4 - 1 The monetary system in any economy facilitates trade and allows people to

Question

4 - 1 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 information presented in the textbook and 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. Money is defined as "Anything that is generally accepted by the people as a medium of exchange". Requirements that something to be considered as money are:

Medium of Exchange : Anything that should be used as the medium of exchange is considered to be money. People have to accept that thing to use for the purchase of goods and services.

Store of Value : Anything would be considered as money if it can be stored for future use together with the feature of medium of exchange.

Measure of Value : Anything that would be measured easily either in terms of kilograms, metres, litres, etc would be considered as money.

Standard of deferred payment : Anything that serves as a standard of deferred payment would be considered as money. Deferred payments refers to those payments which are made in future. When we borrow money from somebody in the present, we have to return both the principal as well as interest amount at some future date.

Dollare have the value because it is backed by the Federal Reserve or Government of the US.

2. Money supply consists of cash, coins, bank balance held in checking accounts. It is the entire stock of currency and other liquid instruments in a country's economy as of a particular time. Money supply includes:

M1 = C + DD + OD

C is the currency held by the public

DD is the demand deposits of the people with commercial bank which can be withdrawn on demand.

OD is the other deposits with Federal Reserve

M2 = M1 + Saving deposits with Post Office Saving Banks

M3 = M1 + Net time-deposits with commercial banks

M4 = M3 + Total deposits with Post Office Saving Organisations (excluding NSC)

3. Functions of the Fed includes:

(i) Monetary function : Under this Fed decides discount rate, interest rate and uses various instruments like open market operation etc to control the supply of money in an economy.

(ii) Banking supervision : This is the other function of Fed in which the Fed supervises all banks. It acts as a banker to the bank and keep constant vigil on the activities of the commercial banks.

(iii) Financial services : The Fed performs financial services for the economy.

The Federal Open Market Committee (FOMC) is the branch of the Federal Reserve Board that determines the direction of monetary policy. The FOMC consists of board of governors, which has seven in numbers and five reserve bank presidents. Open market operation is the primary responsibility of FOMC. Open market operation includes sale and purchase of government securities by the Fed in order to control the supply of money and interest rate.

4. Financial institutions act as an intermediary between the savers and borrowers. It takes excess money from the savers and lend this to persons who need money for some productive purpose. It helps in the development of an economy. Commercial banks earns profit from the interest rate difference between what they charge from investors and what they provide to the depositors.

5. Fractional reserve banking is a term used to describe the situation of banks in the economy. Each bank is liable to keep some proportion of their deposits with the Fed as a required reserve ratio and due to this banks are not able to lend their whole deposit to the investors or businessmen. They can lend a fraction of their deposits due to this 'fractional reserve banking' is used.

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