When you were a child, your parents probably told you, "Money doesn't grow on trees." Now that you are all grown up, you should know where it does come from. (It is very likely to be on the exam.)

Learn more about how the Fed is structured, who Alan Greenspan is, monetary policy and more within the Federal Reserve Board tutorial.

Fiscal Policy
First things first: money does not come from the government. By proposing and passing a federal budget, the president and Congress, respectively, control the country's fiscal policy. That is where Keynesian theory lives in the form of government purchases.

Monetary Policy
Monetary policy is the creature of the Federal Reserve, or "the Fed", the U.S. quasi-governmental, independent central bank. Although the greenback bears the signature of the U.S. Secretary of the Treasury and of the Treasurer, it is the Fed that actually authorizes the printing of money.

The Fed controls the level of business activity in the U.S. in order to prevent or limit the effects of recessions - specifically, inflation and unemployment. It does so through the following means:

  • Reserve Requirements: When you deposit money in a savings account, the bank is not bound to keep every penny on hand at the branch in case you want to withdraw your entire savings tomorrow. After all, the bank makes money by taking that deposit and reinvesting it in something with a higher yield.

    • There is a balance to be struck; that is why the Fed requires banks to maintain reserves - either in the bank's vault or in the Fed's - to meet depositors' demands.

    • These reserves are expressed as a percentage of the deposits. If the Fed mandates that a higher proportion of deposits be kept on reserve, then banks will have less cash to invest elsewhere. Thus, increasing the reserve requirements reduces the supply of money. Conversely, lowering these requirements allows banks to lend more money, primarily by extending more loans, thus increasing the money supply.

  • Open-market Operations: Traditionally, the Fed is the biggest buyer of U.S. Treasury securities, that is, of the national debt. But the Fed decides for itself just how much to buy.

    • The more Treasury instruments the Fed buys, the more money it injects into the economy.

    • This is true whether the counterparty is the Treasury itself or whether the transaction takes place on the secondary market.

    • If the Fed decides to decrease the money supply, it sells its current Treasury holdings.

  • Discount Rate: The interest rate that banks pay on loans from the Fed determines the interest rates they can charge their own borrowers. The Fed's board determines this discount rate monthly. Increasing the discount rate decreases the money supply, and reducing the rate increases it.


    Look Out!
    Do not confuse the discount rate with the Fed funds rate. The Fed sets the discount rate. "Fed funds rate" is a misnomer; it is actually the rate the largest U.S. banks charge each other short-term to borrow reserve funds.


    You should be aware that the Fed also sets policies determining how much a brokerage firm can lend its customers.

Restrictive vs. Expansionary Monetary Policy
When the money supply is reduced, the Fed's monetary policy is said to be "restrictive"; when the money supply is increased, the policy is called "expansionary".

  • Restrictive policy is intended to prevent or curb inflation by taking excess money out of the economy. Just as too many shares of stock dilutes a company's equity and makes each share worth a little less, every Federal Reserve note backed by the full faith and credit of the United States makes all greenbacks worth a little less.

  • A restrictive policy will also have the effect of raising interest rates because while demand for money is constant, supply is being trimmed and the law of supply and demand holds. Prices go up under such circumstances, and interest is nothing more or less than the price of money.

  • Conversely, expansionary policies will tend to drive down interest rates.
International Economic Factors

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