A:

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 (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. Here are three methods the Fed uses in order to inject (or withdraw) money from the economy:

  1. The Fed can influence the money supply by modifying reserve requirements, which is the amount of funds banks must hold against deposits in bank accounts. By lowering the reserve requirements, banks are able 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.

  2. 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. Lower rates increase the money supply and boost economic activity; however, decreases in interest rates fuel inflation, so the Fed must be careful not to lower interest rates too much for too long.

  3. Finally, 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.

To learn more about central banks and their role in monetary policy, check out Formulating Monetary Policy.

(For a one-stop shop on subprime mortgages and the subprime meltdown, check out the Subprime Mortgages Feature.)

RELATED FAQS

  1. What is each party's role in a reverse repurchase agreement?

    Learn about the role of each party in a reverse repurchase agreement transaction, and find out why it's different if the ...
  2. What are some of the major regulatory agencies responsible for overseeing financial ...

    Discover the specific responsibilities of some of the major regulatory agencies that oversee financial institutions in the ...
  3. Under what circumstances would someone enter into a repurchase agreement?

    Learn when investors want to enter into a repurchase agreement, such as to gain quick access to liquidity and enjoy flexibility ...
  4. What are the main risks to the economy of a country that has implemented a policy ...

    Learn about the main risks to a country that has implemented a policy of austerity. Austerity implies cutting government ...
RELATED TERMS
  1. G.19 Report

    A monthly statistical report from the U.S. Federal Reserve that ...
  2. Iraqi Central Bank

    The main banking entity responsible for supervision and management ...
  3. Bond

    A debt investment in which an investor loans money to an entity ...
  4. Deflationary Spiral

    A deflationary spiral is when a period of decreasing prices (deflation) ...
  5. Negative Interest Rate Policy (NIRP)

    A negative interest rate policy (NIRP) is an unconventional monetary ...
  6. Nordic Model

    The social welfare and economic systems adopted by Nordic countries.

You May Also Like

Related Articles
  1. Entrepreneurship

    Fed Raising Rates Affects Startup Funding

  2. Economics

    10 Most Influential Chinese Companies

  3. Stock Analysis

    Is Now the Time to Bet on Vacation Spending?

  4. Economics

    Why Israel Is Attracting Chinese Investors

  5. Mutual Funds & ETFs

    How To Short The U.S. Bond Market

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!