The Federal Reserve System uses monetary policy to control cycles in the economy, to eliminate or lessen the severity of recessions or inflations. During recessions the Fed will increase the money supply, assuming that consumers and businesses will spend the newly created money and the economy will grow. During inflations the Fed will decrease the money supply and consumers and businesses will spend less money because they won’t have as much.
The Fed employs three “tools of monetary policy” in their attempts to change the amount of money in circulation. The first is “open market operations,” the buying and selling of government bonds. The Fed buys back bonds, sends money to the seller and expects the seller to spend it and grow the economy. The Fed can sell bonds to banks or consumers and take their money so that the buyer can’t spend it. The second tool is the “discount rate,” the interest rate at which the Fed lends money to member banks. At a lower rate banks will borrow more money and then lend it to customers eager to borrow. At a higher rate the opposite is true. Neither banks nor their customers will want to borrow money at high rates. You will remember from “How Banks Create Money” that the new money must be lent a bank before money is actually created. The third is lowering the “reserve ratio,” the amount of money the bank must keep on reserve to protect itself from runs by customer trying to get their money before the bank goes broke. Bank runs are a part of my family history. My parents (my father was a timber foreman) lived at a logging camp twenty-some miles from the nearest town, Perry, FL. As the Great Depression (the real one) started, my mother needed new shoes. My parents took the difficult journey to town over unpaved sand roads to draw out their savings of $50.00 from the local bank, using perhaps two bucks of their savings to buy shoes. They had also heard of runs on the bank. When they got to town they found the bank closed. They lost their $50.00 and my mother never got her new shoes.
So what is the Fed up to now? They have been busily trying to increase the money supply to recover from the “great recession,” so called because a second “great depression” did not occur. The Fed has been buying back government bonds from banks in QE’s (quantitative easings) one, two, three and four, and maybe more to come at the rate of $85 billion a month. Banks would then lend the newly found money to consumers and businesses to increase the money supply and stimulate the economy. They have decreased the interest rates to nearly zero, figuring banks would lend money to consumers and businesses that would be eager to borrow at little or no interest. They weren’t. But what about the required reserve ratio? In order to grow the economy, the Fed should decrease the requirement, even though such changes are rarely used as a tool of monetary policy because of resulting heartburn in bank accounting. A major purpose of the RR is to allow banks to survive runs by depositors (remember my mother never got her new shoes). The current reserve ratio is 3% of total assets for small banks and 10% for large banks. The Fed now is considering a change to require banks to hold more cash. Instead of the percentage requirement, the Fed would require large banks to hold enough cash to fund their operations for 30 days, small banks for 21 days. What is the Fed expecting? A new depression with bank runs?

Posted by at November 13, 2013
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