Money Banking and the Federal Reserve System
In their distinguished book, Economics: Principles, Problems, and Policies, McConnell and Brue explain how money performs various roles in an economy. It is a medium of exchange where it makes the buying and selling of goods and services possible. (McConnell and Brue, 200). It effectively replaced the ancient barter trade that had problems of divisibility into units. McEachern pointed out a major shortcoming of the barter trade where by it called for or rather demanded for double coincidence of wants.
Agreement on the exchange rate also caused problems in the exchange of goods and services. (McEachern W, 598). Money is easily acceptable and divisible which makes it an effective and efficient medium of exchange. It is also a unit of account where by it can work as a yardstick for people to evaluate their wealth. Money also serves as a store of value and allows people to transfer their purchasing power to the future through savings.
This paper will focus on the factors that affect the demand and supply for money and the role of the Federal Reserve System in the US monetary system.
In the US economy money could be in currencies in the form of coins or paper money that is in circulation. It could also be in form of deposits in banks as well as in other financial institutions. The total supply for money can be denoted as M1 where it includes all the money in circulation as well as that in checkable deposits. (McConnell and Brue, 233). Another expression or definition of money supply may incorporate the ‘near moneys’ or the liquid financial assets that are not directly used as a medium of exchange can be converted into currencies or checkable deposits. Near monies include savings deposits, money market mutual funds as small time deposits. M2 is therefore equal to M1 plus the ‘near moneys’. The final definition or expression of money supply M3 incorporates large time deposits to M2. Money supply can therefore be expressed comprehensively as M1+M2+M3. (McConnell and Brue, 235).
The value of money depends on the forces of both the demand and the supply. Money value is acquired from its scarcity relative to its utility which could be in the present time or in the future. A decrease in money supply leads to an increase in the interest rates and an increase in the money supply lowers the interest rates.
The purchasing power is refers to the amount of goods and services that a unit of money can buy. It has an inverse relationship with the price levels such that when the price levels rises the value of the currency in this case the dollar declines and the reverse is true. Inflation affects the value of money and consequently affects investment in any given economy. Stability of money value makes it effective in its role as a unit of account. Money value stabilization is possible when there are effective monetary and fiscal policies in place. (McConnell and Brue, 238). Money should have desirable qualities to ensure its effectiveness in performing its roles. It must be durable, relatively stable in value, low opportunity cost, portable and uniform quality. (McEachern W, 600).
The demand for money refers to the amount of money that people want to hold as assets or to purchase goods and services. Demand for transaction purposes is the money people want to have at their disposal to pay their bills and purchase goods and services. Transactional demand depends on the level of nominal GDP. If the total value of all goods in an economy is large then the money needed for transactions is high. People will want more money for transactions when the prices and the real output rises. Asset demand for money refers to the money that people hold which serves as a store of value. In this respect money can be held in various forms like corporate stocks as well as the private or government bonds. People may prefer to hold money in form of assets like bonds where there are likely to earn profits. . (He p et al, 668) On the contrary some prefer to keep their money in liquid form where there are no risks of incurring losses should the prices of bonds go down in the face of inflation. Asset demand for money is inversely related to the interest rates such that when the interest rates for holding money are low people opt to keep their money in form of assets and when those interest rates are low they prefer to have their money in liquid form. (Kiyotaki and Moore, 14). The demand for money is influenced by how effective money is as a store of value.
The need to regulate the banking system came about from the need to regulate the banking system as too much money in an economy caused inflation while too little deterred economic growth as there is reduced purchasing power. (Hubbard R, 64). The board of directors of Fed is the central authority to the US money and banking system. They are appointed by the president and confirmed by the senate. The Federal Open Market Committee is very influential in the making of monetary policies in the US since they assist the board of directors. The Federal Reserve System commonly known as FED is the US central Bank. (www.federalreserve.gov). It has the power to execute monetary policies that influence the supply as well as the demand for money in US. The monetary policies at its disposal include the changing or influencing of the reserve requirement, the discount rates as well as through the open market operations. Open market operations refer to the purchasing or buying of the US treasury as well as the federal agency security to influence the demand and supply of money to the desired levels. The open market operation where government bonds are sold or bought is the most important monetary tool of Fed.
