Banking: Central Banking System | SparkNotes (2024)

Money supply

In the SparkNote on money and interest rates we learned about the money supply. Initially we defined the money supply as the total amount of currency held by the public. While this definition is correct, it is incomplete. In the previous section, we learned that through a fractional reserve banking system, the money supply increases. Thus, the money supply is better defined as the total amount of currency plus deposits held by the public. All available money, either in terms of currency or demand deposits, is thus accounted for.

Initially, money supply was introduced as a vertical line that was only affected by Fed policies. While it is true that the Fed has the majority of the control over the money supply, our new definitionof money supply indicates that the public has so me control as well, albeit unwitting: the public has thepower to make deposits and take out loans. We will work through how both the Fed and the public affectthe money supply through their actions.

There are three basic ways that the Fed can affect the money supply. The first is through open marketoperations. The second is by changing the reserve requirement. The third is through changing thefederal funds interest rate. Each of the se actions in some way affects the total amount of currencyor deposits available to the public.

Open market operations are a form of monetary policy, meaning that the Fed directly affects the moneysupply. Open market operations are the sale and purchase of government bonds issued and regulated bythe Fed. When the Fed sells government bon ds, the public exchanges currency for bonds, thus resultingin a shrinking of the money supply. When the Fed purchases government bonds, the Fed exchanges currencyfor bonds, thus resulting in an increase in the money supply. Open market operations are the most commontool that the Fed uses to affect the money supply. In fact, almost every weekday government bonds arebought and sold in New York City.

The second way that the Fed can influence the money supply is through changing the reserve requirements. This is a form of fiscal policy because the Fed is working with the finances of banks to affect themoney supply rather than with the money suppl y directly. We learned in the section on the purpose ofbanksthat the money multiplier shows how much an initialdeposit increases the money supply after loans are made and redeposited. Recall that the money multiplier is one over the reserve requirement. Thus, if the reserve requirement is decreased, banks are requiredto hold fewer reserves and can then make more loans. This in turn repeats the cycle of loan to deposit,resulting in an increase in the money supply . For a given initial deposit, a smaller reserverequirement will result in a larger money multiplier, and thus in a larger change in the money supply.

The third way that the Fed can influence the money supply is through changing the federal funds interestrate. This is also a form of fiscal policy because the Fed is working with the finances of banks toaffect the money supply rather than with the mone y supply directly. We learned in the section on thepurpose of banks that banks make deposits, withdrawals, and loansfrom banks' banks that are usually branches of the Fed. When a bank makes many loans, its reserves get depleted to near the absolute required minimum. If a customer makes a withdrawal, banks must eitherrecall a loan or take out a loan to pay the withdrawal while still maintaining the necessary reserves. If the Fed increases the federal funds interest rate, banks will be less likely to borrow money from theFed and will thus be more weary of making loans to ensure that they have the necessary reserverequirements. Thus, if the federal funds interest rate is higher, banks make fewer loans, the moneymulti plier is not fully utilized, and the change in the money supply for a given initial deposit issmaller.

Banking in the US

In the US, the banking system is rather complex, yet highly effective. The first part of the US bankingsystem is the treasury. The treasury prints, mints, and stores currency. The next part of the USbanking system is the Fed. The Fed buys and se lls government bonds, changes the federal funds interestrate, and changes the reserve requirements. The Fed has the greatest control over the money supply. Thenext part of the US banking system is the Federal Reserve Banks. These are banks' banks where banks make deposits, withdrawals, and loans. In return, the Federal Reserve Banks check thereserve requirements of the other banks and allow the Fed to implement changes to the money supplythrough the federal funds interest rate. The final part of the US banking system comprises all of theother non-government banks, savings and loans, and credit unions. These are the banks that the publicuses. The interdependent hierarchy that is established through the central banking system in the US allows the money supply and inflation to be carefully controlled, as well as the fiat money tomaintain value over time.

There are a number of safeguards built into the US banking system. The first is the Federal DepositInsurance Corporation. The FDIC insures individual deposits up to $100,000 in the case of a bankcollapse. This measure is supposed to inspire confidence in the public that the money it deposits in abank will not be lost, despite unforeseen events. A second safety measure is a system of bank checks andaudits by the government to ensure that prudent banking practices are being observed. These are simplyvery detailed examinations of bank records and dealings. The third safeguard is the regular verificationthat banks' holdings meet reserve requirements. In this way, banks are prepared to pay depositors asneeded and may be able to avoid a bank f ailure. The fourth safety measure is that banks are limited inthe investments that they may make with deposited funds. Banks not only earn money from interest onloans, but they also invest money in bonds and stocks. By regulating the amount of risk t hat a bank canundertake in its investments, the government ensures that depositors' money will be relatively secure,even in the case of poor economic conditions. In all, the government regulates the actions of banks insuch a way as to maintain the US banking system as one of the safest and most open in the world.