How the Fed Controls the Money Supply

Today, I want to break down how the Federal Reserve controls how much money is circulating in the economy, also called the “money supply”, and how that’s connected to inflation.

First, let’s define what we mean by the “money supply.” Economists usually talk about two main measures.

The first one is called M1: This includes physical cash, checking account deposits, savings accounts, and other forms of money that can be spent immediately. M1 is currently around $18.7 trillion.

The second measure of money is called M2: This includes everything in M1, plus small-denomination time deposits (that is, CDs for relatively small amounts) and balances in retail money market funds-things you can’t spend instantly but can convert to cash pretty easily. M2 is currently around $21.9 trillion.

When the Fed increases the money supply, there’s more money available in the economy. That also tends to lower interest rates and increase spending. When the Fed reduces the money supply, borrowing becomes harder or more expensive, and spending slows down.

Increasing the money supply puts upward pressure on prices, that is, increases inflation, because we have more dollars to buy the same amount of stuff. Decreasing the money supply does the opposite.

The Fed controls the money supply using a few key tools that ultimately affect how much money banks create through lending. If you’re asking yourself, “What do you mean by ‘money banks create through lending’?”, check out my other post on how the money supply system works.

The most important tool the Fed uses is open market operations. This means buying or selling government securities-like Treasury bonds-in the open market, meaning from the public, not the Treasury directly. Note that the goal of these purchases is to maintain maximum employment and keep prices stable. They are not linked to buying and spending decisions of the US government by design.

When the Fed buys bonds, it injects money into the banking system. Banks get money in exchange for the bonds, which increases their reserves. That gives them more capacity to lend, which expands the money supply and also increases inflation.

When the Fed sells bonds, it pulls money out of the system. Buyers give the Fed their cash, which reduces bank reserves, shrinks the money supply, and decreases inflationary pressure.

This process also affects short-term interest rates. More reserves mean lower rates; fewer reserves mean higher rates. Why? Because banks can use excess reserves to lend to other banks that are short of reserves on an overnight basis. But the more excess reserves there are, the higher is supply of money to lend relative to demand. So equilibrium interest rates will be lower. And if excess reserves are scarce, demand is high relative to supply, and equilibrium interest rates will rise as well.

There are other tools used by the Fed, including changing reserve requirements, raising or lowering interest payments on reserves, and quantitative easing, which has been used in extraordinary situations like the aftermath of the 2008 financial crisis. But open market operations are the Fed’s bread-and-butter in most times. They are easy to scale up or down, and the Fed is very experienced in carrying them out. For this reason, they are the best tool we have for stabilizing price growth.

Originally published at https://mytwocentsandcounting.substack.com.