Discount rates are also changed to influence the money supply and demand to the desired levels. It refers to the interest rates charged by the Federal Reserves to commercial banks as well as other financial institutions. (Toma M, 32). It’s also referred to as the ‘discount window’. There are three types of depository windows offered by Fed and they include the primary credit, secondary credit as well as the seasonal credit all of which are assigned varying interest rates. The discount rates for the primary credit are higher than the short term discount rates in the market while those of the secondary credit are higher than the primary credit interest rates. The seasonal credit discount rates are average of the selected market rates. (www.federalreserve.gov).
The Reserve requirement refers to the money or funds that commercial banks as well as other depository institutions must deposit with Fed in terms of reserves against the set deposit liabilities. The board of governors of Fed stipulates within the law the reserve requirements and makes relevant changes. The reserve requirement is held in form of vault cash. Depository institutions include commercial banks, savings banks, saving and loan associations, credit unions, branches and agencies of foreign banks in US, edge corporations as well as agreement corporations. (www.federalreserve.gov). To McEachern the required reserve ratio is the ratio of reserves to deposits that are obligated by regulation to hold. If there is high money supply in the economy the federal banks raise the reserve requirement ratio so that banks have less liquid assets at their disposal and hence little to lend to people. (McEachern W, 642).
The major objective of the monetary policies set or rather adopted by Fed is to maximize or rather raise the employment levels, ensure moderate long term interest rates as well as stable prices by checking on inflation. (www.federalreserve.gov). All this is done to ensure that investment is encouraged and consequently economic growth is registered. Low market interest rates other factors held constant lowers the cost of holding money and people hold their money in liquid form. High interest rates increase the cost of holding money and more money is held in form of assets rather than in liquid. The money multiplier magnifies a change in initial spending into the GDP. It magnifies the excess reserves into a large creation of checkable deposit money. (McEachern W, 263). Price stability is very essential in as far as economic growth is concerned. It is an incentive to investment and it also positively influences the consumer confidence levels. The overall effect of this is that there is economic growth and people’s standards of living are boosted. When prices are unstable or fluctuating there is a higher risk involved as people may incur losses when their assets lose value due to inflation. (He p et al, 645-8)
There are 12 federal banks in the US which contain both the private as well as public control and they perform the role of being a bankers’ bank. According to McConnell and Brue the federal banks are responsible for issuing of currency in the US. They issue Federal Reserve notes or papers into the economy. The banks set the reserve requirement and lend money to other banks. They also provide the banking systems with a means of collecting checks through effective coordination with the various banks. The federal government uses Fed facilities to earn revenues and hence act as a fiscal agent. Fed also supervises banks to check their profitability as well as to ensure that they adhere to the set rules and regulations. The most significant role of Fed is its influence on the money supply of an economy. To raise the money supply Fed buys government bonds, lowers the discount rates or reduces the reserve requirement. To reduce the money supply it sells government bonds increases the discount rates or raises the reserve requirement.
Campbell R. McConnell, Stanley L. Brue. Economics: Principles, Problems, and Policies. McGraw-Hill Professional Publishers, 2004.p 200-345.
William McEachern. Economics: A Contemporary Introduction. Thomson South-Western Publishers, 2005. p 600-648
Board of Governors of the Federal Reserve System. Federal Open Market Committee FOMC. Monetary Policy. Retrieved on 27th May 2008 from http://www.federalreserve.gov/monetarypolicy/fomc.htm
Mark Toma. A Positive Model of Reserve Requirements and Interest on Reserves: A Clearinghouse Interpretation of the Federal Reserve System. Southern Economic Journal, Vol. 66, 1999. p 32
Glenn Hubbard. Money, the Financial System, and the Economy,” fifth edition. New
York: Pearson Addison-Wesley, 2004. p 64
Bullard James and Smith, Bruce D., “Intermediaries and payments instruments,” Journal of Economic Theory, Elsevier, vol. 109(2), 2003. p 172-197.
Ping He, Lixin Huang and Randall Wright,. “Money And Banking In Search Equilibrium,” International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 46(2), 2005. p 637-670.
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