Question

How do banks serve as the mechanism through which money supply may change?

Answer 1

Banks do serve as the mechanism through which money supply may change. The mechanisms are :

1. Reserve requirements : Fed can influence the money supply by modifying the reserve requirements .By lowering the reserve requirements , banks are able to loan more money, which increases the money supply in the economy and vice versa.

2. Changing short term interest rates : Fed can also alter the short term interest rates.By lowering the discount rate that banks pay on short term loans from the federal reserve bank, the fed is able to effectively increase the money supply .

3. Conducting open market operations: Fed can affect the mobey supply by conducting open market operations.Fed buys and sells govt. securities in the open market. If fed wants to increase the money supply, it buys govt. security and vice versa.