Question

What is the function of money in the economy? How is it that banks create money? What is the primary method used by the Federal Reserve to increase/decrease the money supply? How does this method work? How does it relate to the Federal Funds Rate?

Answer 1

Money has mainly three purposes. It is a store of value, a unit of account and a medium of exchange. Money also serves as a standard of deferred payment. Banks create money through fractional reserve system. That is among all the deposits banks receives, it lends out maximum by keeping a fraction of reserves to meet the demand for withdrawal. Let's understand this with a bank balance sheet.

Suppose a bank named it P got the deposit of Rs 1000 and reserve requirement is 10% of deposit. Thus by keeping Rs100 as reserves, it lends out the rest Rs900 to say Households, business.

Assets Liability

Reserves- Rs100 Deposits- Rs1000

Loans-Rs900

Thus bank P increses the supply of money by Rs 900 by making a loan of Rs900. Before the loan was made out, the money supply is Rs 1000.After the loan is made the total money supply is Rs1900: The depositor still has a demand deposit of Rs1000 and the borrower now has Rs 900 at its hand. This way the process of creating money continues.

The primary method used by Federal bank to change the money supply is Open Market Operations. The Federal reserve can increses money supply by purchasing US Treasury securities. This purchase increases the amont of reserves in the system. Therefore increasing the loan activity. This process is called expansionary monetary policy. Similarly it can sell the Government securities to decrease the supply of money. The sale of securities decreases the amount of reserves in the system thereby contracting the loan activity. This process is called contractionary monetary policy.

The federal funds market is the market for bank reserves, where the interest rate moves up and down to balance the supply and demand for reserves. Banks that have excess reserves at the end of the day lend them to banks that have insufficient reserves to meet the equilibrium condition: the total demand for reserves by all banks must be equal to the supply of reserves to the market. The interest rate determined in this market is called the federal funds rate. The Fed can choose the federal funds rate it wants by changing the supply of money.