| The Fed can control precisely the monetary base, which
consists of money held by commercial banks in their reserve accounts, and
notes and coins circulating in the economy. The monetary base is multiplied
up to become the money supply by the decisions of individuals to hold money
in checking accounts. How large this multiplier effect is depends
on the ratio of deposits to currency holdings (that is the ratio
of the fraction of money people hold in their bank accounts to the fraction
they hoild as cash). Because this ratio varies over time, the Fed cannot
directly control the money supply. A good example of the difficulties faced
by the Fed comes from the banking pankings of the Great Depression. Bank
closures reduced the deposit-currency ratio as individuals held (a lot)
mnore of their money as cash. This caused a sharp decline in the money
supply even though the monetary base was rising. |