1. How does the Federal Reserve System control the money supply?
2. Why is the Fed sometimes called the “banks’ bank”?

The Federal Reserve System monitors the nation’s money supply and tries to exert some influence over it. The exact nature of the relationship between the money supply and inflation is best treated by a panel of learned economists and will be explored in depth in your economics classes. Our mission in this lecture is to discuss three ways in which the Federal Reserve (often called the Fed) tries to alter the money supply.

Reserve Requirement

One of several roles of the Federal Reserve System is to regulate commercial banks that have elected to affiliate themselves with the system. One facet of this control is setting the reserve requirement. As you know, banks maintain accounts for depositors and also lend funds to borrowers. This arrangement works well for commercial banks as long as loaned funds earn more interest for the bank than the bank pays out in interest to the savings and checking customers. The difference is called the spread. A bank earns revenues by lending money. However, the bank’s eagerness to earn might drive it to lend so generously that there might be little cash on hand to allow the bank to perform the services expected by savings and checking customers. The Fed has stepped in to control this eagerness by requiring a commercial bank to keep a percentage of its funds in ready reserve for cash emergencies that might arise.

This reserve requirement can be changed by the Fed as it wishes. Raising the reserve requirement means that commercial banks will be forced to hold larger reserves and thus will be less able to release funds into the economy. Lowering the requirement means that banks have more money and can thus release more funds into the economy. Turning the reserve “spigot” on or off affects the amount of money in circulation.

Discount Rate

Our Federal Reserve System is often called the banks’ bank. This means that when a commercial bank has banking needs, it can turn to the Fed. If a commercial bank needs to borrow funds beyond an overnight period, it may borrow from the Fed. The interest rate the Fed will charge such a commercial bank is called the discount rate. If a commercial bank seeks to help a customer with a financing problem and borrows funds for that purpose from the Fed, the interest rate the bank charges its customer will reflect the discount rate the Fed has charged the commercial banks. If the Fed raises the discount rate, that increase will be passed on to the commercial bank’s customer. Such an increase can discourage borrowing, and limiting borrowing can cut down on funds going into the nation’s money supply. On the other hand, lowering the discount rate will make banks more capable of lending “cheap” money, thus adding to the money supply.