The monetary system in any economy facilitates trade and allows people to trade

Question

The monetary system in any economy facilitates trade and allows people to trade more efficiently, as compared to a barter economy. In the United States, the monetary authority is the Federal Reserve System (also referred to as the Federal Reserve, or informally, as the “Fed”.)

For this assignment, use the Fed’s website (http://www.federalreserve.gov/) when addressing the questions below.

1- What are the requirements for something to be considered money? Why does the dollar have value?

2- What does the money supply consist of and what are the respective amounts in the total money supply for the United States?

3- What are the primary functions of the Fed? What role does the Federal Open Market Committee (FOMC) play in our economy?

4- What role do the financial institutions (commercial banks and other institutions) play in our financial system?

5- What is meant by the term “fractional-reserve banking” in our system? What are the implications for consumers?

6- What are the tools available to the FED for controlling the money supply? Which are used most often? Which are most effective?

7- How does the money multiplier help to determine the effects of monetary policy?

8- What are the pros and cons of using monetary policy, as opposed to the use of fiscal policy, for implementing economic policies and practices?

Explanation / Answer

(1)

To be considered as money, an object must be:

- A store of value

- A unit of account

- A medium of exchange.

Dollar has value as a monetary unit because it is a Fiat Money. Fiat Money means that the monetary unit itself (the dollar bill or coin) has no intrinsic value, but derives its value from the legal paper tender assigned to it by the government.

(2)

The money stock is built up as follows:

M0 = Currency & notes in circulation

Base Money (MB) = M0 + vault cash & coins + required reserves at Fed

M1 = M0 + demand deposits + travelers checks + other checkable deposits

M2 = M1 + savings deposits + time deposits + money maket deposits (individual)

M3 = M2 + larger time deposits (> $100,000) + institutional money market deposits + short term repo

For the US:

M1 = $3.04 trillion & M2 = $12.06 trillion (as on July 2015)

M3 = $11.44 trillion (as on July 2014, latest available)

(3)

Primary function of Fed is to control money supply, thereby controlling inflation through it.

The FOMC engages in the most important monetary policy tool - open market operation. When there is excess money supply in the economy, inflation goes up. To control inflation, Fed FOMC conducts open market sale of federal bonds in exchange of money, to squeeze out the additional money supply, thus checking inflation.

During deflation, FOMC engages in open market purchase of bonds to increase money supply, thus increasing price level.

(4)

In an economy, households are the savers & are source of fund, and firms are the borrowers who use the funds. Financial institutions act as the primary facilitator between supply and demand of funds, by acting as an intermediary, where the savers can park their fund as savings, and the borrowers can take loan of funds they require.

(5)

Fractional reserve banking means that, banks have to mandatorily set aside a fraction of the deposits as reserves they cannot use for lending purposes. This fraction is called the required reserve ratio. For example if required reserve ratio is 10%, it means that out of every $1 of deposit, banks can lend only $0.90.

The implication fallout reaches to the total increase in money supply. For every $1 increase in deposit, money supply in the country increases by (1 / Reserve ratio). In our example, for every $1 deposit (and $0.90 lent out by the bank), money supply in the economy will increase by (1 / 0.10) = 10 times.

Therefore, an increase (decrease) in reserve ratio will decrease (increase) total money supply.

NOTE: Out of 8 questions, the first 5 have been answered in full.

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