Federal Reserve Tools, Money Supply, and Monetary Policy

Are Credit Cards and Debit Cards Money?

Credit cards and debit cards are not money; they are financial instruments that facilitate transactions in which money is exchanged. Both types of cards represent a convenient way to access and spend funds held in a bank account — or made available through a line of credit. Because they access different types of accounts, they function differently (Chand, n.d.).

First, what is money? Money is a medium of exchange, a unit of account, and a store of value (Beattie, 2022). It comes in various forms, such as cash, coins, or digital currency (Chand, n.d.). Debit cards are linked to a bank account; when a transaction is made using a debit card, funds are directly withdrawn from that account. Because the transaction draws on funds the cardholder already owns, a debit card can be thought of as an electronic form of cash — but the key point is that the money is the cardholder's own and is drawn directly from their account.

Credit cards, on the other hand, allow the cardholder to borrow money from the card issuer — usually a bank — to make a purchase. Using a credit card is essentially taking out a short-term loan that must be repaid later, often with interest if the balance is not paid in full by the due date.

In both cases, the cards themselves are not money. Rather, they are a means of accessing and using money held in accounts or obtained through borrowed funds.

What Happens When the Fed Makes an Open Market Purchase

The claim that "when the Fed makes an open market purchase of government securities, the quantity of money will eventually decrease by a fraction of the initial change in the monetary base" is incorrect. When the Federal Reserve makes an open market purchase of government securities, the quantity of money typically increases, not decreases. This statement appears to have confused the impact of an open market purchase with that of an open market sale (Amadeo, 2021).

Open market operations are one of the tools the Fed uses to implement monetary policy. When the Fed purchases government securities — such as Treasury bonds — from banks and other financial institutions, it pays by crediting the reserve accounts of those institutions. This process increases the monetary base, which consists of currency in circulation and reserves held by banks at the Fed.

An increase in the monetary base leads to an increase in the money supply through the money multiplier effect. The money multiplier describes the relationship between the monetary base and the broader money supply, and depends on the reserve requirement ratio and banks' willingness to lend. When banks hold more reserves, they can make more loans, creating new deposits and thereby expanding the money supply.

This process can also be inflationary. If the money supply increases rapidly, prices may rise to offset the sudden influx of money in circulation. Recent history offers clear illustrations: the various market bubbles that followed the Fed's open market operations — also known as quantitative easing (QE) — include the housing bubble, the stock market bubble, and what commentators have called the "everything bubble" (Amadeo, 2022).

The Fed's Monetary Policy Tools

The Fed can use several tools to influence the money supply and indirectly affect the level of real GDP. The three main tools it can employ to increase the money supply are open market operations, the discount rate, and reserve requirements. Each allows the Fed to perform a distinct function (Board of Governors of the Federal Reserve System, 2023).

Open market operations (OMOs) are a key tool used by the Federal Reserve to implement monetary policy. By buying or selling government securities in the open market, the Fed can influence the money supply and interest rates, which in turn affect overall economic activity. When the Fed wants to increase the money supply and stimulate economic growth, it conducts expansionary open market operations by purchasing government securities.

Open Market Operations

The process works as follows. First, the Fed decides to purchase government securities — such as Treasury bonds — from banks and other financial institutions. These transactions are conducted through the Federal Open Market Committee (FOMC), which is responsible for open market policy decisions. When the Fed buys these securities, it pays by creating new reserves, which are credited to the reserve accounts of the selling institutions. This effectively increases the amount of reserves in the banking system and expands the monetary base.

With more reserves at their disposal, banks are able to extend more loans to businesses and consumers. As banks make more loans, they create new deposits, which leads to an increase in the broader money supply — for example, M1 or M2. This is the money multiplier effect. The increased money supply puts downward pressure on interest rates, as banks compete to lend their excess reserves. Lower interest rates make borrowing more attractive for businesses and consumers, encouraging investment, expansion, and spending (Board of Governors of the Federal Reserve System, 2023).

As borrowing and spending increase, businesses respond by raising production and hiring more workers to meet growing demand. This increase in economic activity leads to higher real GDP — the measure of an economy's output adjusted for inflation. However, the Fed must carefully monitor the effects of these actions to avoid causing excessive inflation or overheating the economy.

Conclusion

When the Fed implements expansionary monetary policy by increasing the money supply, the goal is to stimulate economic growth, reduce unemployment, and avoid deflationary pressures. The trouble is that this policy can also carry significant downsides: it can create inflationary pressures if the economy is already operating near full capacity, and it can prop up economically unviable firms and households. Neither outcome is beneficial in the long run.