Federal Reserve Operations and U.S. Money Supply Control

Introduction: The Federal Reserve and Money Supply

The Federal Reserve plays a central role in regulating the U.S. money supply through a set of monetary tools, most notably the discount rate. The discount rate is the interest rate that the Federal Reserve charges on loans it extends to commercial banks experiencing financial difficulty and seeking support. Lending to these banks is processed through the "discount window," which is administered by the individual Reserve Banks.

Factors Influencing Federal Reserve Discount Rate Adjustments

Discount rates provided by the Federal Reserve to borrowing banks are primarily used as tools for controlling the amount of money in circulation within the economy (Wiedemer & Baker, 2012). The Federal Reserve currently uses the discount rate strategy widely and frequently because it is relatively simple to implement and straightforward for the public to understand. In most cases, two conditions prompt the Fed to adjust discount rates: an excess of money supply in the economy, and a shortage of money supply in the economy.

When the Fed decides to increase discount rates, it notifies all lending banks of the change. This increase directly affects the public, as borrowers must pay higher interest on loans. Higher borrowing costs discourage consumers from taking out loans, thereby reducing excess money supply in the economy. The opposite occurs when the Fed reduces discount rates. A reduction leads to lower interest rates charged by banks to borrowers, a measure adopted when the Federal Reserve wishes to stimulate money supply in the economy (Wiedemer & Baker, 2012).

The relationship between Fed discount rates and bank interest rates is straightforward: an increase in the discount rate causes banks to raise their own interest rates, while a reduction in the discount rate lowers bank interest rates, ultimately increasing money supply in the economy (Delaney & Whittington, 2012).

Monetary Policy and Disinflation

Disinflation is defined as a significant reduction in the rate of inflation, and should be distinguished from deflation, which refers to an actual decrease in commodity prices in the market. For disinflation to occur, a short-term sacrifice is required, because the Federal Reserve must implement a contractionary monetary policy. The Fed reduces the money supply — for example, by raising discount rates — which leads to a contraction of aggregate demand. Reduced aggregate demand causes firms to produce smaller quantities of goods and services, and any fall in production levels leads to higher unemployment rates.

At a certain point, inflation rates will be low while unemployment remains high. Eventually, the public perceives the slowdown in price increases, inflation levels fall, and unemployment gradually returns to its original position — achieving disinflation. As illustrated by the Phillips curve, any economy seeking to avoid inflation must be prepared to endure short-to-medium-term effects of higher unemployment and reduced output (Mankiw, 2011).

Monetary Policy Effects on Money Supply

The Fed, which is mandated to oversee monetary policy, adjusts its policies to control money supply in the economy. This is most commonly accomplished through open market operations. The Federal Reserve buys and sells treasury bonds, adjusting money supply by influencing bank reserves. Because the Fed transacts directly in government bond markets, the initial liquidity impact is felt in bond markets, as sellers of bonds to the Fed experience increased liquidity. Changes in money supply subsequently affect the broader aggregate economy (Reilly & Brown, 2011).

Conclusion

The Federal Reserve has the obligation to control inflationary rates in the country, and this can be accomplished through the regulation of discount rates when lending money. Due to the adverse economic consequences of inflation and excess money supply, these conditions must be carefully monitored and managed. The control of inflation and the factors contributing to it can be addressed through either monetary or fiscal policy, depending on the root causes of the inflationary pressure.

References

Delaney, P. R., & Whittington, O. R. (2012). Wiley CPA Exam Review 2012: Business environments and concepts. John Wiley and Sons.

Mankiw, N. G. (2011). Principles of macroeconomics. Cengage Learning.

Mastrianna, F. V. (2009). Basic economics. Cengage Learning.

Reilly, F. K., & Brown, K. C. (2011). Investment analysis and portfolio management (with Thomson One-Business School Edition and Stock-Trak Coupon). Cengage Learning.

Tainer, E. M. (2006). Using economic indicators to improve investment analysis. John Wiley and Sons.

Wiedemer, J. P., & Baker, K. (2012). Real estate financing. Cengage Learning.