Money supply

Money supply ("monetary aggregates", "money stock"), a macroeconomic concept, is the quantity of money available within the economy to purchase goods, services, and securities.

Bank reserves at Central Bank

When the Fed is "easing", it increases the monetary base by purchasing US Treasury securities on the open market. When the Fed is "tightening", it reduces the monetary base by selling Treasuries on the open market. It reduces or increases the supply of short term government debt, and inversely increases or reduces the supply of currency.

Related Topics:
Monetary base - US Treasury securities - Open market

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The operative notion of easy money is that the Fed creates new bank reserves (also known as "federal funds", trades in the "money market"), which let the banks lend out more money. These loans get spent, and the proceeds get deposited at other banks. Whatever is not required to be held as reserves is then lent out again, and through the magic of the "money multiplier", loans and bank deposits go up by many times the initial injection of reserves.

Related Topics:
Bank reserves - Federal funds - Money market - Deposit

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However in the 1970s the reserve requirements on deposits started to fall with the emergence of money market funds, which require no reserves. Then in the early 1990s, reserve requirements were dropped to zero on savings deposits, CDs, and Eurocurrency deposits. At present, reserve requirements apply only to "transactions deposits" - essentially checking accounts. The vast majority of funding sources used by banks to create loans have nothing to do with bank reserves.

Related Topics:
Money market funds - Savings deposit - CD - Eurocurrency deposits - Transactions deposits - Checking accounts

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These days, commercial and industrial loans are financed by issuing large denomination CDs. Money market deposits are largely used to lend to corporations who issue short term commercial paper. Consumer loans are also made using savings deposits which are not subject to reserve requirements. These loans can be bunched into securities and sold to somebody else, taking them off of the bank's books.

Related Topics:
Commercial and industrial loans - CD - Money market - Short term commercial paper - Savings deposit

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The point is simple. Commercial, industrial and consumer loans no longer have any link to bank reserves. Since 1995, the volume of such loans has exploded, while bank reserves have declined.

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In recent years, the irrelevance of "open market operations" has also been argued by academic economists renown for their work on the implications of rational expectations, including Robert Lucas, Jr., Thomas Sargent, Neil Wallace, Finn E. Kydland, Edward C. Prescott and Scott Freeman.

Related Topics:
Open market operations - Rational expectations - Robert Lucas, Jr. - Thomas Sargent - Neil Wallace - Finn E. Kydland - Edward C. Prescott - Scott Freeman

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