How The Federal Reserve Manages Money Supply
Throughout history, free market societies have gone through boom-and-bust cycles. While everyone enjoys good economic times, the downturns are often painful. The Federal Reserve was created to help reduce the injuries inflicted during the slumps and was given some powerful tools to affect the supply of money. Read on to learn how the Fed fights recession. (To find out more about recession, see Recession: What Does It Mean To Investors? and Recession-Proof Your Portfolio.) The Evolution of the Fed
When the Federal Reserve System was established, its founders did not intend it to pursue an active monetary policy to stabilize the economy. The basic ideas of economic stabilization policy were foreign at the time, dating only from John Maynard Keynes' work in 1936. Instead, the founders viewed the Fed as a means of preventing the supplies of money and credit from drying up during economic contractions, as happened often in the pre-1914 period. One of the principal ways in which the Fed was to provide such insurance against financial panics was to act as the "lender of last resort". That is, when risky business prospects made commercial banks hesitant to extend new loans, the Fed would step in by lending money to the banks, thus inducing banks to lend more money to their customers.
The function of the central bank has grown and today, the Fed primarily manages the growth of bank reserves and money supply in order to allow a stable expansion of the economy. To implement its primary task of controlling money supply, there are three main tools the Fed uses to change bank reserves:
A change in reserve requirements
A change in the discount rate
A change in reserve ratio is seldom used but is potentially very powerful. The reserve ratio is the percentage of reserves a bank is required to hold against deposits. A decrease in the ratio will allow the bank...
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