Do you know how the Federal Reserve "pumps" money into the economy? Recently, the news media have reported that the Federal Reserve has "pumped" money into the economy, but they do not explain exactly how the Fed does this.
One of the fundamental functions of government is to control the money supply. The more you understand how governments control the amount of money in the economic system, in a global economy, the better you can take control of your own personal economic system.
Every nation has a central bank. In the United States, the central bank is the Federal Reserve. The central banks pay attention to the condition of the current economic conditions, and then take actions to either heat up or cool down the economy.
You might hear that the Fed is "pumping money" into the economy to calm fears of an economic panic. At other times, you will hear that the Fed will "drain money" from the system, to cool it down. Although the news media uses such language, they don't explain exactly how the Fed increases or decreases the amount of money.
First, let's make clear that Fed does not pump more money into the system by printing more currency. Currency is not the same as money.
The Fed has several methods to control the amount of money in the system.
The first tool the Fed uses is to adjust the reserve requirement of banks. The "reserve" is the portion of customer deposits that the bank must keep. It cannot loan all of its deposits.
If you deposit $1,000 in the bank, the bank makes money by loaning out most of your $1,000 to other customers. However, the bank cannot loan the full $1,000 amount.
The Federal Reserve sets the reserve requirements for banks. The banks must keep 3-10% of customer deposits on reserve. This means that the bank needs to keep on reserve only 3-10% of your $1,000. With a 10% reserve, the bank must keep $100 on reserve. That means it can loan out the remaining $900. With a 3% reserve, the bank must keep only $30 on reserve. It is allowed to loan out the remaining $970.
The Fed can use the reserve requirements to control the amount of money banks have available to loan. If the Fed wants to increase the amount of money in the economy, it reduces the reserve requirements. If it wants to decrease the amount of money, it increases reserve requirements. This is how the Fed "pumps" money into the system and "drains" money from the system.
With a lower reserve requirement, the bank has more money to loan. With a higher reserve requirement, the bank has less money to loan. This is the difference between loaning out 97% of its deposits with a 3% reserve rate and 90% of its deposits with a 10% reserve rate. The changes in reserve rates increase and decrease the money supply.
So even though the media talk about the Fed "pumping" more money into the economy, this language is a bit misleading. The banks do the "money-pumping" when the Fed allows banks to loan out a higher percentage of its deposits. This is one way the Fed controls the amount of money in the economic system.
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