Essay on The Money Supply Is Determined By Interactions
Central banks manipulate money supply in the economy by controlling its money liability called the monetary base (MB). MB, in fact, equals to the total currency in circulation (C) plus
Reserves (R) which are cash in banks’ vaults and commercial banks’ deposits with the Fed.
When the Fed engaged in Open Market Operation (OMO), they are controlling the MB by selling and buying any securities, but in most cases, Fed prefers government bonds over other assets. If the Fed wants to increase MB, it buys securities from the banks or other primary dealers. For instance, let’s say if the Fed buys $1 million worth of government bonds, the banking system would lose $1 million worth of bonds but gain $1 million of reserve. Likewise, when the Fed wants to decrease MB, it sells securities in which the banking system would lose reserves but gain securities. In addition, the Fed can also increase MB through offering loan, but when the borrowers repay loans, MB is normally lowered.
It is, however, important to note that the Fed only controls the size of MB but not the money supply because , in other words, each $1 of additional MB creates some multiple (m) of new deposits through the process known as multiple deposit creation.
Fractional Reserve banking system makes multiple deposit creation possible. For…