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Monetary policy

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The Federal Reserve implements monetary policy by manipulating the money supply.

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Money Aggregates There are different kinds of money in the economy. The main categories are

  • M1: Currency, Traveler's checks, Demand Deposits (checking accounts)
  • M2: M1 + small Savings deposits, Money market mutual funds
  • M3: M2 + Large deposits, repo[?] (Repurchase agreements)

How is money created When money is deposited in a bank it can then be loaned out to another person. If the inital deposit was $100 and the bank loans out $100 to another customer the money supply has increased by $100. However, because the depositer can ask for the money back, banks have to maintain minimum reserves to service customer needs. If the reserve requirement is 10% then in the earlier example the bank can only loan out $90 and thus the money supply increses only to $190. This relationship between increase in money supply and reserve requirement is expressed as:

 m = 1 / RR

where

 m = money multiplier
 RR = reserve requirement

Federal Reserve and Money Supply The Federal Reserve has two main mechanisms for manipulating the money supply. It can sell treasury securities. When it sells treasury securities it reduces the money supply (because it accepts money in return for a promise to pay in the future). It can purchase treasury securities. When it purchases treasury securities it increases the money supply. Finally, the Federal Reserve can adjust the reserve requirement. The reserve requirement is indirectly related to the money multiplier as show above.

Money Supply, Interest rates and the Economy When the money supply increases interest rates go down. When interest rates go down businesses and consumers have lower cost of capital and can increase spending and capital improvement projects. This helps the economy. Conversely, when the money supply falls the interest rates go up and reins in the economy. The Federal reserve increases interest rates to combat inflation.

See also: Monetary policy of Sweden



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