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Money Supply - Essay Example

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How can the fed affect the money supply by using the discount rate? Interest rates that are adjusted by the Fed, otherwise known as the Federal Reserve System are at times used as a means for money supply control…
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Money Supply Money Supply Question How can the fed affect the money supply by using the discount rate? Interest rates that are adjusted by the Fed, otherwise known as the Federal Reserve System are at times used as a means for money supply control. By lowering the discount rate, the Fed will decrease the money supply and vice versa. However, discount rates are used by the Fed for direct changes in the monetary policy rather than control the money supply. The discount rate is described as the interest rates charged on commercial banks borrow reserves by the Federal Reserve banks. Therefore, a decrease in discount rates will encourage borrowing by banks. This in turn increases the amount available in reserves of the banking system; this will automatically trigger a money supply increase. This is the same way an increase in the discount in the discount rate will have an opposite effect on the money supply. Question 2: Discuss the factors that led to deregulation of the U.S financial markets in the 1980s. Deregulation can be described as the process where there are adjustments made to the law. What this means is that financial institutions will have more freedom in the way that they compete. Deregulation, therefore, is the process where regulations are reduced or at times removed to increase the efficiency of markets. The reason behind deregulation is promotion of competition. It will result in low prices and a marketplace that is more effective. In the 1980s, japan was one of the highly regulated financial markets. However, there was an agreement between Japan and the U.S in 1984 to liberate the markets. The rapid deregulation helped to strengthen the Yen and sustained capital flows to the U.S economy. This prevented unwarranted weakening of the American dollar. The U.S also was the first to deregulate its financial sector. This was for attracting investors at a time when deficits of the U.S government were high. This was because of spending on the war in Vietnam. The U.S had also been weakened in its trade position as industries in Japan and Europe thrived. Question 3: What are the differences between M1 and M2? M1 is described as the official money supply for the American economy. If for example an individual is making a payment for buying a good or service, they will use two concepts. These concepts are the M1 paper currency or the checking account fund deposit. Almost a half of M1 comprises of paper currency. It is not only limited to paper currency but metal coins too issued by the federal government. Currency and metal coins held by non-bank public is categorized as M1. The checking accounts is run and maintained by the commercial banks. M2, on the other hand, is the medium-range monetary aggregate that is a combination of M1 and small denomination near monies in the short term in the U.S economy. Financial assets function directly as money or can easily turned into money are categorized here. Saving deposits, money market deposits, certificate of deposits and mutual funds of the money market added to M1 derive the M2. Question 4: What are the three functions of money, and why are they important? Money as a medium of exchange is probably money’s most vital function. As a medium of exchange, money facilitates transactions. The other option available apart from money is barter, acting as the medium of exchange. When money serves as a medium of exchange, it eliminates the wants problem of double coincidence associated with barter trade. This is because it is universally accepted regardless of the desire for the good or service. Money will function as a unit of account. This means it provides a common measure for the value of all goods and services that are exchanged. The value of any good or service is defined and known by its price. This will enable the purchaser and supplier to make decisions on quantity and quality of a good in a transaction. Money will also function as a store of value. Money has to be such that it keeps its value over time to act as a medium of exchange. It has to last for a long period and still hold its value intact. This makes it unique as opposed to other store of value like land. Furthermore, money is easily portable store of value and available in numerous denominations. Question 5: Explain how banks are financial intermediaries. What are reserves? What are excess reserves? Explain how the Fed can affect the quantity of excess reserves in the banking system. Financial institutions, in this case, commercial banks, accept deposits from the public. They will go a step further to make loans available to those in need of credit services. By doing this, banks act as the intermediaries between economy (savers) and borrowers (Deficit spending units) in the cash surplus units. As a financial intermediary, a bank facilitates borrowers to tap into a wealth pool of federally insured deposits. Reserves can be described as a required amount of money by the law so that a commercial bank is able to make loans or continue in its service offering business. This reserve is held by the Federal Reserve System. Excess reserves are the capital reserves that a financial institution or bank holds way over what the law requires. Standard reserve requirements set by the central banking authorities is used to measure excess reserve in the case of commercial banks. A set amount or required reserve sets the minimum liquid deposits. This minimum must always be at the bank as reserve. Bank’s excess reserves are held by the Fed and do not earn any interest. This means it becomes part of the money supply. This means that the Fed can continue printing lots of money and it will not result in lots of inflation. References Bade, R. & Michael, P. (2002), Foundations of Microeconomics, Boston, MA: Addison-Wesley McEachern, W.A. (2012), ECON Macro 3 (3rd ed.), Mason, OH: South-Western Read More
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