The Federal Reserve Board utilizes three basic methods in its alteration of the money supply:
- Through Its Control of the Fractional Reserve Requirements. The fractional reserve requirement is the control that would have kept Gaffney Goldsmith from loaning out too much of his gold, i.e., each lending institution is required to maintain a certain percentage of its deposits in reserve, either in their own vaults or on deposit in one of the Federal Reserve Banks. The Fed has the right to raise or lower the percentage of those reserves within congressional limits. Quite simply, if the Fed requires the bank to retain a larger percentage of the deposits, then there is less money to be loaned out, thus the money supply tends to fall or shrink. If the reserve requirement is lowered, then the money supply tends to expand and it is easier for you to borrow the bank’s money.
- Through Its Control of the Discount Rate. Banks not only use their customer’s money, but they also borrow money from the Fed. The rate at which banks borrow money from the Federal Reserve is known as the discount rate. As the discount rate is lowered, it becomes more attractive for the banks to borrow. The banks borrow so that they can loan more money out to their customers. When money is loaned out to the borrowers, the money supply expands. When the discount rate is increased by the Fed, there is a tendency for the banks to borrow less. Therefore, there is a tendency for the banks to loan out less to their customers, and the money supply tends to shrink. The prime rate is the rate of interest charged by a bank to its best customers. Prime rate is largely determined by the Fed’s discount rate and the customers’ demand for money. If the prime rate gets too high, it becomes impractical for the customers to borrow.
- Through Its Activities of Buying or Selling Notes and Securities of the U. S. Treasury. This procedure will be explained in detail in the next section. But let it be simply stated here that the most dramatic method for altering the money supply is through the monetizing of the Government’s deficit spending by the Federal Reserve System!
It is very important for you to take the time to understand the concept of Money and to learn the functions of the Banking System. Without that knowledge it will be impossible for you to understand and appreciate the origin and effect of perhaps the most serious threat to any economy . . . inflation!
Next Week: What do you believe to be the cause of inflation?
(Research ideas from Dr. Jackson’s new writing project on Cultural economics)