Central banks use several different methods to increase or decrease the amount of money in the banking system. These actions are referred to as monetary policy. While the Federal Reserve Board—commonly referred to as the Fed—could print paper currency at its discretion in an effort to increase the amount of money in the economy, this is not the measure used, at least not in the United States.
The Federal Reserve Board, which is the governing body that manages the Federal Reserve System, oversees all domestic monetary policy. They are often referred to as the Central Bank of the United States. This means they are generally held responsible for controlling inflation and managing both short-term and long-term interest rates. They make these decisions to strengthen the economy, and controlling the money supply is an important tool they use.
Key Takeaways
- Central banks use several methods, called monetary policy, to increase or decrease the amount of money in the economy.
- The Fed can increase the money supply by lowering the reserve requirements for banks, which allows them to lend more money.
- Conversely, by raising the banks' reserve requirements, the Fed can decrease the size of the money supply.
- The Fed can also alter short-term interest rates by lowering (or raising) the discount rate that banks pay on short-term loans from the Fed.
Modifying Reserve Requirements
The Fed can influence the money supply by modifying reserve requirements, which generally refers to the amount of funds banks must hold against deposits in bank accounts. By lowering the reserve requirements, banks are able to loan more money, which increases the overall supply of money in the economy.
Conversely, by raising the banks' reserve requirements, the Fed is able to decrease the size of the money supply.
How Do Central Banks Inject Money Into The Economy?
Changing Short-Term Interest Rates
The Fed can also alter the money supply by changing short-term interest rates. By lowering (or raising) the discount rate that banks pay on short-term loans from the Federal Reserve Bank, the Fed is able to effectively increase (or decrease) the liquidity of money.
While the Fed can directly influence a market rise, it is more commonly held accountable for market downturns than it is lauded for upswings.
Lower rates increase the money supply and boost economic activity; however, decreases in interest rates fuel inflation, and so the Fed must be careful not to lower interest rates too much for too long.
In the period following the 2008 economic crisis, the European Central Bank kept interest rates either at zero or below zero for too long, and it negatively impacted their economies and their ability to grow in a healthy way. Although it did not bury any countries in economic disaster, it has been considered by many to be a model of what not to do after a large-scale economic downturn.
Conducting Open Market Operations
Lastly, the Fed can affect the money supply by conducting open market operations, which affects the federal funds rate. In open operations, the Fed buys and sells government securities in the open market. If the Fed wants to increase the money supply, it buys government bonds. This supplies the securities dealers who sell the bonds with cash, increasing the overall money supply.
Conversely, if the Fed wants to decrease the money supply, it sells bonds from its account, thus taking in cash and removing money from the economic system. Adjusting the federal funds rate is a heavily anticipated economic event.