Takeaway

To return to the opening of this chapter, we now have a sense why the Fed chairperson is (possibly) the second most powerful person in the world. The Federal Reserve is the government’s bank and the banker’s bank, and it has the power to create money. The ability to create money, regulate the money supply, and potentially lend trillions of dollars means that the Fed has significant powers to influence aggregate demand in the world’s largest economy.

The concept of “the money supply” can refer to several different measures. It is important to know the major definitions of the money supply and how they differ. The Fed controls the money supply by buying and selling government bonds in what are called open market operations.

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By buying and selling bonds, the Fed changes bank reserves. A change in reserves changes the money supply through a multiplier process of rippling loans and deposits. The final result is that ΔMS = ΔReserves × MM. The money multiplier, however, changes over time, so the Fed’s influence over aggregate demand is subject to uncertainty in both impact and timing.

When the government buys securities, the interest rate decreases and that stimulates consumption and investment borrowing. When the government sells securities, the interest rate increases, thereby reducing borrowing for either consumption or investment. For day-to-day operations, the Fed focuses its attention on the Federal Funds rate, the interest rate on overnight loans between major banks. The Fed has the most influence over real rates of interest in the short run. The Fed has little influence over long-run real rates of interest.

The Fed serves as a “lender of last resort” for banks and for major financial institutions that find themselves in trouble. Preventing “systemic risk”—or the spread of financial problems from one institution to another—is one of the Fed’s most important jobs.