How is money created? What is a deposit multiplier and money multiplier?

Question

What are teh major ways in which the Federal Reserve Bank can control money? Why would they wish to control money?

Answer 1

The Federal Reserve main tool for controlling the money supply but first and foremost is Open Market Operations where they buy and sell Treasury Bills on the open market using thin-air money. That is, when they buy a T-Bill, it's with money created out of thin air. When they sell a T-Bill, the money disappears into thin air.

The Deposit Multiplier is the effect of loaning money on deposit, which (after it's economic purchase) is re-deposited, and reloaned. But each subsequent loan becomes less since banks have to keep some of the original deposit on reserve. So a loan of $100 might eventually generate deposits of $500 before no surplus reserves remain. In this case, we would say the deposit multiplier is 5.

The deposit multiplier is factored into monetary policy targets. So if the Fed wants to increase the money supply by say $5B and the Multiplier is 5, they only need to buy $1B in T-bills, and then let the marketplace increase the rest.

Other ways:

- Adjusting the Federal Fund rate (the interest rate for overnight loans between banks). A change in the Federal Fund rate can be considered a signal that the money supply is being tightened or loosened.

- Setting the bank depository reserve requirement (actually not very effective since banks typically care more than the minimum legal requirement anyway)


Why control money?

The purpose of monetary policy is to acheive an elusive equilibrium of maximum employment within target inflation rates. It's tough and the demand for cash changes with the seaons (more is needed at Xmas), with a disaster, trade deficits, etc.

Answer 2

Bank and other financial institutions borrow /lend to each other in an overnight market so they can balance ther books every day. The rate for the loan is called the fed funds rate. The Fed buy/sell bonds in the overnight market for funds, to keep the interest rate ( Fed funds rate) at or near the target value. When they buy they are putting money into the banking system when they sell they are taking money out of the system.http://en.wikipedia.org/wiki/Money_creation
Economic theory, which most economist more or less believe, says that if there is too much money in the system it will create inflation, too little will raise interest rates and create a recession.