The Concept of Money and Its Creation - Essay Example

CONTEMPORARY BUSINESS ANALYSIS The concept of money and its creation Money occurs in two main forms as either banknotes or coins. These are the main medium of exchange currently used (Chung et al., 2012). For many centuries since the invention of money as an alternative medium of exchange from the old system that used barter trade, the medium has revolutionalised financial systems. Without the invention of money, one would wonder whether we would have the current financial institutions. The use of money eased the process of making payment and purchasing of items. The process of creating money is often a misunderstood phenomenon. Although many studies show that there are two main institutions tasked with the process of money creation, the process involved in creating money without the manual paper consideration is elusive. The two main institutions involved in the creation of money are the financial banks and the government (Hiroshi, 2007).It is estimated that about 97% of the money created originates from the banks while only 3% comes from the governments (Christensen and Rudebusch, 2012). The essay will unravel how these institutions create money, elaborate on the differences between the broad and narrow money. Besides, the assessment of how the creation of money occurs will help in the determining the role of central and commercial banks in determining the size of a country’s money supply. Using the United States as a case study in describing and assessing the effects and effectiveness of qualitative easing would provide a platform on how to stabilise economic growth. Explain the difference between narrow and broad money Narrow form of money is the most common medium of exchange (Han et al., 2012). It is the form of money in circulation within any economy. It consists of coins and notes as well as sight deposit. The site deposits belong to accounts whose owners can make withdrawals without attracting penalties. The narrow form of money is corroborative indicators for the spending regimes (Adrian and Shin, 2009; Baumeister and Benati, 2012). In fact, the form of money used in carrying out most of the day-to-day transactions of services and goods are the narrow form of money. Therefore, narrow money is the main form of exchange involving the monetary value. The zero maturity money is the sum of coins and notes on hold by the private sectors (the non-bakers) (Chung et al., 2012; Christensen and Rudebusch, 2012). For instance, employers pay their employees either by cash or cheque. Besides, these companies used the same form of money to pay and offset their expenditures. Unlike the broad form of money, the narrow form of money gives a clear outlook on the assets employed as the medium of exchange (Bartolini and Prati, 2006). However, the broad money captures more than just the medium of exchange. It is a broadened measurement of the monetary value because it includes the financial assets (Joyce et al. 2012). Besides, it also includes the time deposit. These are deposits that banks hold and save for the purposes of subsequent transactions. The appropriate definition of broad money must capture the broad aggregate of asset components that provide transaction services (Curdia, and Woodford, 2011). Explain the role of central and commercial banks in determining the size of a country’s money supply The association between the government banks (central banks) and the banking sector within a country is the main driver of that country’s economic strength (Joyce et al. 2012). The two players have different roles in ensuring sufficient circulation of money and avoid the occurrence of inflation. The central bank holds the money and formulates monetary policies and frameworks. On the other hand, the commercial banks take part in the implementation of the framework and other monetary policies (Bartolini and Prati, 2006). One of the functions of the central banks is to regulate lending and circulation of the broad monetary value. The commercial banks offer borrowing and lending of the money to the public and other investment forums. For that reason, the fundamental function of the commercial banks is to hold money. According to Krishnamurthy and Vissing-Jorgensen, (2011), holding the money by the commercial banks serves two functions. The money holding segments include the non-monetary intermediates taking part in the financial aspects, other governments with the exception of their central government, non-financial corporate, and the households (Clouse et al., 2003). These agencies constitute the commercial banks that hold both the narrow and broad forms of money. The broad form of money constitutes money stored as value, deposits, and other forms of assets. The holding process serves to regulate the demand and supply regimes thereby ensuring an appropriate growth of monetary value of the country (Bartolini and Prati, 2006). Through the holding process, the government can quantify how various economic sectors contribute to the growth of money. The government can comprehend what factors affects the growth of money. The strategy helps in understanding the view of monetary expansion (Baumeister and Benati, 2012). Second, the holding of money is the most appropriate way for the formulation of a normative framework. Such frameworks are crucial in the assessment of the price stability and consistency of money stocks in the economy (Chung et al., 2012). Economist and policy formulators would use the data generated