The Federal Reserve is not in complete control of money supply Essay


The Federal Reserve is not in complete control of money supply in the American economy at all times - The Federal Reserve is not in complete control of money supply Essay introduction. The reasons being the banks are becoming increasingly deregulated and do not act exactly the way the Federal Reserve wants. Only a portion of the increase or decrease in rates is not passed on directly to the investors and the customers. Also, the definition of money is broadening. The money supply is not only dependent on the deposits in the banks and government bonds. The fluctuations in the prices of all asset classes like stocks, bonds, real estate, commodities, etc. impact the money supply as well. The newer trend of development of electronic forms of money poses as the potential threat to the Federal Reserve’s power to control money. This electronic form serves as the proxy for money. The money market controls a substantial portion of the money supply. The weakening of Government control is also caused by Securitization where the bonds are issued backed by some asset. The opening up of stock markets for the foreign institutional investors to an extent influences the total amount of money in the economy at any point in time.

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The monetary base popularly known as narrow money is a part of the total money supply. This basically includes all the money which can be directly controlled by the Federal Reserve. It comprises of metallic coins, paper notes and the reserves of the commercial banks with the Federal Reserve. On the other hand, money supply is the sum of monetary base and other broader measures of money like the public’s bank deposits including money in the current accounts, savings accounts, etc.

2. Part l

The money multiplier is denoted by M= {(1 + c)/(c + R)}*B

Here M is the total money supply, c the currency to deposit ratio, R the required reserve ratio i.e., the amount of reserves to be kept per unit of deposits as per the Federal Reserve rule. Lastly, B is the monetary base.

This means that the money multiplier measures the change in the money supply for a per unit change in the monetary base.

When currency holdings are zero, the money multiplier is equal to 1/R.

When currency holdings are greater than zero, the money multiplier is (1 + c)/(c + R).

(1/R) > (1 + c)/(c + R) since c is a fraction greater than zero

This means that the money multiplier is higher when currency holdings are zero. The reason being there is no cash drain when currency holdings are zero and all the monetary base can be used by the banks to increase money supply.

2. Part ll

If currency to deposit ratio increases,

There is no effect on the monetary base.

The money supply decreases since the money multiplier decreases. The reason being the larger cash drain occurs because of more currency holdings.

Total deposits decreases because people now hold more of currency.

The economic growth also suffers as the money supply created is less.

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