Cutting the Money Supply

Now suppose instead the decision is instead to reduce the money supply, perhaps as a means of avoiding inflation. Then the method is just the reverse.

The FOMC sells bonds.
The check written to pay for the bonds is cleared through the FED.
This reduces bank reserves.
With less reserves, banks must cut back on money creation.

In this case, Jane Roe buys a $1,000 bond from the holdings of the Federal Open Market Committee, and pays for it with a check on her account in the First National Bank of Enumclaw. This check goes directly to the Fed, which "clears" it by reducing the deposits in the name of the First National Bank of Enumclaw. First National of Enumclaw will in turn reduce Jane Doe's account by $1,000. Let's see what that does to First National's required reserves in the Table 4:

Table 4

First National Bank of Enumclaw
1	Deposits	60000
	reserves	10000
2	check cleared	1000
	total deposits	59000
	required reserves	9833.33
	actual reserves	9000
	shortfall	833.33333

The problem is that the reduction of $1,000 in Jane Roe's deposit reduces the required reserves by only a fraction of $1,000, in this case by one-sixth. Thus, First National is left with $833.33 less reserves than it needs. How are they to get the reserves they require? In the short run, they can borrow reserves; but in the longer run, they will have to turn down some applications for loans.

For example: on the next day, two customers visit First National. Richard Bowe repays his loan of $833.33 (interest included) and Donald Lowe (who has good credit) applies for a loan of $833.33 to buy a new television set. If the bank had plenty of reserves, they would probably "recycle" the $833.33 repayment by making the loan to Donald -- but they have to turn down Donald's loan application and apply the amount to their reserves instead. Donald goes on and buys the TV set anyway, writing a check on his account at Second National. But that means Second National's reserves are reduced, and they, too, have to cut back on loans. And thus the decrease in reserves leads, again, to a multiple reduction in the money supply -- eventually a $6,000 reduction, assuming, again, a 1/6 required reserve ratio.

(How) Does It Work?