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Government Methods to Create Money - Essay Example

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This essay "Government Methods to Create Money" discusses 3 methods which governments can create money, its pros and cons, calculating reserve ratio and total money supply from banking systems, what will happen to interest rates if the money supply and demand change and how does change in interest rate affect investment…
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Government Methods to Create Money
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The money supply can be influenced through three main tools that the Federal Reserve or the Central Bank of a country will use to either create money or reduce money. These options include
1. Changing the Required Reserve Ratio – Reserve Ratio can be described as the percentage of depositors balances which the banks are expected to have on hand as cash. The Federal Reserve can change this rate depending on whether it wishes to reduce or increase the money supply. When the ratio is lowered, the banks can lend out more funds, increasing the money supply. Conversely, if the reserve ratio is increased, the banks have to lend less and keep more money in the reserves.
2. Changing the discount rate or the prime lending rate – at which the commercial banks borrow from the central bank can also create more money or less money. If the prime lending rate is low the commercial banks can borrow more and lend out to the economy which will create more money within the market.
3. Engaging in open market operations - By actively engaging in open market operations such as buying and selling of various credit instruments and foreign currencies or commodities, the Federal reserve can either create or reduce money.
Open market operations allow central banks great flexibility in the timing and volume of monetary operations at their own initiative, encourage an impersonal, businesslike relationship with participants in the marketplace, and provide a means of avoiding the inefficiencies of direct controls.
To calculate the reserves, the depositor's money should be multiplied by the reserve rate stipulated by the Federal Reserve + 100. For example, If the reserve rate is 10% and the bank has deposits of $1 billion, it is required to have $110 million on reserve. If the bank has 220 billion in its reserve and depositors deposits are 190 billion then to find out the reserve rate. Read More
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