Let’s turn to an example of Fed action that starts the process going. Here again we assume no currency. In the example that follows we have a very similar story to the one we just completed. But in what follows we start with no bank having excess reserves to lend until the FED makes an action. Banks have lent all they can. So, banks have assets and liabilities and they have just enough reserves. We will start with a bank and not know the value of its assets and liabilities. But we do not need to know the totals here, only the changes need be known. The FED action is to purchase bonds from a bank. The bonds the bank can hold are US government bonds. The FED pays for the bonds by giving the bank reserves.
A L + NW Let’s assume the bank has no excess reserves and the reserve requirement r = 0.10, or 10%. Now say the Fed buys 10 worth of the banks bonds. The Fed does this by taking the bonds and increases the BR of the bank. Since the bank was already meeting its reserve requirements the new reserves are all excess and can be lent. The loan will be spent. The final position on this bank is the 10 in bonds moved to 10 more in loans. But we are not done. B –10 BR +10 L +10 D +10 BR – 10 D -10 L +10 B -10
Round 2 round 3 BR+10 D +10 L +9 D +9 BR -9 D -9 BR +1 D +10 L +9 BR + 9 D +9 L +8.10 D +8.10 BR – 8.10 D -8.10 BR + .9 D +9 L +8.100
When the first bank lent the 10, stuff was bought and the money ends up in the bank of the seller of the stuff. That bank now has 10 more in D and 10 more in BR, so with a r = .1 it can lend 9 and keep 1 in BR to meet the new deposit requirement. The process repeats and the next bank gets 9 in D and 9 in BR, but only has to keep .9 in BR and can loan the rest. This goes on and on with other banks. The change in the money supply within the banking system from the Fed action is (10 + 9 + 8.1 + …) = 10 (1 + .9 + .92+ …) = 10(1/.1) = 100 = 10(1/r) = the initial excess reserves divided by the required reserve ratio.
The Federal Reserve The Federal Reserve, hereafter called the Fed, is the central bank in the US. It is often called a banker’s bank or a lender of last resort. The Fed is the organization in the economy that can influence the money supply in the US. The three tools it can use to influence the money supply - currency and checkable deposits - are 1) open market operations (buying and selling bonds) 2) reserve requirement setting policy 3) discount rate policy.
reserve requirements If the Fed changes the reserve requirement then banks have to adjust the amount of demand deposits they hold. A decrease in the reserve requirement would mean that banks have more to lend and the money supply could expand.
discount rate The discount rate is the rate at which the Fed would lend to banks. Do not confuse this rate with the Fed Funds rate, the rate banks lend to each other. The two are related, though. If the Fed lowered the discount rate it would make it more attractive for banks to borrow from the Fed. In reality, what the Fed does when it lends is to put reserves into the bank. The bank can then lend out the reserves.