from deviation from the norm to make assessments and subsequent analysis of the deviation from equilibrium (Bernanke et al., 2004). Information obtained when the stock money deviates from the known level depending on empirical regularities are vital for the formulation of monetary policies (Curdia and Woodford, 2011). The supply of money and demand is the main factor affecting monetary development. These factors form the main strategy for the assessment of the relationship between wealth, asset price development, and the money (Hiroshi, 2007). Banks are the major sources of the broad money supply. Commercial banks are the institutions tasked with supplying deposits and granting loans to the public. Besides, they screen and monitor borrowers. These strategies ensure banks transform assets and redistribute some of the risks (Kimura and Small, 2006). The effects and effectiveness of quantitative easing in the USA Quantitative easing is a deliberate process by the governments to pump money into the economic segments of the country (Christensen and Rudebusch, 2012). The process ensures that strategies to stabilise the country’s economic trends. The process may seem unorthodox, but it has been hailed as the most strategic and effective way of combating the recession. When money gets into the economy through quantitative easing, the main aim involves lowering the long-term rates of interest (Han et al., 2012). The major factor that triggered the global recession that took place in 2008 was plummeting interest rates. The interest rates had dropped to zero prior to the commencement of the global recession. Such trends required that exception and unconventional strategies developed especially concerning policies related to interest rates (Curdia, and Woodford, 2011). The quantitative easing program emerged to be the most preferred method for combating issues that trigger the global recession. The Japan government gets the credit for spearheading the concept of quantitative easing. Japan pioneered and implemented this concept in 2001; however, other countries began to implement the model in 2008 (Krishnamurthy and Vissing-Jorgensen, 2011; Dobbs, et al., 2013). Governments through their Central Banks have used different strategies to attain financial stabilities. Some of these strategies include the credit markets, securities, liquidity facilities, and assets (Brunnermeier and Pedersen, 2009; Krishnamurthy and Vissing-Jorgensen, 2011). These strategies bored different results to stimulate the economy as shown in the diagram that follows. Figure 1: illustrating strategies used by governments for financial stability and monetary stimulation The aftermath of 2007 real estate bubble was the triggering factor for the 2008 financial crisis. The USA began implementing the quantitative easing concept in 2008. The USA government needed to institute a strategy that prevents financial instabilities. The recession was attributed to dwindling circulation of money in the economy (Chung et al., 2012). The interest rates hit nearly zero making it hard for banks to have money to lend as loans. The government, through the Central Bank, had to take deliberate measures to pump money into the economy and make it available for the various institutions hence combating the recession (Adrian and Shin, 2009; Baumeister and Benati, 2012). The USA began its first quantitative easing in 2008 (QE1) and the second batch took place in 2010 (QE2) while the last batch took place in 2012 (QE3) (Dobbs, et al., 2013). The program involves the purchase of large-scale assets. These assets were considered as securities and long-term bonds, besides the Federal Reserve used the operation twist. The operation twist aimed to trade short-term bills with the long-term bonds. These purchases were made through the security market program. The deliberate process involves making the purchase of some securities (Brunnermeier and Pedersen, 2009). For instance, the USA Central Bank adopted quantitative easing by pumping money to purchase the mortgages. These are strategies also involve buying of long-term securities. These strategies are aimed at ensuring that the interest rate gets lower over a longer duration. Besides, it is the most appropriate way to stimulate economic growth. Availability of money through the financial institutions makes the funds available for various sectors of the economy. Such strategies would mean that various sectors of the economy would be in a position to borrow money in terms of loans. The net effect is increased circulation of money, creation of jobs (Chung et al., 2012). Pumping money increases the lending regimes by the banking institutions. Given that about 97% of the money created in any economy originates from the banking institutions, the Central Banks must take a deliberate measure to ensure that they empower the banks to steer the economy (Joyce et al. 2012). One of the ways to steer economic growth is through the creation of jobs and reducing joblessness. Increased circulation of money into the economy opens the potential economic areas that entrepreneurs may identify appropriate for the investment. Therefore, one of the effectiveness of quantitative easing is the possibility of reducing unemployment (Brunnermeier and Pedersen, 2009). Besides, the purchasing of assets by the government helps in the stabilisation of the asset prices. Normally, the low-interest rate affects the households as well as the emerging markets. In 2012, the USA adopted its third quantitative