FED's Capacity to Boost Money Is Factor of Ten

US Central Bank's Fractional Reserve Set Up Levers the System

Oct 5, 2009

When the Federal Reserve Bank buys a $10,000 US Treasury note, or any acceptable asset of that amount from a member bank, it can set off a ten-fold jump in money supply.

An electronic entry credits the member's account at the FED. The entry becomes part of the member bank's required reserves backing up its demand deposits, which are usually checking accounts.

The transaction starts a chain reaction. The member bank can lend 90% or $9,000 of the $10,000, because the FED's current deposit reserve regulation is only 10%. On other types of bank customer accounts, such as time deposits or CDs, the central bank of the US requires different reserves.

Fractional Reserve System Creates a Multiplier Effect for Money Supply

When the member bank lends up to 90% or $9000 of the new loanable reserves, a principle known in economics as the Multiplier Effect kicks in. Next, recipients of the $9,000 lend out 90% or $8,100 in new deposits, which can be used by yet other banks to lend $7,290; and so on, until the original $10,000 FED injection of reserves has increased the money supply in the banking system ten times or by $100,000.

On the other hand, the Fed can reverse the process by selling a Treasury note or bond to a member bank. To pay for the purchase, the member's reserve at the Fed is reduced by $10,000, thus diminishing its reserves for lending by $9,000. This sucking in of reserves reduces the nation's money supply as loanable funds contract throughout the economy, in a negative Multiplier Effect.

The amounts used in these examples are minuscule, in the Federal Reserve scheme of things. Actually, the system moves millions of dollars about, sometimes billions, in their stratagems to stimulate or slow down the economy; so, when the central bank acts incorrectly, the mistakes are financial Godzillas.

Success of Federal Reserve System Is Debatable

In a nutshell, that is how a fractional reserve banking system works, and explains how the FED can exert so much impact on the US economy. Like a pump blowing helium into a balloon, the FED can send the economy flying; or, deflate it to a squishy rubber ball.

There are other ways this complex system expands or contracts the money supply, but this article will not address them due to lack of space. Sometimes the US super bank applies too much monetary fuel, resulting in inflation; or, too little, resulting in deflation and/or recession.

Economists differ on the success of the Federal Reserve System. Some, like the monetarist and Nobel Laureate Milton Friedman argued the central bank would always misfire, leading to unnecessary swings in the economy. He suggested that the FED, by tamping down the money supply too vigorously in the 1930s, accentuated, if not caused, the Great Depression.

First US National Banks Established to Pay Off War Debt

Three national banks had existed in the US, previous to the creation of the Federal Reserve System. The First Bank of the United States operated from 1791 to 1795. The Second Bank of the United States lasted from 1816 to 1836, and the National Banking Act of 1863 established a supervised network of national bank branches, until 1913.

Congress created each of them to pay off war debt- first, the American Revolution; second, the War of 1812, and then the Civil War.

Economic History of US Reflects Aversion to Central Banks

In the turbulent history of the US, an aversion to a central or national bank has existed, partly out of expectations that wealthy individuals and regions would alone receive real benefits. But in 1913, according to About.com, "America's economic growth both at home and abroad required a more flexible, yet better controlled and safer banking system. The Federal Reserve Act of 1913 established the Federal Reserve System as the central banking authority of the United States."

President Woodrow Wilson signed the Federal Reserve Act two days before Christmas, in his first year in the White House. It was one of his several progressive reforms, according to an article by Heather Strong of Suite101.com.

Proponents Claim It Was Time for Federal Reserve System

The journalist Paul Dean writes the Federal Reserve Act officially provided for the establishment of federal reserve banks; and unofficially, "Brought the United States out of the 19th century financial world and into an acceptable financial position just in time for its entrance onto the world stage in WWI and the resulting economic chaos."

Of particular interest to investors, under its Regulation "T" powers, the FED establishes the margin requirements for purchasing stocks on credit or selling them short. Presently, the margin required is 50% of the market purchase, payable in cash or stocks.

FED Carries Out Five Important Missions

Under its board of seven governors, appointed by the President, and through 12 regional banks, the FED:

In the recent financial crises and continuing recession , the FED has gone where none have gone before in easing financial hardships on banking and insurance institutions, certain manufacturers and strapped local governments. By most accounts, it is too early to judge the results.

The copyright of the article FED's Capacity to Boost Money Is Factor of Ten in Economics 101 is owned by Howard Bryan Bonham. Permission to republish FED's Capacity to Boost Money Is Factor of Ten in print or online must be granted by the author in writing.