Money Supply

By John T. Harding  

 Money is the lifeblood of a modern economy. Too much of it, however, puts pressure on the body politic, causing high prices for goods and services, eventually creating a bubble which can block a trade artery, leading to an economic aneurysm and the political equivalent of stroke or cardiac arrest.
   Not enough money means an anemic economy, unable to grow because people don't have the wherewithal to buy stuff. In extreme cases, this leads to a barter economy.
   So how much money is enough, and who decides? A central bank, that's who.
   In the U.S., the monetary decider in chief is the Federal Reserve Board, an independent government agency popularly known as the Fed, with headquarters in Washington and twelve regional Federal Reserve Banks throughout the country.
   In addition to deciding how much money should be in circulation, the Fed's mission is to be a lender of last resort for local banks that may be strapped for cash, and to monitor the financial health of banks under its supervision to ensure they stay healthy. Along the way, the Fed adjusts the supply of money available, in order to 1/ control inflation and prevent soaring prices for goods and services, and 2/ encourage or discourage lending so the overall economy grows at a moderate, healthy rate.
   It's a difficult job, and calls for constant monitoring and tweaking of the money supply and interest rates in the hope that, in a reasonable time, the economy will react as desired. (How long is a reasonable time? Ay, there's the rub. That, too, requires constant monitoring and tweaking.)
   So how does the Fed do its tweaking, and why should we care?
   Second question first. We should care because what the Fed does, through its monetary policy, can strongly influence the overall economy of the nation. The other major influence is fiscal policy, or the amount of money the government spends.

Tweak this

   First, banks cannot lend out all the cash they have on deposit, but must keep a reserve of cash available for depositors to draw on, as well a cash reserve, usually a percentage of assets, which they forward to the Fed for safekeeping. Hence the name Federal Reserve.
   The Fed's ability to adjust this percentage is one way of increasing or decreasing the total amount of money in circulation. Another is through its "open market" operation, where the Fed buys or sells government bonds, thus adding to or reducing the money supply. The concept is simple: When the Fed buys, it puts money into circulation; and when it sells, it takes money out. It sells bonds and keeps the cash.
   In fiddling with the supply of money in circulation, the central bank does two things: It raises or lowers interest rates, and secondly, it tries to control inflation, which is the price of everything else.
   The interest rate is nothing more than the price one pays to borrow money. And money, as with any other commodity, is subject to the Law of Supply and Demand. When the supply goes up, the price (interest rate) goes down. So by increasing the supply of money, the Fed hopes to push the interest rate down. In turn, this is supposed to encourage companies to borrow money for investment in new projects, or for people to purchase homes, automobiles and other stuff, which in turn boosts the economy out of recession.
   The risk of too large a money supply (inflation) is that overall prices go up to absorb the amount of money available.
   That's not the major problem facing the American economy today, however. The Fed has pushed interest rates to near zero for major borrowers, and home mortgage rates are at an all-time low. But still the economy is in a rut.
   Bottom line: Monetary policy has not been enough to restart the American economy. Cheap money is not encouraging new investment by the private sector. What's left is fiscal policy, or new investment by the public sector.