Money, Banking and the Federal Reserve System - Essay Example

Money, Banking and the Federal Reserve System Every world economy requires money to transact its operations. Money is a liquid asset applicable making transactions in acquisition of goods and services. There are several monetary forms present in the world today. The United States of America uses the monetary unit of a Dollar. The United States Treasury prints money bills for distribution to the banks in form of bank reserves. The banking system provides the platform for reserving money for distribution to the public. In order to ensure a balance of the bank reserves and to control the monetary base, the Federal Reserve was established. For efficient use of money in the United States, the Banks and the Federal Reserve work together. Money is the most widely used liquid asset in the world today. Cash is the liquid form of money that is applicable and usable in many of the small and medium business ventures. However, there are other forms of money acceptable in many places. These include traveler’s checks, and checkable bank deposits. Money has the capability of generating gains from trading activities since its nature allows indirect exchange. It also provides a uniform way of transacting given that every product or service can be exchanged with money. It contradicts the barter system of trade (Krugman 412). Money plays three main functions in the United States economy. Firstly, it the sole medium of exchange across the country, it is possible to obtain any goods and services in exchange of money. This medium of exchange lacks the capability to be consumed hence it has to be applied in obtaining consumable goods and pay fro services. Hard economic times have called for use of different monetary forms. This has been evident in some Latin American countries that have resulted into the use of the American dollar, a situation also seen in Eastern Europe where they have used Euros. Secondly, it is used as a store of value, meaning money has the ability to purchase power over a given period. Other assets complement money as a store of value but its uniqueness is that its value appreciates in most cases. Lastly, money is a unit of account. In accounting, money is widely accepted as the medium of setting prices and calculating the value of other assets 413-414. The concept of money has continued to change with time. In historical times, silver and gold were considered as the medium of exchange, this was facilitated by their valuable nature in making of making of ornaments and jewellery. Around independence time in 1776, paper money was getting used to complement the gold and the silver coins. The transition saw the introduction of commodity-backed money that whose value was dependent on the promise that it could be possible to turn it into value on demand. (Krugman 414).To further enhance the monetary form, the United States Dollar was adopted as a generally acceptable mode of transacting in exchange of goods and services. This introduced the so-called fiat money that derives its value from the official status it adopts. This type of money has advantages over the former types in that it does not use other resources apart from the material used in its making and secondly, its supply can be regulated to take care of specific economic needs. However, the challenge remains in production of fake currency (Krugman 415). There are two types of monetary aggregates, denoted by the Federal Reserve as M1 and M2. M1 entails the cash, traveller’s checks and checkable bank deposits. Other near-moneys are inclusive in M2. In the United States, year 2011 September, M1 was equivalent to $2,136.9 billions while M2 was $9,603.6 billions of dollars (Krugman 416). Near-moneys are accompanied by interests that the cash dos not, this is the reason why they pay higher interests than checkable bank deposits. Banks plays a critical role in the money industry in the United States and all over the world. It is evident that banks play a role in linking the Federal Reserve and the borrowers. They use the liquid assets to fund investments from borrowers. The money found in banks has different levels of liquidity depending on the proposed use. They also balance between the withdrawals and deposits, they have an obligation from the depositors to preserve their money and retrieve it upon need. In addition, borrowing keeps them in business, therefore, the need to balance between the needs of the borrowers to those of the depositors. The liquid assets owned by banks takes the forms of currency in the bank’s vaults or currency in their account with the Federal Reserve that can be easily convertible for use by banks. These two sources of liquid are generally referred to as bank reserves. A T-account is a tool that is used by financial institutions for analyzing the status of their account in order to regulate money supply. The account shows the financial position of the bank of the bank at every given time; it consists of assets on the left side and liabilities on the right side. Every time the assets should surpass the liabilities, an aspect that is regulated by the Federal laws. It is required that the assets should be higher than the liabilities by a certain percentage (Krugman 417). The dynamics of depositing, withdrawing and borrowing from the bank should be well balanced. It is obvious that the main source of revenue is through borrowing. Therefore, it is a necessity for the business to remain healthy. A crisis brought about by many or all the depositors requiring their money from the bank is solved by selling of the loans given by the bank to individual investors or other banks (Krugman 419). This strategy is not healthy to the bank since it will stand to lose the revenue it was meant to raise in form of loan interest. If the loans are not sufficient, they result into selling of assets, of which they will go at a cheaper price. The main source of the rapid withdrawals may be facilitated by rumours or suspicion that the bank is getting into a financial crisis. The resultant phenomenon is what is referred to as bank run, referring to massive withdrawals from fear that the financial institution is in the verge of failure (Krugman 420). Bank run can be in itself the main cause of the collapse of the bank, even if all was well with the bank. The Federal Government has developed measures to prevent bank run. Firstly, all banks in the United States are insured under the Federal Deposit insurance corporation (DFIC). The banks insure the deposits with the agency and upon incapability to provide the depositors with their money; the agency intervenes and provides up to $250,000 per depositor for every insured bank. Secondly, Due to the limitation of the deposit insurance to cover for the ability of the depositors to monitor how their bank is doing. The capital requirement imposed by the regulators ensures that every bank has a higher value of assets than that of the deposits. The regulation actually requires that the value of bank’s capital to be at least 7% of the total asset value. Thirdly, the Federal Reserve in the United States requires that reserve ratio for checkable bank deposits be not less than 10%. The final regulation requires that the Federal Reserve provide a discount