M1 and M2 and the Importance of Bank Deposits in the Money Supply - Money Essay Example

 

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This paper aims to write a four paragraph minimum essay related to Terminal Course Objectives (TCOs) #7 and 10.  An article related to the Money Supply, or Deposit Expansion Multiplier, or FOMC, or the monetary policy is selected for the purposes approaching this paper.  A key point here is to stay focused on the economic issues of the TCO while related social or political issues are no longer expanded.  TCO 7 is: “Given the assets and liabilities of a bank and the required reserve ratio, calculate the maximum potential of the banking system to create deposits, assuming no leakages from the banking system.”  While TCO 10 is : “Given a need to make and defend a decision based on economic factors only, develop a rational approach for legitimizing both social issues and political agendas as part of a statement announcing this decision.”

The article selected is entitled “The U.S Economy and Monetary Policy”  in a speech delivered by FR Bank President Janet L. Yellen to the members of Parliament at the Conference on US Monetary Policy convened by the European Economics and Financial Centre London, England (Yellen, 2006) .  Relevance of money supply to the economy must be obvious under the article since money supply is a topic under monetary policy.  A topic that is discussed in the article is the problem, (i.e. increasing prices of goods and energy) in the economy that is caused by Katrina.  The article said that monetary policy, unfortunately, has little scope to cushion the immediate economic fallout because monetary actions can’t be directed only at a particular area of the country and because their effects take time to be felt.  The speaker in the article instead said that it’s appropriate to use the tools of fiscal policy—especially government spending and transfers—to address the immediate crisis.

At the latter part of the article, it was said: “Higher energy prices put U.S. monetary policy on the horns of a dilemma.  On one side, the negative impact of higher energy prices on spending tends to damp economic activity, which calls for a more accommodative policy, although in this case, the rebuilding effort will provide some offset.  On the other side, it adds to inflationary pressures, which calls for a tighter policy.”  (Yellen, 2006)  What can be learned therefore is that economist either used the fiscal policy and monetary policy in certain.  For the purpose of this paper what is worth emphasizing is the use of monetary policy to address in inflationary pressures.  This might involve regulating the money supply via government having may be to borrow from the public or banks through treasury bills or regulating reserve requirements of banks to siphon off some excess money supply.

After knowing the issue in the article let us clarify first some of the terms.  Samuelson and Nordhaus (1992) said that M1 includes the transaction money consisting of coins, paper currency and checking accounts.  M2 on the other hand is called the broad money which includes M1 as well as savings accounts in banks and similar assets that are very close substitutes for transactions money.  They are considered part of money in the money supply.  Bank Deposits there fore converts M1 to M2 has the so called multiplier effect in causing an increase magnitude in the amount of money supply.  Therefore it could be concluded that MI and M2 and bank deposits determines money supply and the significance money supply is its influence in managing the economy.  As learned from the article the Federal Reserve Bank can control money supply in case prices are rising and there is excess money supply causing inflation.  For illustration, please Appendix A.

Conclusion

The economy cannot be stable sometimes because of dislocations that could be cause by the man or natural calamities like in the case of Katrina.  The government is however not helpless to use its power through the Federal Reserve Bank to control inflation if the is a need to.  This could be done by reducing money supply by government borrowing from the public or influencing the reserve requirement of banks.

Appendix A  – Excel file, illustration of effect of increase of decrease in money supply to                     GNP growth

 

Works Cited:

1. Sameulson and Nordhaus, 1992, Economics, McGraw-Hill, New York, USA

2.  Yellen, J. (2006) The U.S Economy and Monetary Policy in a speech delivered by FR Bank to the members of Parliament at the Conference on US Monetary Policy convened by the European Economics and Financial Centre London, England  {www document} URL http://www.frbsf.org/news/speeches/2005/0927.html, Accessed October 13,2006

 

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