easing (QE3) by pumping $85 billion (Dobbs, et al., 2013). These strategies involve purchasing the mortgage, bonds, and the securities. Other than buying mortgages, other strategies used by the Central Bank during quantitative easing are the process of buying bonds. When a government buys the bonds, it provides a good opportunity for the banks to begin borrowing the bonds. These approaches not only scaled up the amount of money circulating in the country but also kept the economy of USA going. Through the implementation of qualitative easing, the United States has experienced mixed trends. For instance, from 2007 to 2012, the United States banks experienced increasing effective marginal net interests that were paid as interests on deposits (Dobbs, et al., 2013). However, its liabilities reported immense decline as opposed to interests from other assets and loans. During the same period, the US Banks reported $150 billion increase in its cumulative net interest income (Dobbs, et al., 2013). These trends illustrate that the US banks diverged their competitive positions. One interesting trend during the entire period that saw the implementation of qualitative easing is the differences between interest rates and bond prices. During the same period (2007 to 2012), the interest rates declined with increasing bond prices. It is reported that during the era, the corporate and sovereign bonds increase by $15.9 trillion (Dobbs, et al., 2013). However, previous studies did not report whether these trends boosted the equity market. The occurrence of the economic crisis requires that country’s adopt a strategic approach would keep its financial muscle strong. In 2008, the federal reserve of the United States took strategies that sought to identify specific markets to ease the pressure on credit facilities (Christensen and Rudebusch, 2012). For instance, during that time, the Federal Reserve generated measures by purchasing 90-day commercial paper (Dobbs, et al., 2013). The strategy ensured that it provided the liquidity for the money market fund, hence helping the process of issuing the asset-backed security. The economy with very low-interest rates is likely to experience a number of challenges. For instance, in the US, the low-interest rate is one factor that played a significant role in bolstering house prices. Besides, the structural factors could have influenced the house prices in the US market. These prices were found to be around 15% higher when compared to their counterparts in the United Kingdom (Christensen and Rudebusch, 2012). A low rate of interest reduces the rate and cost at which individuals and institutions would borrow. These trends argue that a decline in interest rates leads to an increase in house prices. References Adrian, T. and Shin, H.S. (2009) Money, Liquidity and Monetary Policy, American Economic Review, 99: 600–605 Bartolini, L., and Prati, A. (2006) Cross-country differences in monetary policy execution and money market rates’ volatility, European Economic Review, 50(2): 349–376 Baumeister, C., and Benati L. (2012) Unconventional Monetary Policy and the Great Recession: Estimating the Impact of a Compression in the Yield Spread at the Zero Lower Bound, European Central Bank Working Paper Series, 1258. Frankfurt: European Central Bank, October Bernanke, B. S. (2000) Japanese monetary policy: a case of self-induced paralysis? In Ryoichi Mikitani and Adam S. Posen (eds.), Japan’s Financial Crisis and Its Parallels to U.S. Experience, Institute for International Economics, Washington, D.C Bernanke, B.S., Reinhart, V.R. and Sack, B.P. (2004) Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment, Brookings Papers on Economic Activity, Economic Studies Program, 35(2): 1–100 Brunnermeier, M. K., and Pedersen, L. (2009) Market Liquidity and Funding Liquidity, Review of Financial Studies, 22: 2201–38 Christensen, J.H.E. and. Rudebusch, G.D. (2012) The Response of Interest Rates to U.S. and U.K. Quantitative Easing, The Economic Journal 122(564): 385–414 Chung, H., Laforte, J., Reifschneider, D. and Williams J.C. (2012) Have We Underestimated the Likelihood and Severity of Zero Lower Bound Events, Journal of Money Credit and Banking, 44(February): 47–82 Clouse, J., Henderson, D., Orphanides, A., Small, D. and Tinsley, P. (2003) Monetary Policy when the Nominal Short-Term Interest Rate is Zero, The B.E. Journal of Macroeconomics, 1: 12 Curdia, V. and Woodford, M. (2011) The Central-Bank Balance Sheet as an Instrument of Monetary Policy, Journal of Monetary Economics, 58(1): 54–79 Dobbs, R., Lund, S., Koller, T. And Shwayde, A. (2013) QE and ultra-low interest rates: Distributional effects and risks, The McKinsey Global Institute (MGI) (Discussion Paper), www.mckinsey.com/mgi Han C., Curdia V. and Ferrero, A.A. (2012) The Macroeconomic Effects of Large‐Scale Asset Purchase Programmes, Economic Journal, Royal Economic Society, 122(564): F289–F315 Hiroshi, U. (2007) The Effects of the Quantitative Easing Policy: A Survey of Empirical Analyses, Monetary and Economic Studies, 25(1): 1–47 Joyce, M.D., Miles, A.S. and D. Vayanos. (2012) Quantitative Easing and Unconventional Monetary Policy—an Introduction, The Economic Journal, 122: F271–F288 Kimura, T., and Small, D.H. (2006) Quantitative Monetary Easing and Risk in Financial Asset Markets, Topics in Macroeconomics, vol. 6(1): Krishnamurthy, A and Vissing-Jorgensen, A. (2011) The Effects of Quantitative Easing on Interest Rates, Brooking Papers on Economic Activity 43(2): 215– 287 Read More