The money supply is the total amount of deposits in financial institutions, and is a key measure of economic health. The US Federal Reserve controls the money supply through interest rates, bond purchases and reserve requirements to strike a balance between sustained growth and inflation.
The money supply represents the totality of deposits in financial institutions, or money outstanding and not accounted for by any other measure. This money is often very fluid, flowing in and out of the system, and is a key measure of economic health. If the money supply is too much, inflation could result. If it is too little, economic growth may not occur.
Given the dangers of inflation or lack of growth, the US Federal Reserve, and any other country’s central bank under monetary policy, will try to control the money supply through a number of different methods. In the end, the overall goal is to provide an equilibrium that generates sustained growth, but not so much growth that it causes inflation. Both extremes need to be protected, and economies can change dramatically, making it a very difficult balance to strike.
Interest rates are a way to control the money supply. The Federal Reserve, or national bank, can arbitrarily change the interest rate on the money it lends to banks. If a high interest rate is charged, banks make fewer loans. This leads to a constraint on the inflation rate, because there is less money to spread around, so it becomes more valuable. If interest rates are lowered, more trading is likely to occur. Interest rates often get a lot of media attention because they have such a direct effect on so many people’s lives, especially when it comes to long-term loans like mortgages. The Federal Reserve Board usually meets once a quarter to consider this.
Another method that the Federal Reserve has to control the money supply is through the purchase of bonds. The money from these bonds is placed in the system for the banks to use. These banks will take over and try to lend the money for profit. This provides an engine for economic growth.
If the Federal Reserve wants to restrict the money supply, it can also sell bonds. This reduces the money to borrow because the money that would normally be used for such purposes is used to buy the bonds that the Federal Reserve sells. Therefore, the money supply is reduced, which should control inflation, but could also choke the economy, if done to too high a degree.
The last way the Federal Reserve can control the money supply is through reserve requirements. Each bank, credit union, or other depository institution is required to hold a certain amount of your money in reserves, defined as a certain percentage. The Federal Reserve can change the amount required for reserves, thus freeing up money or further restricting its use, depending on what the economic situation may require.
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