Money in Macroeconomics - Essay Example

?Question The economists define money as something that serves as a medium of exchange, a unit of accounting, a standard for deferred payments, anda store of value. As a medium of exchange, money can be used as an intermediary for trade that helps remove the inefficiency of barter system. As a unit of account, money serves as a standard numerical unit for measuring the value of goods, services, and other transactions. As s standard for deferred payments, money must be usable to settle debts at the future date. As a store of value, money must be able to be saved, stored and retrieved at a later date and be predictably useful when retrieved. Further, economists use different level for recognizing money (like M0, M1 etc.). And economists define a money multiplier to see the ratio of money supply and the actual monetary base in the economy. Now, the recent financial crisis has affected some parts of the definition of money especially as a store of value. The financial upturn has shown that most assets and asset classes previously believed to be the “safe” stores of value for money are in fact all driven by risk and can at some point in time not be “so safe”. For example, houses are one the largest stores of value but the global deterioration of property prices has made this option less valuable. Similarly, government bonds which were considered as the safest bets for store of value were actually no longer safe either as we see the example of Greece and their impending default of payment and/or restructuring of debt in Greece. Bank deposits were badly hit as storage of value with the bank-runs seen in Northern Rock, UK and several other banks in the US. Currencies by nature of being subject to market demand and supply appreciate and depreciate with time and cannot be considered as safe stores of value either as was seen in the example of Asian financial crisis of the late 1990s. Secondly, the money multiplier, m, as explained by economists is supposed to be 1/R where R is the reserve requirement for banks. As seen during the financial crisis, this equation was not valid at all. Figure 1 below shows the variation of money multiplier from 1984 to present. We see that as soon as the financial crisis hit, even though there was little or no change in the reserve requirements, the money multiplier saw a huge drop to end up at less than 1.This means that while the government was creating supply of money, banks were reluctant to lend. Figure 1. M1 Money multiplier in the US – 1984 to March 2011 Source: Federal Reserve Bank of St. Louis Given the turnout of events as happened during the financial crisis, there seems to be no readily identifiable group of assets that economists would consider as money. To be accepted as money by all, none of the assets satisfy all the criteria – bill of exchange, bonds, equities, deposits. Gold, silver and precious metal come close but as these are rare, and cannot really meet the demand for money, they cannot really be considered as money. Question 2 The structure of Federal reserve system is shown below in figure 1. Figure 1. Structure of Federal reserve system The components of the federal reserve system and their functions are described below: 1. Board of governors: they are appointed by the US president and confirmed by the US senate. The primary responsibility of the Board members is the formulation of monetary policy. The Board sets reserve requirements and shares the responsibility with the Reserve Banks for discount rate policy. 2. Federal Reserve banks: The 12 Federal Reserve banks operate under supervision of the board of governors. Each bank has 9 directors who appoint the bank presidents who form part of the Federal Open Market Comittee. The main role of the reserve banks is to influence the flow of money and credit in the economy. The Federal Reserve Banks hold, in their vaults, collateral for government agencies to secure public funds that are on deposit with private depository institutions. The Federal Reserve Banks also issue and redeem instruments of the public debt, such as savings bonds and Treasury securities. They have certain responsibilities for allotment and delivery of government securities and for wire transfer of securities. In addition, the Reserve Banks make periodic payments of interest on outstanding obligations of the U.S. Treasury, federal agencies, and government-sponsored corporations. 3. Federal Open Market Committee: The Federal Open Market Committee (FOMC) consists of twelve members - the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis. The FOMC holds eight regularly scheduled meetings per year. At these meetings, the Committee reviews economic and financial conditions, determines the appropriate stance of monetary policy, and assesses the risks to its long-run goals of price stability and sustainable economic growth 4. Member banks: Each member bank is a private bank that holds stock in one of the 12 regional Federal Reserve banks. The amount of stock each member bank must buy is set to be equal to 3% of its combined capital and surplus of stock in the Reserve Bank within its region of the Federal Reserve System. Holding stock in a Federal Reserve Bank is not, however, like owning publicly traded stock. The stock cannot be sold or traded. Member banks receive a fixed, 6% dividend annually on their stock, and they do not directly control the applicable Federal Reserve Bank as a result of owning this stock. They do, however, elect six of the nine members of Reserve banks' boards of directors. The advantage of the member bank status is that it gives one the right to receive loans from Federal Reserve Banks, use their services and get useful information. Importance of Federal Open Market Committee (FOMC) The FOMC is the key monetary policy decision-making unit of the Federal Reserve. It oversees/guides the open-market operations - the principal tool of monetary policy which influences short-term interest rates and determines reserve and monetary growth. Largely, the FOMC, by buying and selling US treasury securities controls the money supply and the interest rates. It also directs foreign exchange market operations of the Federal Reserve System. The FOMC, by guiding the reactive and pro-active open market operations decides the changes in overall money supply that helps to stabilize the businesses cycles, reduce unemployment and inflation, and affect economic growth. References Federal Reserve Bank of St. Louis. M1 Money Multiplier (Mult). Accessed 12 June 2011. http://research.stlouisfed.org/fred2/series/MULT Federal Reserve Board. The Structure of the Federal Reserve System. Accessed 12 June 2011. http://www.federalreserve.gov/pubs/frseries/frseri.htm Read More