Understanding Money Supply Adjustments: The Fed and Economic Propping-Up

The recent discussion about the Federal Reserve (often referred to as "the Fed") and its money supply adjustments has sparked some interesting conversations. Many mistakenly believe that the Fed is responsible for 'propping up' the economy through the creation of new money. However, as we'll explore, the Fed is actually working to reduce the money supply to combat inflation, a process known as money destruction.

The Current State of Money Supply Adjustments

The Federal Reserve has been actively destroying money over the last year, a practice known as money destruction, to manage inflation. Contrary to popular belief, the Fed does not typically 'prop up' the economy through new money creation. Instead, it sells government bonds to banks and removes the money the banks pay from circulation. This effectively 'unprints' the money, thereby reducing the overall money supply.

It's important to understand that the U.S. economy is currently doing quite well with increasing job growth and wage growth, even as inflation has been brought down. No new money creation is needed to support the economy; it is driven by the millions of workers, investors, and entrepreneurs. Let's delve deeper into how the Fed operates and the concepts of the money multiplier and open market operations.

Key Concepts: Money Multiplier and Open Market Operations

Two important concepts to understand in relation to the Fed's operations are the money multiplier and open market operations. These are not just boring financial terms; they are crucial for understanding how the Fed manages the money supply.

Money Multiplier: This concept explains how banks use your deposits to support many multiples of deposits and loans. Essentially, if you deposit money in a bank, the bank can then create more loans, which in turn generates more deposits. This process repeats, leading to an amplification of the money supply based on the initial deposit. Open Market Operations: These are actions taken by the Fed to influence money supply. The Fed can buy or sell government bonds in the open market. When the Fed buys bonds, it increases the money supply, and when it sells bonds, it reduces the money supply. This is a key tool for managing inflation or stimulating the economy when necessary.

The Role of the Treasury and Money Creation

The Treasury can't create new money; it can only borrow funds by selling Treasury bonds. This provides a crucial distinction between the Treasury and the Fed. The Treasury focuses on fiscal policies, such as issuing bonds, while the Fed manages monetary policy, such as adjusting the money supply to control inflation.

The Dual Mandates and Potential for Money Printing

In times of crisis, the Fed can switch back to money printing, as seen in March 2023. However, the decision to print money or destroy money depends on the economic conditions. The Fed has a dual mandate to maintain both low inflation and low unemployment. In a serious crisis, the Fed may decide to prioritize one over the other, but this is a complex decision deeply rooted in economic theory and current conditions.

The True Drivers of Economic Success

It's crucial to recognize that the economy is not 'propped up' by money creation. Instead, it is driven by the actions of millions of workers, investors, and entrepreneurs. Economic success is also influenced by productivity growth, effective government policies, entrepreneurial dynamism, and deep capital markets. These factors enable credit to be extended and debt to be sold, allowing individuals and businesses to achieve their ambitions more quickly and efficiently.

Credit and debt, when used properly, are powerful tools that enable modern economies to function. Without these financial instruments, your modern economy would not exist. Governments play a critical role in providing the framework and support necessary for these systems to thrive.

Conclusion

The Fed's actions, whether through money creation or destruction, are driven by the needs of the economy and the goals of maintaining stable prices and full employment. Understanding these concepts is essential for anyone interested in the inner workings of the financial system and the economy.