Meaning and Types of Money, the Federal Reserve System - Coursework Example

First Last Dr. First Last 3 May 2008 Monetary Policy Money is a form of exchange of value in an economy and a regulatory policy that controls the supply of money is termed as “Monetary Policy”. However, before discussing the nuances of a monetary policy and what it constitutes, it is essential to understand the nature of money, what role it plays in an economy, the role of a banking system and then, finally, how money supply can be controlled. These aspects presented here are a summary of Mankiw’s discussion on the subject (641-660). Meaning and Types of Money: Money is the form of asset used and accepted regularly to buy and sell products and services. This definition is in contrast to wealth, where even though a person may have a number of assets, those assets could not be used for transactions directly like, for example, cash does. Such assets that constitute wealth but do not fall in the category of money include property, stocks, expensive art etc. More specifically, money is differentiated from other forms of assets in terms of its three usages. Other assets may have one or more of these properties but only money has all three. Money is considered a medium of exchange of value. Universally, buyers and sellers can complete transactions by exchanging money. It is also considered a unit of account allowing a standard mode of determining price and value. Finally, as a store of value, people can use the money they have at any given time to buy something in the future, thus transferring their purchase power. Money retained for future purchase is considered a part of wealth. As seen earlier, wealth may also include items other than money such as property and stocks. However, such assets can only be used as medium of exchange when they are converted into money. If an item can be converted quickly into money, it is considered more liquid than others. With the above three definitions in mind, money can be classified into two categories, commodity money and fiat money. When a commodity has an intrinsic value and can be verified and used easily, it is called commodity money. Gold is an example of commodity money that was in use in the past. The other category, fiat money, is one in which something which does not have an intrinsic value is given a legal cover to be used as money. Currency is fiat money as paper, which otherwise has little corresponding inherent value, is accepted as valuable when used as money. It must be noted here that currency is not the only form of money as discussed in the following section. The Amount of Money in an Economy: The total amount of money present in an economy is called the money stock. As mentioned earlier, money has been characterized with three definitions and currency is clearly classified as money accordingly. However, there are other assets that could be considered as money and contribute to the total amount of money in the economy. Personal checks drawn on checking accounts are widely used as medium of exchange to make purchases. Consequently, these checks and, by extension, the balance in checking accounts is also considered money. Such accounts are termed as demand deposits as they can be converted into money on demand and their liquidity is as high as currency itself. Debit cards also fall in the same category as whenever they are used, the account is directly debited. Credit cards, on the other hand, cannot be classified as money even though instant purchases can be made through them. Credit cards effectively defer payment rather than make the actual payment. The bank promises to pay the merchant at a future date and subsequently bills the card holder. It is not straightforward to assess all assets in terms of whether they fall in the category of money or not. Therefore, more than one measures of total money in an economy have been established. For example, M1 includes currency, traveler’s checks, demand deposits and other checkable deposits. M2 includes everything in M1 and savings deposits, small time deposits, money market mutual funds etc. For simplicity, this discussion treats currency and demand deposits as money. Federal Reserve System: Money is pervasive in an economy and the amount of money, total or in circulation, has a strong bearing on its health. For example, prices tend to go up when money supply in an economy is higher. Money supply has short and long term effects on inflation, employment and production. An agency, typically the central bank, in every country and economy regulates its money supply. In the United States, this agency is called the Federal Reserve, or, in short, Fed. Created in 1914, the Federal Reserve is run by a seven member Board of Governors headquartered in Washington D.C. One of the governors is appointed as Chairman for a four year term by the President of the United States. Other members of the board are also appointed by the President and further confirmed by the Senate. These members are appointed for 14 year terms. The Chairman presides over board meetings and is responsible for testifying before congressional committees. The Federal Reserve System also consists of 12 regional Federal Reserve Banks with their respective board of directors and a president selected by these boards. The members of each bank’s board typically come from banks and the business community in the respective region. The Fed performs two broad functions. The first, falling mostly under the purview of regional Federal Reserve Banks, is to regulate and facilitate the banking industry. This function comprises of monitoring banks’ financial health, lending money to them, and. providing a clearinghouse for checks. While lending, the Fed also assumes the responsibility of lender of last resort for financially troubled banks. The second function, having an effect on the entire economy, is to manage the amount of money in the economy. This total amount of money is called the money supply and the policy and decisions that govern this management are part of the monetary policy. This function is performed by the Federal Open Market Committee. Federal Open Market Committee: The Federal Open Market Committee (FOMC) comprises of 12 members. All 7 members of the board of governors and the president of New York Federal Reserve Bank are permanent members of FOMC. The other 4 are rotating members who are drawn from the presidents of remaining 11 regional Federal Reserve Banks. In a regular six-weekly meeting, the FOMC decides the levels of money supply to maintain in the US economy. Other presidents of regional banks, though not voting members, also attend this meeting. The FOMC, in its meeting, reviews the monetary policy and determines money supply for the next six weeks. It does so by removing money from the market if it is found in excess or to print and infuse more money into the market if it is found in short supply. The Fed has three methods of influencing money supply, namely open market operations, reserve requirements and discount rates. These will be seen later in this essay. Effect of Banks on Money Supply: Bearing in mind that money broadly comprises of currency as well as demand deposits, it is pertinent to briefly examine the effect of banking on the monetary system. This would help in understanding the three methods Fed uses to control money supply. Every single dollar of currency corresponds to a single dollar in the money supply. In contrast to