The stock of money is determined by the Fed through its control of the monetary
base (high-powered money); by the public, through its preferred currency-deposit
ratio; and by the banks, through their preferred reserve-holding behavior.
The money stock is larger than the stock of high-powered money because part of the
money stock consists of bank deposits, against which the banks hold less than 1 dollar
of reserves per dollar of deposits.
The money multiplier is the ratio of the money stock to high-powered money. It is
larger the smaller the reserve ratio and the smaller the currency-deposit ratio.
The Fed creates high-powered money in open market purchases when it buys assets
(e.g., Treasury bills, gold, foreign exchange) by creating liabilities on its balance
sheet. These purchases increase banks' reserves held at the Fed and lead, through the
multiplier process, to an increase in the money stock that is larger than the increase
in high-powered money.
The money multiplier builds up through an adjustment process in which banks make
loans (or buy securities) because deposits have increased their reserves above desired
levels.
The Fed has three basic policy instruments: open market operations, the discount
rate, and required reserves for depository institutions.
The Fed cannot control both the interest rate and the money stock exactly. It can
only choose combinations of the interest rate and money stock that are consistent
with the demand-for-money function.
The Fed operates monetary policy by specifying target ranges for both the money
stock and the interest rate. In order to hit its target level of output, the Fed should
concentrate on its money stock targets if the IS curve is unstable or shifts about a
great deal. It should concentrate on interest rate targets if the money demand function
is the major source of instability in the economy.
The Fed targets not only money stock and interest rates but also total nonfinancial
debt, or the volume of credit, in the economy.
