The monetary base, or high-powered money, consists of the sum of currency held by the non-bank
public and banks’ reserves. In an all-currency economy, the money supply equals the monetary base.
The money multiplier is the number of dollars of the money supply that can be created from each
dollar of monetary base. In a system of 100% reserve banking, the reserve-deposit ratio is one and the
money multiplier is one. Under fractional reserve banking, with all money held as deposits, the
money multiplier is the reciprocal of the reserve-deposit ratio. The multiplier is higher under
fractional reserve banking because banks hold only part of the monetary base as reserves and create
money in the form of deposits with their excess reserves. Under 100% reserve banking, deposits
simply substitute for the currency that is held by banks as reserves—no new money is created by
banks. So the money multiplier is higher under fractional reserve banking, in which banks create
money, than under 100% reserve banking, in which banks do not create money.
Changes in the desire by the public for holding currency affect the currency-deposit ratio, thus
changing the money multiplier. Similarly, changes in banks’ desire to hold reserves affect the reserve-
deposit ratio, thus changing the money multiplier. Increases in either the currency-deposit ratio or the
reserve-deposit ratio reduce the money multiplier. But these effects do not mean that the central bank
cannot control the money supply, because changes in the money multiplier can be offset by changes
in the monetary base to leave the money supply unchanged.
An open-market purchase increases the monetary base. The increase in the monetary base leads to an
increase in the money supply through the multiple expansion of loans and deposits.
Monetary policy in the United States is determined by the Federal Reserve System. The president
appoints the seven members of the Board of Governors of the Federal Reserve System, including the
chairman, but otherwise has no direct influence on monetary policy.
Means of controlling the money supply other than open-market operations include:
(1) Reserve requirements. An increase in reserve requirements forces banks to hold more reserves,
increasing the reserve-deposit ratio, thus reducing the money multiplier. With a lower money
multiplier, the money supply is reduced for a given size of the monetary base.
(2) Discount window lending. A reduction in discount window lending, which may be caused by the
Fed increasing the discount rate or by the Fed refusing to lend, causes a reduction in banks’
reserves, decreasing the monetary base. Also, a higher discount rate may lead banks to choose a
higher reserve-deposit ratio, so the money multiplier declines. Both effects reduce the money