How Central Banks Can Increase or Decrease Money Supply

Monetary Policy Tools

Central banks use several different methods to increase or decrease the amount of money in the banking system. These methods are referred to as monetary policy. While the Federal Reserve Board—commonly known as the Fed—could print paper currency at its discretion in an effort to increase the amount of money in the economy, this measure is not used, at least not in the United States.

The Federal Reserve Board of Governors is the governing body that manages the Federal Reserve System, which is the U.S. central bank. It is responsible for controlling inflation and managing both short-term and long-term interest rates through monetary policy activities.

It does so to strengthen the economy and to "promote maximum employment, stable prices, and moderate long-term interest rates." Controlling the money supply is an important tool that the Fed uses to carry out its responsibilities.

Modifying Reserve Requirements

The Fed can influence the money supply by modifying reserve requirements, which refers to the amount of funds banks must hold against deposits in bank accounts. By lowering reserve requirements, banks are able to loan more money, which increases the overall supply of money in the economy.

Conversely, by raising the banks' reserve requirements, banks must keep more money in reserve. In this way, the Fed is able to reduce the size of the money supply.

Changing Short-Term Interest Rates

The Fed can also alter the money supply by changing short-term interest rates. By lowering (or raising) the discount rate that banks pay on short-term loans from the Federal Reserve Bank, the Fed effectively increases (or decreases) the liquidity of the banking system.

Lower rates increase the money supply and boost economic activity. However, decreases in interest rates can fuel inflation. So the Fed must be careful not to keep interest rates too low for too long.

In the period following the 2008 economic crisis, the European Central Bank kept interest rates either at zero or below zero for too long. That negatively impacted European economies and their ability to grow in a healthy way.

Although this action did not consign any country to economic disaster, it has been considered by many to be a model of what not to do after a large-scale economic downturn.

Conducting Open Market Operations

Lastly, the Fed can affect the money supply by conducting open market operations. These affect the federal funds rate. In open market operations, the Fed buys and sells government securities in the open market.

If the Fed wants to increase the money supply, it buys government bonds. This supplies the securities dealers who sell the bonds with cash, increasing the overall money supply.

Conversely, if the Fed wants to decrease the money supply, it sells bonds from its account. Doing so takes in cash and removes money from the banking system. Adjusting the federal funds rate is often a heavily anticipated economic event.

The Bottom Line

The U.S. central bank has a variety of monetary policy tools that it can use to alter our nation's money supply. Three well-known ways that it increases or decreases the amount of money in our banking system are:

• Conducting open market operations, during which it buys or sells Treasury securities
• Raising or lowering the discount rate to affect bank borrowings at the Fed
• Modifying the amount of reserves that banks must keep on deposit at the Fed

By increasing or decreasing the money supply, the Fed aims to maintain stable prices and moderate interest rates, as well as to promote maximum employment.