Do You Know How The Fed Pumps Up The Money Supply?

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Do You Know How The Fed Pumps Up The Money Supply?

By: Kalinda Rose Stevenson, PhD...

Do you know how the Federal Reserve "pumps" money into the economy? Recently, the news media have reported that the Federal Reserve has "pumped" money into the economy, but they do not explain exactly how the Fed does this.

You might be wondering how this matters to you. The fact is that the more you understand how governments control money, the better you will be able to take control of your own economic situation, especially in a global economy. One of the primary functions of a government is to control the amount of money in the system.

Every nation has its own central bank. One of the functions of a central bank is to respond to current economic situations to either cool down or heat up the economy. In the United States, the central bank is the Federal Reserve.

The news media use colorful language to say that the Fed is "pumping money" into the economy to calm fears of an economic panic. In other situations, the media refer to actions of the Fed intended to "drain money" from the system. Even though the media report that the Fed "pumps" money or "drains" money, they don't explain clearly how the Fed does this. How exactly does the Fed increase or decrease the amount of money?

First, it's important to be clear what it does NOT mean. The Fed does not pump more money into the system by printing more currency. Currency is not equivalent to money.

The Fed can control the money supply with several methods.

One method involves the reserve requirements for banks. A bank must keep a portion of its deposits on reserve. In other words, the bank can only loan out a percentage of its deposits as loans. The percentage it cannot loan out is the reserve.

Banks make money by loaning out customer deposits to other customer deposits. This means that if you deposit $1,000 in the bank, the bank loans most of your money to other customers. However, the bank is not allowed to loan out the full $1,000.

The Federal Reserve sets the reserve requirements for banks. Typically, the reserve ranges from 3-10% of its deposits. So, with your $1,000 deposit, the bank needs to keep on reserve only $30 with a 3% reserve and $100 with a 10% reserve. The bank is free to loan out whatever is left after the reserve requirement. With a 3% reserve the bank can loan out $970 of your money. With a 10% reserve, the bank can loan out only $900.

The Fed can use the reserve requirements to control the amount of money banks have available to loan. If the Fed wants to increase the amount of money in the economy, it reduces the reserve requirements. If it wants to decrease the amount of money, it increases reserve requirements. This is how the Fed "pumps" money into the system and "drains" money from the system.

With a lower reserve requirement, the bank has more money to loan. With a higher reserve requirement, the bank has less money to loan. This is the difference between loaning out 97% of its deposits with a 3% reserve rate and 90% of its deposits with a 10% reserve rate. The changes in reserve rates increase and decrease the money supply.

So even though the media talk about the Fed "pumping" more money into the economy, this language is a bit misleading. The banks do the "money-pumping" when the Fed allows banks to loan out a higher percentage of its deposits. This is one way the Fed controls the amount of money in the economic system.

Article Source: http://www.find-investment-advice.com

Kalinda Rose Stevenson, Want to find out how investors use money? Learn how in a real estate investing book about the world's most well-loved board game. How would you like a www.accesstoprivatemoney.com">private money investor for huge projects?

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