window for troubled banks. This means the bank can borrow from the agency in order to pay the depositors, hence preventing the crisis of selling its assets (Krugman 423). Money making from the financial is an n important factor in preserving the bank in an operational mode. The multiplication of money in the bank account is determined by the borrowing of the bank. The initial increase in capital enhances more spending. Money borrowed finds its way back into the financial institutions, not necessarily the lender. However, the borrowers in their private possession retain some of the borrowed amount. This amount reduces the amount of money multiplier resulting into some complicated financial implications. Excess reserves lent by the bank ends up initiating a money multiplier. The excess reserves become a checkable deposit in another bank. These excess reserves are those that appear over and above the bank’s needed reserves. The complication of the money multiplier is brought about by not only by the ratio between reserves and bank deposits but also by the fact that individuals will tend to uphold some of the money outside the banking system. The amount of money in circulation and the bank reserves are cumulatively called the monetary base. The Federal Reserve fails to control the distribution of money in circulation and the bank reserves by the banking sector. The money supply and monetary base have variations in that bank reserves are not part of money supply as in the case with monetary base. Another difference is that checkable bank deposits are available for spending hence becoming part of the money supply and not monetary base (Krugman 425). The ratio of the money supply to monetary base consists what is referred to as money multiplier. Measuring money using M1 United States has achieved varying money multipliers, during normal times the range has been 3.0 to 1.5, despite hitting an all time low of 0.7 during the 2007-2009 recession. All the matters of money and the regulation of its use solely fall under the safe hands of the Federal Reserve, otherwise referred to as Fed. Established in 1913, the agency is a semi-autonomous body consisting of the Board of Governors appointed by the President and approved by the Senate, and twelve regional Federal Reserve Banks. The board oversees the general running of the institution while each of the 12 Federal Reserve Banks provide regions with supervisory and banking services. Federal Open Market Committee makes major decisions in the monetary policy system (Krugman 426). This committee comprises of the Board of Governors and five regional bank presidents, one being the one for New York while the rest of the positions rotating around the other 11 regions. Fed utilises three main policy tools including discount rate, reserve requirements and open market operations. Fed has currently set the reserve requirement at a minimum of 10% for checkable bank deposits. Failure to comply with the regulation attracts penalties for the incompliant banks. The federal funds market is a platform in which incompliant banks can be able to meet the additional reserve requirement through borrowing from other banks with additional reserves. The discount window is also an applicable way of borrowing from the Fed itself. Fed uses the tool of discount rate to enhance its operations; it involves the regulation of the lending interest as provided in the discount window. In an effort to regulate the supply of money, they adjust the discount rate and the reserve requirements appropriately. The reserve requirement is not very much applicable in managing money supply. In fact, the reserve requirement remains unchanged since 1992. In facilitating open-market operations, they are discharged with the mandate of selling the United States Treasury bills through commercial banks (Krugman 431). Fed’s equals in the sector of regulating the monetary policies are so spread across the world. Some of these are much older than Fed, like the Sveriges Rijksbank of Sweden and the Bank of England for Britain. Created in 1999, the European Central Bank (ECB) has been on the forefront of regulating the use of the Euro since its adoption by the members of the European Union. ECB serves the member countries that have left their internal mechanisms to adopt the euro zone in the same way as Fed (Krugman 432). Comparing with Fed, the role discharged by ECB is tantamount to that of the board of Governors. In contrast to Fed, the ECB’s Executive Board is chosen by mutual agreement of the member states’ national governments. In addition, they have a governing council that can be compared to the Federal Open Market Committee. Therefore, the European counterpart has many similarities with Fed but the structure and mandate of Fed is more clearly cut out and well developed. The banking system has achieved tremendous changes that have enabled it to get to the level of success experienced today. A move to transform the Federal Reserve as well as the banking system was initiated in 2008 and so far, several changes are evident (Krugman 433). Historically, the federal government regulated the banking industry until the establishment of Fed in 1913. This was a kneejerk to the many accompanying challenges in the management of the industry, the fact that the money supply was not sufficiently responsive. A major incidence was reported in 1907 where banking institutions referred as trusts took huge deposits humiliating the national banks since themselves were not regulated in any way. The economy started awakening when the trusts did speculations in the real estate industry and the stock market. Wealthy individuals such as J. P. Morgan, John D. Rockefeller and U.S. Secretary of the Treasury intervened to save the situation (Krugman 435). They assured the people that they could withdraw their money in the banks hence making the panic to cease. The previous crisis prompted the establishment of permanent measures to ensure monetary policy is effectively regulated. Bank runs were not fully eliminated by the mere introduction of standardized and centralized holding of bank reserves. In the 1930’s during the great depression more bank, runs were experienced prompting more measures. In 1933, President Roosevelt declared no banking activity until the regulators fully handled the underlying banking woes. In addition to the woes of the 1930’s, there appeared the savings and loans crisis that occurred around the 1980’s (Krugman 436). To crown the incidences of banking industry woes was the 2008 Financial Crisis; the issue was blamed on inefficient long-term Capital Management by the Federal government (Krugman 438). The rise of the United State as a super power in economic development has not been by chance. The journey to establishing a credible and valuable currency and a monetary system has been long and daunting. The Federal Reserve System is a powerful regulatory and control strategy that will require evaluation from time to time to prevent any other financial crisis. Works Cited Krugman, Paul. Macroeconomics. Money, Banking and the Federal Reserve System, Chapter 14. Web 14th Nov 2013. http://www.worthpub.com/Catalog/uploadedFiles/Content/Worth/Product/About/Look_Inside/Krugman,_Macroeconomics_3e/KW3e_Macro_CH14.pdf Read More