Determination of Money Supply - Essay Example

?Determination of Money Supply Money is one of the most significant macro economic variables and the correct understanding of its role in the economyhinges on how it is defined and measured correctly. In economics, money stock or money supply refers to the total amount of money available at a particular point in time. This comprises of all currency including deposits, coins and bills issued by the central bank of a particular country (Howells and Bain, 2009). The amount of money in an economy needs to be moderated because it has a direct effect on inflation, business cycle and price levels. For example, there is a strong proof that when money increases rapidly in an economy, there develops a direct relation between money-supply and long-term price inflation. On the other hand, a decrease in the level of money supply in a country leads to a decrease in economic activity, tightened spending levels and a fall in consumer demand. The quantity theory of money states that money supply has a relationship that is directly proportional in nature to the price level (Friedman, 1956). Different institutions have different but correlated roles to play in the determination of money supply in a country and the global economy. Examples of such institutions are the central bank and depository institutions. Depositors also have a part to play in this. Roles of the central bank Every country has a central bank that monitors and determines money supply in the country’s economy. In the US, the money supply is determined by the US Federal Reserve, the central banking system of the US. Its role is to foster economic growth in the US by regulating the actions of private banks and stabilizing the money supply. The Federal Reserve, also known as Fed, uses the expansive monetary policy as a guide in expanding the US money supply (Shin, 2009). Using the expansive monetary policy, the Federal Reserve channels more reserves to the banking system so as to allow private banks more liquidity and to make sure that they have the required ability to issue loans. In the UK, determination of money supply is the function of the Bank of England while that of the counties under the EU is the European Central Bank (ECB) (Burda and Wyplosz, 1997). In order to stabilize an economy in a country, the central bank has the power to determine the level of money stock through the operation of different monetary policies. These policies include reserve requirements, open market operations and discount rates. The most dominant among the three monetary policies is the open market operations policy. According to Howells and Bain (2009), an open market operation is a situation in which the central bank purchases or trades government securities for cash in an effort to contract or expand the total money supply. Money supply in the country will increase if the central bank purchases government securities but it will contract if the central bank sells government securities. The responsibility of the central bank in relation to fractional reserve banking is to hold a particular fraction of all deposits. This can be in account with the central bank or in cash. In order to alter money supply, the central bank alters the percentage of total deposits that needs to be held by commercial banks. In this way, the central bank can increase the monetary base in a country by reducing the reserve requirements or reduce the monetary base by increasing the reserve requirements (Mishkin, 1998). The central banks also determine money supply in a country by controlling discount rates. This is possible because the central bank in every country supplies commercial banks with the money they require to meet consumer demand. Therefore, the central bank can meet and control consumer demand for money by controlling the national interest rates. For example, the consumer demand for money will increase greatly if the interest rates decrease while a decrease in consumer demand for money will arise if the interest rates increase. Roles of depository institutions By definition, depository institutions are those financial institutions that are legally allowed to receive monetary deposits from the public. These include commercial banks, savings bank, credit union and savings and loan association. They are important in determining the money supply because they profit from taking money from depositors. Commercial banks account for about 25% of the money supply though their demand deposits. Shin (2009) defines demand deposits as those deposits that are payable to the depositor on demand. They are usually maintained by businesses and they do not have any interest payments. As depository institutions receive more money, it increases the amount they will have to deposit to the central bank as its reserve requirement. If the amount of the money they receive increases rapidly, the central bank will be forced to increase their reserve requirements. This will lead to a reduction in the money supply. Roles played by depositors Depositors can influence the level of money supply by converting some of their deposits in depository institutions into currency. Therefore, these reserves are used as currency in the hands of the public (Shin, 2009). Depositors can also withdraw huge amounts of money leading to a reduced deposits pool in banks. This could arise from a panic in banks which makes