasing the money supply, that money multiplier process we've been through. And in our other example here on the right hand side. Now, let's say the Fed says, Okay, you only have to hold 8% in reserves. Well, that means from the 100 million in checkable deposits, they only have to hold 8% now, which is eight million. So they have an extra $2 million to play with right before they had 10 million, they had to hold on to by law. Now, they only have to hold on to eight million. So the 100 million minus the eight million in this case, gives us 92 million that they can loan out. Right? So by having those greater loans, the lower ratio adds to the money supply through that process. Right? The lower reserve ratio, Cool. So, those are the less common things that the Fed does, let's go through the open market operations
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Money Supply:Open Market Operations
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Alright. So now let's go through the open market operations. So what are open market operations? This is when the Fed buys and sells US Treasury securities, generally it's US Treasury securities such as bonds or more likely Treasury bills, which are short term Treasury investments and they buy and sell them with the public. And when I say public, it's not like you can call up the Fed and say, hey, let me buy some Treasury securities. No, they're dealing with banks in this case. They're dealing with with with the banks and the banks are part of the public in this idea. Okay, so the Fed having money is taking money away from the public. The Fed uh, giving money to banks is money going into the hands of the public and remember everything we're focused on here is how much money is in the money supply. Okay. So the Federal Open Market Committee, right. F. O. M. C. They're the ones that handle the open market operations and they do this most often to deal with the money supply because it gives them the most control. They get the most control over the money, the money supply because they can set the volume of purchases and sales. Okay, So think about it. They can buy or sell 100 million in US Treasury Securities or they can do 200,000,500 million. They can do 50,000,020 million. The size of the open market operation is totally up to them. So it gives them a lot more control over how they're gonna adjust the money supply. Another great benefit of doing open market market operations is that they're easily reversible If they make an open market operation and they see that it's having negative impacts. Well, they can do the opposite and just immediately cancel out what was happening. Such as if they buy 20 million in US Treasury Securities from the banks. And then they see that things aren't going so well, well, they can just sell them back to the banks, get the 20 million back and, um, reverse what just went, went through and they can be quickly executed, right? There's not a whole bunch of administrative burden going on here. The committee makes a decision and they make it happen. Okay? So there's two things they can do. They can either buy or sell U. S. Treasury Securities. Okay. So if they're buying US Treasury Securities, think about the Fed. Okay. In this situation, the Fed is going to be like the government. We're going to think about the Fed is being like the government and the bank's being like the public, the ones who have, uh, the money in the public would be in the money supply. If the money is in the Fed, Well, it's not in the money supply. So if they're buying US Treasury securities, we have the Fed buying. So they're going to give to the banks, what are they giving to the banks? If they're buying US Treasury securities, they're giving the banks money and they're getting Treasury Securities in return. Right? So, in this situation, who's getting the money in this case? The banks, right? The banks are getting the money. So when the Fed buys us securities, there's more money in banks. And when the banks have the money, that's like the public having the money. So there's more money supply. Okay. The money supply is higher when they buy us securities. And this is where a lot of students get tripped up. Because you have to follow the logic of who's getting the cash and who's getting the securities when the Fed gets the securities? Well, they're paying out cash to the public. Okay. And then it's the opposite for the for the second situation, I'll do it here in blue. So Fed. And banks again, in this case, I'll do it a little further down. So we have space now in this case, they're selling Treasury securities. So, what is the Fed giving to banks and what our banks giving to the Fed. In this case, the Fed is giving the banks, Treasury Securities, right. The Fed is selling Treasury Securities, and they're getting money from the banks. So, who has the money? Now, do the banks have the money or the Fed? The Fed has the money in this case. Right? The Fed is gonna have the money. So there's less money in the banks, because now they have Treasury Securities, instead of the dollars. And when there's less dollars in the bank, that's less money supply. Okay. So this is the idea the Fed is trying to control the supply of money, which is that M1 that we talked about right? The currency in circulation plus the checkable deposits. This is them controlling that amount that's in the public. Okay. And we're gonna see why they want to control that amount when we go to the graphs and we kind of see the demand for money and the supply for money on the graph. But for now it's important to just understand how they conduct the open market operations and it's as simple as buying and selling us securities. Okay. So when we're studying monetary policy, it's important to think like this kind of how we've been doing so far the Fed, we're gonna say as the government now, they're not exactly the government. But we're just gonna say it like that, they're the central bank of the U. S. And they're going to be the insiders, right? They're not part of the public. And then the public is going to be banks and of course consumers as well, right, consumers. But mostly the Fed is only gonna be dealing with banks, right with the the Fed is mostly just gonna be dealing with the banks and going through these operations with the banks. It's not like you call up the Fed yourself. Okay. So the Fed is the government and the banks is the public, we're seeing who has the money. Does the Fed get the dollars or does the banks get the dollars? So the money supply is the money in the hands of the public? Okay. So when the money is in the hands of the public, it's in the money supply, it's circulating. Um and that's what we're concerned with is how much is in the money supply, and how is that affecting the markets? Alright, so that's about it here, let's go ahead and move on to the neck.
