Do You Know How The Fed Pumps Up The Money Supply?

Do you know how the Federal Reserve "pumps" money into the economy? Recently, the news media have reported that the Federal Reserve has "pumped" money into the economy, but they do not explain exactly how the Fed does this.

Controlling the amount of money in the system is one of the most important functions of a government. Money is never simply personal. It is a matter of government policy. The more you understand how governments increase and decrease the amount of money available, the more you will be able to control your personal economy.

Every nation has a central bank. In the United States, the central bank is the Federal Reserve. The central banks pay attention to the condition of the current economic conditions, and then take actions to either heat up or cool down the economy.

Although the news media use this type of language, they don't explain exactly how the Fed increases or decreases the amount of money. What does the Fed do when the media report that the Fed is "pumping money" into the economy to calm fears of an economic panic? What does it do to "drain money" from the system, to cool it down?

First, it's important to be clear what it does NOT mean. The Fed does not pump more money into the system by printing more currency. Currency is not equivalent to money.

The Fed has several tools it can use to decrease or increase the amount of money in the system.

One method involves the reserve requirements for banks. A bank must keep a portion of its deposits on reserve. In other words, the bank can only loan out a percentage of its deposits as loans. The percentage it cannot loan out is the reserve.

If you have ever wondered how banks make money, they make it by loaning out customers deposits to other customers. However, the bank cannot loan out all of its deposits. If you deposit $1,000 in the bank, the bank loans most, but not all, of your $1,000 to other customers.

The Federal Reserve sets the reserve requirements for banks. Typically, the reserve ranges from 3-10% of its deposits. So, with your $1,000 deposit, the bank needs to keep on reserve only $30 with a 3% reserve and $100 with a 10% reserve. The bank is free to loan out whatever is left after the reserve requirement. With a 3% reserve the bank can loan out $970 of your money. With a 10% reserve, the bank can loan out only $900.

This example demonstrates that the Fed can control the amount of money banks can loan by changing the how much the banks must keep on reserve. When the Fed wants to "pump" money into the system, it reduces the reserve requirements. The same process works in the opposite direction. The Fed can "drain" money from the system if it increases the reserve requirements.

So, if a bank only has to keep 3% of its deposits on reserve, this means it can loan out 97% of its deposits to customers. If the bank has to keep 10% of its deposits on reserve, it can loan out only 90% of its deposits. So, lower reserve requirements result in more money available for loans. Higher reserve requirements shrink the available money supply for loans.

So even though the media talk about the Fed "pumping" more money into the economy, this language is a bit misleading. The banks do the "money-pumping" when the Fed allows banks to loan out a higher percentage of its deposits. This is one way the Fed controls the amount of money in the economic system.