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Understanding Money


How the Fed Creates and Destroys Money
Part II

The main way in which the Fed manipulates the money supply is by buying and selling bonds, as I have described in the previous section. However, for completeness, I would like to mention that there are two other ways in which the Fed can raise or lower the money supply.

First, as I explained, the percentage of money that a bank must keep in reserve is dictated by the reserve rate. For instance, if the reserve rate is 10%, a bank must reserve 10% of its deposits. This is money that cannot be loaned out.

One way the Fed can change the money supply is by raising or lowering the reserve rate. For example, if the Fed were to lower the reserve rate, banks would be able to loan out more of their deposits, which would increase the money supply. Modifying the reserve rate, however, is a big deal, and the Fed rarely does it.

The other way in which the Fed can affect the money supply has to do with the actual cash that is on reserve. The Fed is itself a bank and, by law, all the money that the regular banks hold in reserve must be deposited at the Fed itself. For example, let's say that, on a particular day, a bank is required to have $100 million on reserve. That $100 million dollars is kept in an account at the Fed in the name of that bank. From day to day, as the amount of money held by banks changes, the amount that each bank must keep on deposit at the Fed changes as well.

On a particular day, a bank may find that it does not have quite enough money on deposit to the Fed to meet its reserve obligation. Similarly, another bank may find that it has a surplus. When this happens, the second bank may loan money to the first bank. Most of the time, such loans are made for only a single day.

Now, as it happens, even though the Fed requires banks to keep all their reserve money in the Fed's bank, the Fed does not pay interest on that money. However, a bank that loans money overnight to another bank is allowed to charge interest. Thus, banks with a reserve surplus are always happy to lend money to banks with a reserve deficit.

The rate at which banks may lend each other reserve money is set by the Fed and is called the FEDERAL FUNDS RATE. From time to time, you may hear that the Fed is raising or lowering the "interest rates". What they are really doing is changing the federal funds rate.

Although this rate applies only to very specific, short-term, bank-to-bank loans, it tends to affect other interest rates in the economy. For this reason, people make a big fuss when the Fed changes the rate. However, in reality, the federal funds rate has less effect on the money supply than the buying and selling of bonds, something the Fed does every day.

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