M3 101 (Or, the basic scoop I learned on how the money supply is regulated):
The Fed manages the money supply in three ways:
1. Reserve Requirements.
Commercial banks must retain a percentage of money to back up the customers' deposits. These retained funds are placed on deposit in that particular bank's account at the Federal Reserve Bank. Any money the commercial bank has in excess of it's reserve requirement, can be lent out as corporate or personal loans. For example, if the Bank of Dapper Dave has 100 million in deposits and the Fed's reserve requirements are 12%, the bank can lend 82 million to justabid.com so long as it deposits 12 million in a reserve account at the Fed.
So, to manage the money supply, the Fed could direct public banks to increase reserves. In effect, more money would be put on ice in a type of a “savings account” and thus unavailable to lend for corporate capital equipment needs, consumer purchases, or margin accounts. Conversely, if the Fed decreases reserve requirements, more money is available to be loaned out with the potential that it will be used to grow the economy.
Since changes in the reserve requirements blankets the whole banking system—it is a blunt instrument—the Fed uses this management tool sparsely.
2. Discount Rate.
The Fed will loan money to individual banks that may then be placed in the bank's reserve account at the Fed. The loan rate the Fed applies to this money is called the discount rate. For example, if the Bank of DD has 12 million on reserve but takes on 1 million in a loan from the Fed and places this on deposit in its (Bank of DD) reserve account at the Fed, it can increase its loan to justabid.com an additional 8 hundred and 20 thousand. (Justabid.com may need this much money, actually. I've heard rumours that it is chasing after some pretty high priced talent for its executive floor. And, the clothes that guy Lars wears!)
The Fed could increase the discount rate, thus making the banks pay more to rent this extra money reserve money. But, the Fed does not lend for this purpose willy-nilly. In fact, it is very tight with these loans—Banks are only allowed to borrow small amounts to cover simple deficiencies in their reserve accounts that crop up in the course of daily business. Since this is the case, changes in the discount rate serve more as signals about the Fed's intentions regarding the economy and less as direct drivers of the money supply.
3. Open Market Operations.
Here is where the Fed really twirls the dials. Are you ready for some pecuniary prestidigitation?
In its open market operations, the Fed buys and sells government bonds. When the Fed buys bonds from securities dealers on the open market, the purchases are paid for with Fed cheques. (Yep, that's how the “cheques” is spelled in Canada.)
The securities dealers then put the cheques on deposit in their commercial banks. The banks then place the funds into their reserve accounts at the Fed and, having gained reserves, are allowed to issue additional loans. When the Fed goes on a bond buying spree, it is called monetising the debt. My Concise Oxford dictionary defines “monetising” thus: ‘to put into circulation as money.' In this process, government debt which was tied up in bonds, has now been placed back into circulation and used to grow the economy.
Run that by me again? The Fed buys government debt on the open market with government cheques and there is less government debt in the form of fewer outstanding bonds but it (the government, the Fed) had to buy the bonds somehow, with debt or something or….. Man, this is too much! <vbg>
On a serious note however, this still leaves me unclear regarding how, exactly, the monetised debt gets into the stock market. And, writing about the Fed's recent actions, if it has stopped monitising the debt (or substantially reduced its monetisation), then how exactly will this choke off the speculative fever in the equities markets? Is the answer as simple as, “tight money means that businesses will be less able to make capital equipment purchases and thus less able to hire more workers and increase their production and sales? And, furthermore, the ‘smart money' knows this and will therefore expect that corporate profits will slacken down the road and will therefore sell off stocks?”
Ciao,
David Todtman
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