Loading the player...
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. How is money supply used in monetary policy?

    Learn about the three components of the Federal Reserve's monetary policy. Understand how these three components use the ... Read Answer >>
  2. How do open market operations affect the money supply of an economy?

    Understand how open market operation affect the supply of money in the economy and learn the specific ways the Federal Reserve ... Read Answer >>
  3. How does the law of supply and demand affect monetary policy in the United States?

    Learn about how the law of supply and demand affects monetary policy in the United States. Changing interest rates leads ... Read Answer >>
  4. How does monetary policy impact the cost of debt?

    Learn how monetary policy impacts the cost of debt. This economics lesson explains how the Federal Reserve influences interest ... Read Answer >>
  5. How do open market operations affect the overall economy?

    Understand how open market operations affect the overall economy. Learn how the Federal Reserve uses open market operation ... Read Answer >>
  6. What are the implications of a low Federal Funds Rate?

    Find out what a low federal funds rate means for the economy. Discover the effects of monetary policy and how it can impact ... Read Answer >>
Related Articles
  1. Insights

    Understanding How the Federal Reserve Creates Money

    Read about how the Federal Reserve actually targets and creates new money in the economy, and find out why the savings and loans system magnifies this process.
  2. Trading

    Explaining the Federal Reserve System

    The Federal Reserve System is the central bank of the United States. It regulates monetary policy and supervises the nation’s banking system.
  3. Taxes

    The Link Between The Fed, Money, Debt And Taxes

    Assets on the Fed's balance sheet, money supply level, national debt level and economic production should be maintained in equilibrium.
  4. Insights

    7 Misconceptions About The Federal Reserve

    There are many fallacies about the Fed. The following misconceptions are among the most popular.
  5. Investing

    How The U.S. Government Formulates Monetary Policy

    Learn about the tools the Fed uses to influence interest rates and general economic conditions.
  6. Insights

    How Central Banks Control The Supply Of Money

    A look at the ways central banks pump or drain money from the economy to keep it healthy.
  7. Investing

    The Fed's New Tools For Manipulating The Economy

    The economy can be volatile when left to its own devices. Find out how the Fed smoothes things out.
  8. Insights

    How Much Influence Does The Fed Have?

    Find out how current financial policies may affect your portfolio's future returns.
RELATED TERMS
  1. Easy Money

    In the most literal sense, money that is easily acquired. Academically ...
  2. FED Pass

    An action taken by the Federal Reserve that looks to increase ...
  3. Broad Money

    In economics, broad money refers to the most inclusive definition ...
  4. Federal Funds

    Excess reserves that commercial banks deposit at regional Federal ...
  5. Federal Open Market Committee - FOMC

    The branch of the Federal Reserve Board that determines the direction ...
  6. Monetary Base

    The total amount of a currency that is either circulated in the ...
Hot Definitions
  1. Portfolio Investment

    A holding of an asset in a portfolio. A portfolio investment is made with the expectation of earning a return on it. This ...
  2. Treynor Ratio

    A ratio developed by Jack Treynor that measures returns earned in excess of that which could have been earned on a riskless ...
  3. Buyback

    The repurchase of outstanding shares (repurchase) by a company in order to reduce the number of shares on the market. Companies ...
  4. Tax Refund

    A tax refund is a refund on taxes paid to an individual or household when the actual tax liability is less than the amount ...
  5. Gross Domestic Product - GDP

    The monetary value of all the finished goods and services produced within a country's borders in a specific time period, ...
  6. Inflation

    The rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of ...
Trading Center