this one-to-one relation of currency with money supply, bank deposits do not necessarily form such a straightforward relation. This is explained through an example. If there are only 100 dollars of cash in an economy and no bank deposits, the total money supply would be $ 100. This follows from the explanation that money supply equals currency and demand deposits. Demand deposits, in this case, are zero. Now, if this money is deposited in a bank and the bank holds this money indefinitely without using it for loans, currency becomes zero and demand deposits go up by $ 100. In this example, the entire deposit, which is $ 100, is readily available to the depositor through checks or debit card. Going by the definition that money equals currency and demand deposits, the money supply still does not change. Out of total deposits, the amount of money that the bank does not loan out is called a reserve which, in this case, is $100. Extending this example a little, it is now assumed that the bank feels keeping only 10% of deposit in reserve is enough to cater for usual withdrawal and check requirements and reduces the reserve to $ 10. This frees up $ 90 for the bank which it loans out to another person. A count of money supply now gives an interesting result. The original $ 100 in demand deposit remains the same. What becomes different now is that the person who has taken the loan now has currency in shape of $ 90. So, the money supply in this case becomes $ 190. When a bank keeps a percentage of deposits as reserve and loans out the rest, this percentage is called the reserve ratio. In this example, the reserve ratio is 10% or 1/10. The system of banking where this bifurcation between reserves and loans takes place is called fractional-reserve banking. It must be noted here that even though the money supply has increased, no wealth addition takes place since the borrower still owes money that needs to be paid back This example can be cyclically repeated where each loan given is then deposited in a bank again, further loan/reserve bifurcation based on reserve ratio is made and the money is loaned out again. In the first cycle, the reserve would be 10% of $ 90, which is $ 9, and amount to be loaned out would become $ 81. Each successive cycle reduces the loan amount and calculations show that the total money created out of these cycles of deposit-reserve bifurcation-loan-deposit comes out to be $ 1000. On the basis of this example, it is now seen that a deposit of $ 100 with a reserve ratio of 10% or 1/10 results in money creation of $ 1000. The amount of money created in banking for each dollar in reserve is called the money multiplier and is the reciprocal of reserve ratio. So, for a reserve ration of 1/10, the money multiplier would be 10 and, similarly, for a reserve ration of 20% or 1/5, the money multiplier would be 5. So, finally, for example, if a deposit of $ 50 is made in a bank which has a reserve ratio of 30%, money creation would be as follows: Deposit: $ 50 Reserve ratio: 20% or 1/5 Money multiplier: 5 Money supply: $ 50 + 5 x 50 = $ 300. Fed’s Tools of Implementing Monetary Policy: In preceding sections, the elements considered as money and the effect of fractional-reserve banking on money supply have been summarized. The role of Fed in the economy has also been explained. It is now possible to describe the three ways in which the Fed can implement its monetary policy to maintain optimum levels of money supply. Open Market Operations: Used most often, this method entails the sale and purchase of government bonds by the Fed. When the Fed decides that money in the economy needs to be increased, it prints currency and uses it to buy government bonds from public in the open market. This infuses more money into the system by reaching the public thus increasing the total money supply. If this additional money is used as currency, an equivalent amount is added to the money supply. However, if a portion of this money is deposited in banks, more money can be created through the multiplying effect of fractional-reserve banking. On the other hand, if Fed wishes to reduce the money supply, it sells bonds into the market. As the public pays for these bonds, the money is transferred from the public to the Fed, and results in reduction of money in circulation. Reserve Requirements: Fed can issue regulations to banks to increase or decrease their minimum reserve requirements. When the reserve requirements are increased, banks are forced to allocate more money to their reserves by increasing their reserve ratio and thus reducing the amount available for loans. When the reserve ratio is increased, its inverse, the money multiplier, is decreased thus reducing the money creation effect in banking. This has the effect of reducing the money supply. Reducing the reserve requirements has the opposite effect. As evident, this method is indirect and depends on changes in money creation through banks. It is also considered intrusive to banking and is used sparingly. Discount Rate: As described earlier, Fed lends money to banks which, when it enters the banking system, increases the money supply through money creation. It is seen that typically banks use these loans to maintain their minimum reserve requirements when they use their existing resources for other business or withdrawals. More money coming in from Fed would allow the banks to increase their reserves as well as allocations for their loan portfolio. The interest charged by Fed on these loans is called the discount rate. An increase in discount rate discourages banks from taking loans from Fed and, as a result, they tend to limit their loan giving capability. They maintain or reduce their reserves instead of increasing them. Consequently the corresponding money supply does not increase. When Fed wants more money to enter the system, it reduces the discount rate. The banks are encouraged to take loans from Fed and therefore increase their reserves as well as money available for loans. This results in cash creation and money supply. Issues in Controlling Money Supply: Fed’s methods to control money supply, though effective to a large extent, do not always produce predictable results. In running the monetary policy, the Fed faces certain issues over which they have no control. It is clear by now that Fed places a strong emphasis on money creation through banks when deciding its monetary policy. However, money creation depends on deposits and a vast percentage of that comes from households. If households reduce the amount or number of deposits in banks, there will be less reserves and therefore less money creation through loans. The household behavior cannot be directly predicted or controlled by Fed and brings in an element of uncertainty in the process. Another issue that Fed faces is bank policies. If a bank, on its own, reduces the amount available for loan, there will be less money creation in this case too. Banks may do this for a host of reasons including future cash requirements or their own estimations of economic conditions. This too brings uncertainty in money supply management like in the previous example. However, the Fed does have methods in place to monitor this behavior as it regularly receives information on deposits and reserves in the banking system. It can take an informed decision based on the trends observed. Works Cited Mankiw, Gregory N. " Principles of Economics". 4th ed. Mason: Thomson South-Western, 2007. Read More