Saturday, June 11, 2011

The Fed and the Money Supply

In order to remove the political motivations that may otherwise manipulate the money supply arbitrarily, the powers to do so are granted to a private entity known as The Federal Reserve, or as it is sometimes called “The Fed”. Although it is technically a private institution and not officially part of the government, the Fed acts as the policy arm of the US treasury. The board of the Fed is appointed by the president and approved by congress. The actions of the Fed are also overseen by congress, although not directly regulated by them. In other words, the Fed doesn’t need to ask permission to act, but if its actions are perceived to be devious by congress, it has the power to revoke the Fed’s authority. The Fed is the US central bank, of which all other private banks throughout the country must be a member, and it is tasked by congress with two main objectives: maintaining high employment and low inflation. It attempts to accomplish these goals primarily through adjusting the money supply to meet demand. Theoretically, if the supply of money is kept in balance with demand, then employment will remain high, and prices will remain stable. As was discussed in the last post, the operations of the Fed become necessary because the government needs some leeway when it comes to the budget. It is just not practical to adjust the money supply completely by government spending and taxation alone.

In order to create a buffer in which the money supply can be adjusted, we operate under the fractional reserve banking system. This means that banks are allowed to lend a portion of the funds deposited with them, and still allow those funds to be demanded for withdrawal by depositors at any time. As long as not too much of the money is demanded for withdrawal on any given day, the bank has enough funds on reserve to pay out normal requests for withdrawals. When too many withdrawals are requested at once, it is called a run on the bank. Usually, a bank run is driven by the fear that the bank will fail. People flock to pull out their money, and thus failure becomes a self fulfilling prophecy when the amount of withdrawals demanded becomes greater than the reserves held. In order to quell fear and prevent bank runs, the federal government created an insurance program called the FDIC, which insures accounts up to a certain dollar amount (currently $250,000). When bank failures occur, and they still do, the government steps in to take over the bank temporarily and pays out its creditors while insuring that depositors are kept whole up to the insured amount. This creates a stable banking environment where your average consumer no longer needs to worry about bank failures, since their money is safe even if the bank itself does go under.

Fractional reserve banking creates a buffer in the money supply known as “bank money”, or the “private money supply”. The Fed can use interest rates and reserve requirements in order to influence the size of this buffer to try and balance the demand for money. To understand how this works, we’ll take an example of someone depositing $100 in their local bank. The current reserve requirement for US banks is currently 10%. This means that when person A deposits $100, the Fed requires that the bank keep at least $10 in reserve on account with the Fed. The bank is then free to lend the other $90 as it wishes. So, the bank then lends $90 to person B, who turns around and buys something from person C. Person C then deposits that $90 in another bank. That bank must keep $9 in reserve, but then lends out the remaining $81. You can see that if this keeps on going with each bank lending out the maximum allowed, by the time the last person deposits the proceeds of the last loan there is $1000 total in deposits at various banks. Only when all the loans are eventually paid back does the money supply shrink back down to the original $100. You can see that because the supply of money can be influenced to grow up to 1/R times, where R is the percentage of reserve requirement, it becomes a powerful tool for managing the supply of the currency.

Ok, so what does all of this have to do with government debt? When the government creates more currency from spending than it removes in taxes, it is required to create treasury bonds in the amount of the difference. While this wouldn’t technically be required by the rules of a floating exchange currency, it does make congress feel all warm and fuzzy that the deficit is accounted for somehow. The creation of federal debt also serves some other important functional purposes. It gives people, businesses, and foreign investors somewhere safe to store the currency where it will be protected against inflation. Also, federal debt is the means by which the Fed is able to institute monetary policy. The issuance of government bonds allows the Fed to buy and sell them on the open market in order to target interest rates, which in turn influences the bank money supply. When the economy is hot, and the demand for money is low, the Fed can move to shrink the money supply by selling government debt that it holds. The increase in the supply of privately held bonds puts upward pressure on the interest rates demanded in order to hold those bonds. That pressure directly impacts the “overnight rate”, or the rate at which banks are willing to loan to each other in order to satisfy their reserve requirement with the Fed. Say that on a given day, a bank has lent out more than 90% of all the deposits they hold. In order to satisfy the reserve requirement, that bank has to borrow the difference from a bank that has more reserves than required. The lending bank would only choose to lend its excess reserves if the interest rate was slightly better than it could otherwise get from holding treasury bonds. That bank in turn will be incentivized to offer higher rates for deposits, and will have to charge higher rates to the borrowing public to make it worth the risk. So, if interest rates are rising, that then influences the public to pay down debt, which shrinks the private money supply, thereby bring the total supply of money back down to meet demand so that inflation does not occur. That is how the Fed looks to prevent inflation. By targeting interest rates which in turn influence the private money supply it can adjust for the demand of currency, hence stabilizing prices. It can only do this because of the existence of government debt. The system is supposed to work pretty much the same way in reverse, but it turns out that attempting to control unemployment by influencing the growth of private money is a little bit trickier. That fact is evidenced by what we are currently seeing with the present state of the economy, and is what we’ll explore in the next post.

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