depositors fear that they could make huge losses in their deposits. It could also result from an anticipation of a surge in surge in inflation which increases the attractiveness of currency as compared to deposits. Depositors could also leave their money in banks for extended periods of time. This means that banks will have more money and therefore an increase in the money supply within the economy. Change in the conduct of monetary policy by central banks during the recent credit crunch Money policy is an important tool that a country can rely on for controlling inflation in its economy. The role of central banks is to implement the monetary policy chosen by a particular country. At the most basic level, this role involves determining the form of currency the country will have, that is, whether it should have a gold-backed currency, fiat currency, currency union or a currency board. If a country has its currency, the role of the central bank will be to issue standardized currency (Mishkin, 1998). Some of the goals of the monetary policy include the attainment of interest and price stability, high employment, economic growth and financial market stability. Due to the current global economic meltdown, there has been a general reduction in the availability of loans. Banks have also tightened the conditions required for customers to obtain loans and these have resulted to difficulty in obtaining investment capital. In order to address this situation, the central banks were forced to change the way they conduct their monetary policies (Mishkin, 2010) The most initial response by central banks was to ease their monetary policy in order to minimize the fallout from the existing financial crisis on the real economy. They also increased short-term funding to the local financial system in their countries. An example in the ease in monetary policy is the reduction in the reserve requirement for the banks. In this way, commercial banks would be able to retain a good amount of money and use it as their lending base. An increase in short-term funding to the local financial system was meant to improve their lending capacity. One of the programs incorporated into the monetary policy by the US Federal Reserve to address the credit crunch was Term Auction Facility (TAF) (Shin, 2009). Though short-term, the TAT program was able to address the increased pressures experienced by short-term funding markets. Under Term Auction Facility, the Federal Reserve auctioned loans that were collateralized with terms of 28 and 84 days to depository institutions. These were only those depository institutions that were in a good financial condition generally and were expected to maintain their position over the terms of the Term Auction Facility loans (Mishkin, 2010). In the European Union, the European Central Bank had to change its monetary policy too as the crisis spread to other areas other than real-estate and mortgage sectors. The European Central Bank started to distribute funds through fine-tuning operation or discount window. This was in response to the 2007 credit crunch and by 9th of August, 2007. It had lent €95 billion ($112 billion) to European Union banks. The United States of America Federal Reserve also adopted the same policy measure and by this time, it had distributed $12 billion through repo operations (Shin, 2008). Conclusion A regulation of money supply is very important in the economy of a country as it determines piece levels, levels of economic activity, employment levels and spending levels. The central bank is the key player in the determination of money supply in a country. It does this through the functioning of its three monetary policies namely reserve requirements, open market operations and discount rates. Other players in money supply determination include depositors and depository institutions. A recent occurrence of credit crunch forced central banks to alter they way they conduct their monetary policies in order to minimize the fallout from the existing financial crisis on the real economy. For example, the European Central Bank had to issue funds through fine-tuning operation or discount window. Bibliography Bijapur, M. (2010). “Does monetary policy lose effectiveness during a credit crunch?” Economics Letters (106) pp 42-44 Burda, M. and Wyplosz, C. (1997). Macroeconomics: A European text. Oxford: Oxford University Press. Friedman, M. (1956), “The Quantity Theory of Money: A Restatement” in Studies in the Quantity Theory of Money Reprinted in M. Friedman The Optimum Quantity of Money (2005) pp 51-67. Froyen, R. (1998). Macroeconomics: Theories and Policies. 6th ed. Upper Saddle River: Prentice Hall, 1998. Howells, P. and Bain, K. (2009). The Economics of Money, Banking and Finance. New York. Pearson. Mishkin, F.(1998). The Economics of Money, Banking and Financial Markets. 5th ed. Reading, PA: Addison-Wesley. Mishkin, S. (2010). The Economics of Money, Banking and Financial Markets (Global Edition), Ninth Edition. New York. Pearson. Ritter, L. Silber, W. and Udell, G. (1997). Principles of Money, Banking and Financial Markets. 9th ed. Reading, PA. Addison-Wesley. Shin, H (2008). “Leveraged Losses: Lessons from the Mortgage Market Meltdown” (with David Greenlaw, Jan Hatzius and Anil Kashyap) US Monetary Policy Forum Report No. 2 Shin, H. (2009). “Money, Liquidity and Monetary Policy. American Economic Review (99) pp 600–605. Read More