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Recent news reports announce that Federal Reserve has "pumped" money into the economy, without making clear what this means. Do you know how the Federal Reserve "pumps" money into the economy? Controlling the amount of money in the system is one of the most important functions of a government. Money is never simply personal. It is a matter of government policy. The more you understand how governments increase and decrease the amount of money available, the more you will be able to control your personal economy. Every nation has its own central bank. One of the functions of a central bank is to respond to current economic situations to either cool down or heat up the economy. In the United States, the central bank is the Federal Reserve. The news media use colorful language to say that the Fed is "pumping money" into the economy to calm fears of an economic panic. In other situations, the media refer to actions of the Fed intended to "drain money" from the system. Even though the media report that the Fed "pumps" money or "drains" money, they don't explain clearly how the Fed does this. How exactly does the Fed increase or decrease the amount of money? First, it's important to be clear what it does NOT mean. The Fed does not pump more money into the system by printing more currency. Currency is not equivalent to money. The Fed has several tools it can use to decrease or increase the amount of money in the system. One method involves the reserve requirements for banks. A bank must keep a portion of its deposits on reserve. In other words, the bank can only loan out a percentage of its deposits as loans. The percentage it cannot loan out is the reserve. Banks make money by loaning out customer deposits to other customer deposits. This means that if you deposit $1,000 in the bank, the bank loans most of your money to other customers. However, the bank is not allowed to loan out the full $1,000. The Federal Reserve requires banks to keep on reserve 3-10% of its deposits, and allows the banks to loan the rest. In the case of your $1,000, this means that the bank needs to keep only 3-10% of your $1,000 on reserve. With a 3% reserve, the bank must keep only $30 on reserve, and is allowed to loan out the remaining $970. With a 10% reserve, the bank must keep $100 on reserve and is allowed to loan out only $900. If the Fed wants to increase the money supply, it can reduce the reserve rate. If the Fed wants to decrease the amount of money in the system, it increases the reserve requirements. This simple example demonstrates how the process works, and how the Fed pumps money into and drains money out of the system by changing the reserve requirements. With a lower reserve requirement, the bank has more money to loan. With a higher reserve requirement, the bank has less money to loan. This is the difference between loaning out 97% of its deposits with a 3% reserve rate and 90% of its deposits with a 10% reserve rate. The changes in reserve rates increase and decrease the money supply. It is a bit misleading to claim that the Fed "pumps" money into the system. In fact, the Fed allows the banks to "pump" more money into the system, because the Fed has reduced the reserve rate. The lower the rate, the more money the banks can pump into the system. The ability of the Fed to change reserve requirements is one powerful tool Fed uses to control the amount of money in the economy.
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