There are three ways in which the Federal Reserve uses, controls, and supplies money to the nation. The first way is to modify banks' reserve requirements. A bank reserve is an amount of money held to meet the demands of daily transactions and withdrawals. This must meet an amount set by the Federal Reserve Board known as the required reserve. The required reserve is the amount of money banks must hold in reserve versus deposits made by their customers. If the board lowers the reserve requirements, then banks will be able to loan more money, which would increase the overall supply of money. On the other hand, if the board increases the reserve requirements, it decreases the amount of money a bank is able to lend out to its customers. Any monies held by banks and financial institutions above and beyond what are required by internal controls, regulators, and creditors is called an excess reserve.
Depending on economic conditions, a bank might want to keep more money in its reserves. Regulations may require banks to keep more reserves on hand in times of economic turmoil, such as during the Great Depression, to ensure that the banks do not fail. Conversely, in times of great economic expansion, the Federal Reserve may require banks to maintain minimal reserves. Lower reserve requirements help banks expand their operations, which may include lending more. However, there is a risk when the reserve requirements are lowered that could have a catastrophic effect on the banking system and within the overall economy. Thus, while lowering the reserve requirement leads towards more money being injected into the economy by giving banks excess reserves, which promotes the expansion for bank credit and lowered rates, it also removes a safety net which allows for more loans to be given to the public and businesses. This may effectively increase the rate of loan default, which will put a strain on the banking system to sustain itself. Another effect may be with regard to spending activity that can also work to increase inflation, which will drive up the prices of goods and services thus slowing the economy and putting it into a recession, or in a worse scenario, a depression.
The second way the Federal Reserve can use monetary policy to influence banks and the economy is by changing short-term interest rates. The federal discount rate is the interest rate charged to commercial banks and other depository institutions on loans received from the Federal Reserve. If the Federal Reserve lowers the federal discount rate on short-term loans, it is able to increase liquidity throughout the economy. Liquidity is the measure of the ability to convert assets to cash with ease, usually because of a financial obligation. During times when interest rates are lower, these rates may be passed on to the customer. This means that more loans can be given and more money can be made. This is a sign of a good economy. An increase in the supply of money tends to lower interest rates, which can, in turn, generate more investments, put more money in the hands of the consumer, and stimulate spending. Businesses respond in such conditions as well by purchasing more materials to build and grow. This can lead to a growth in employment because increased business activity requires more labor. A problem arises when the increase in money lasts too long and inflation occurs; the money supply is not worth as much as it was previously, resulting in increases of the prices of labor, supplies, and other assets.
When higher interest rates are charged, fewer loans are given because banks have to pay more in interest. This means that businesses have lower profits and that higher interest rates are passed on to customers. Bank solvency is the ability of a bank to meet its financial obligations for the long term.
When the supply of money decreases, interest rates rise, which results in less money for consumers. As a result, people tend to spend less, which causes businesses to buy fewer materials and conduct fewer business activities. Ultimately, employers will not need the same number of employees as before, making the unemployment rate rise. Over a long period, these economic movements can cause a recession. This is why the Federal Reserve actively monitors the ups and downs of the economy. A good example of this is when the supply of money decreases. For example, customers may be buying less insurance than they were before. Vision Inc., a hypothetical insurance company, may thus offer fewer positions for a job than it had in the past; current employees are asked to perform additional tasks. Because of a budget shortage, employees now assume additional responsibilities in order to help the company continue to make a profit. Overall, there are fewer resources, projects, and upgrades available to the company.
The third way the Federal Reserve can affect the money supply is to conduct an open market operation. An open market is an unrestricted market with free access to enter, buy, and sell. This affects the federal funds rate, or the interest rate at which banks and credit unions lend reserve balances to other banks and credit unions overnight. To conduct an open market operation, the Federal Reserve buys and sells government securities in the open market. If the Federal Reserve wants to increase the money supply, it buys government bonds, which, in turn, supplies the security dealers who sell the bonds with cash, increasing the overall supply of money. Conversely, if the Federal Reserve wants to decrease the money supply, it sells bonds, taking in cash and removing that money from the system. An accommodative monetary policy is an action taken by a central bank in an attempt to boost the overall supply of money during times of slow growth. An example would be if, during a time of slow growth, the Federal Reserve started selling securities to securities dealers in order to try to boost the economy. If the cost of the securities is lower than when they are scarce, the securities dealers can sell these securities to their buyers with more flexibility. The outcome would be a stimulated economy because people would spend more money and buy more securities.