How Does the Federal Reserve Manage Money Supply?


The Federal Reserve (Fed) uses several tools to manage the money supply and in turn control the economy. Money supply essentially means the entire stock of currency as well as liquid assets circulating in an economy i.e. with the public at a particular time. The Fed regulates this money supply to suit the needs of economy to keep it more or less constant.

When the economy faces a slump, Fed increases the supply, where as when the threat of inflation is imminent, Fed reduces the supply to prevent the phenomenon. This continuous regulation ensures a stable growth of economy despite changing market trends on a day-to-day basis.

The tools used to manage money supply include:

Open Market Operations-

This is the most commonly used tool and comes in handy when the money supply is to be regulated. Fed either purchases or sells government securities. To increase the money supply, Fed purchases issued securities like Treasury bills, treasury notes, savings bonds etc. while to reduce the supply, Fed puts up these securities as collateral to get overnight loans from primary dealers in competitive auctions.

This exchange by Fed causes the banks and public to adjust accordingly. Following such an operation, the reserve ratio of a bank is altered and thus necessary measures are taken by the bank to maintain the CRR in form of expanding loans or digressing from it. In turn the money flow in economy gets affected.

Altering Discount Rates-

This is the tool which helps Fed to regulate the borrowing schemes of commercial banks. Discount rates are the rates of interest (different from market rates) charged by Fed when commercial banks need to borrow additional reserves. According to the change in rates charged by Fed, the short-term market interest rates change. A lower discount rate encourages banks to borrow more and thus increasing the money supply while higher rates tend to discourage borrowing and thus reduce money supply.

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Altering Reserve Ratio-

Reserve Ratio also called Cash Reserve Ratio (CRR) refers to the percentage of deposits that commercial banks are required to keep as cash according to the Central Bank policies. A lower reserve ratio increases money supply and vice versa. A lower ratio lets banks have more funds to disburse as loans to the common public and thus more money in circulation while a higher ratio ensures that banks reserve more funds to themselves and comparatively less money circulates in the economy.

The Federal Reserve plays a very important role in how efficiently and smoothly the money is circulated in an economy. The continuous ups and downs of market are to be kept in check and acted upon accordingly to prevent financial crisis and to have a steady economic growth.

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