The Fed and the Money Supply Financial managers and investors are interested in the supply and

The Fed and the Money Supply Financial managers and investors are interested in the supply and

demand for money because it is the interaction of supply and demand that ultimately affects the interest rates paid to borrow funds and the amount of interest earned on investing funds. The demand for money is determined by the availability of investment opportunities. The supply of money is determined, in large part, by the actions of a nation’s cen- tral bank.

The decisions of the Fed affect the money supply of the United States. The money supply consists of cash and cash-like items. In fact, there are different definitions of the money supply, depending on the cash-like items you include. For example, the most basic definition of money supply, M1, consists of:

■ cash (currency and bills) in circulation, ■ demand deposits (non-interest earning deposits at banking institutions

that can be withdrawn on demand), ■ other deposits that can be readily withdrawn using checks, and ■ travelers’ checks.

A broader definition of money supply is M2, which consists of every- thing in M1, plus

■ savings deposits, ■ small denomination time deposits, ■ money market mutual funds, and ■ money market deposit accounts.

A still broader definition of money supply is M3, which consists of everything in M2, plus:

■ large denomination time deposits, ■ term repurchase agreements issued by commercial banks and thrift

institutions, term Eurodollars held by U.S. residents, and ■ institution-owned balances in money market funds.

FOUNDATIONS

A savings deposit is an amount held in an account with a financial institution for the purpose of accumulating money. A time deposit is a type of savings account at a financial institution. A certificate of deposit (CD) is an example of a time deposit. The term “time” is used to describe the account because originally these accounts required that the saver notify the institution in advance (e.g., 90 days) of making a withdrawal. Though this practice of advance notification is no longer around, the term “time deposit” remains. Money market mutual funds are funds invested in an account that invests in short-term securities. Money market deposit accounts are funds deposited at financial institutions such as a bank or a thrift, that can be readily withdrawn. Eurodollars are deposits of U.S. dollars in foreign banks or in foreign branches of U.S. banks.

The money supply, whether defined as M1, M2, or M3, is managed by the government, and is one of the many tools that the government has to affect the economy. The role of non-M2 elements of the money supply has gained in importance in the money supply over this period, due primarily to the increasing popularity of money market funds.

The Fed affects the country’s money supply and, ultimately, its econ- omy through three devices. One device is a change in the reserve require- ment, the fraction of deposits that a bank accepts that must be held either on deposit with the district Federal Reserve Bank or in cash in the bank’s own vault. The money not held in reserve can be used to make loans and purchase securities. Changing the reserve requirement affects monetary expansion; the lower the reserve requirement, the more funds that can be put into the economy through loans and investments and, hence, the greater the supply of money in the economy. Raising the required ratio reduces the effects of money expansion, and hence the money supply.

Another device is the use of open market operations. The FOMC affects the money supply through its decisions regarding open market operations, which are purchases and sales of government securities by the Fed. Buying securities injects money into the economy; selling secu- rities reduces the amount of money available.

Still another device is the change in the discount rate, the interest rate charged by the Fed for loans to banks for reserves. These loans are secured—that is, backed—by U.S. government securities or other, suit- able collateral. These loans are made by the district Federal Reserve Banks through a source referred to as the discount window. Banks can borrow from the discount window to shore up their reserves for short periods of time (generally less than fifteen days). Increasing the discount rate discourages borrowing by banks, which in turn discourages banks from lending funds. Lowering the discount rate has the opposite effect— encouraging bank lending.

Financial Institutions and the Cost of Money

These three devices are used by the Fed to control the money supply. Since these devices have an effect on interest rates and the availability of loanable funds, many businesses watch the actions of the Fed with great interest.