Keeping a modern economy running smoothly requires a pilot who’ll keep it from stalling or overaccelerating.

The United States, like most other countries, tries to control the amount of money in circulation.

The process of injecting or withdrawing money reflects the monetary policy that the Federal Reserve adopts to regulate the economy.

Monetary policy isn’t a fixed ideology. It’s a constant juggling act to keep enough money in the economy so that it flourishes without growing too fast.

How fast money goes?

 Money’s velocity is the speed at which it changes hands. If a $1 bill is used by 20 different people in a year, its velocity is 20. An increase in either the quantity of money in circulation or its velocity makes prices go up — and, when both increase, an even larger jump typically occurs, driving prices significantly higher.

How it works

Changes in monetary policy tend to be gradual, though over a period of months it may change course.

The Fed can initiate a shift in monetary policy by:

  1. Ordering the Federal Reserve Bank of New York to buy or sell government securities on the open market.
  2. Adjusting the credit it extends to banks through the discount window.
  3. Changing the reserve requirements of depository institutions
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Changing the supply

About 11:15 a.m. every day, the New York Fed decides whether to buy or sell government securities to implement the Federal Reserve’s Federal Open Market Committee (FOMC) policy decisions.

To slow down an economy where too much money is in circulation, it sells securities, taking in the cash that would otherwise be available for lending. To give the economy a shot in the arm, it creates money by buying securities. There isn’t any limit on the amount of money the Fed can create and it can — and does — vary.

The Fed’s reserve requirement makes banks hold a percentage* of certain accounts in cash to cover any unusual demand from customers.

*Reserve 10%

Putting policy to work

When the FOMC implements monetary policy it impacts the federal funds rate, which is the rate that banks charge other banks for overnight access to the balances in their reserve accounts. Changes in the rate affect other short-term interest rates almost immediately, and also influence long-term rates, the value of the dollar against other currencies, and stock prices.

The dilemma, from the FOMC’s perspective, is that it must rely on estimates to make policy decisions and to assess whether or not the policies it adopts are working. For example, it can’t be certain what effect a change in the federal funds rate will actually have or how soon the economy will respond.

Controlling the Money Flow

Adjusting the rate and creating money

The Fed can also increase or decrease the discount rate, the rate it charges banks to borrow money. If the rate is increased, banks tend to borrow less and have less available to lend. If the rate is decreased, banks theoretically tend to borrow more and lend at attractive rates.

To create money, the New York Fed buys government securities from banks and brokerage houses known as primary dealers. The money that pays for the securities hasn’t existed before, but it has value, or worth, because the securities the Fed has bought are valuable.

  1. More new money is created when the banks and brokerages use the money they receive from selling the securities to lend to customers who spend it on goods and services. These simplified steps illustrate how the process works.
  2. The Fed writes a check for $100 million to buy the securities from a primary dealer. The firm deposits the check in its own bank (A), increasing the bank’s cash.
  3. Bank A can lend its customers $90 million of that deposit after setting aside 10%. The Fed requires all banks to hold 10% of their deposits (in this example, $10 million) in reserve. A young couple borrows $100,000 from Bank A to buy a new house. The sellers deposit the money in their bank (B).
  4. Now Bank B has $90,000 (the deposit minus the required reserve) to lend that it didn’t have before. A woman borrows $10,000 from Bank B to buy a car, and the dealer deposits her check in Bank C.
  5. Bank C can now loan $9,000. This one series of transactions has created $190,099,000 in just four steps. Through a repetition of the loan process involving a wide range of banks and their customers, the $100 million that the Fed initially added to the money supply could theoretically become almost $900 million in new money.

How Does Government Control The Money Flow? by Inna Rosputnia

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