Question

Question 1: Elaborate with an example that how commercial banks create money under fractional-reserve banking. Elaborate the tools used by Central bank of a country to increase and decrease the money supply.

Question 2: Based on the material of the chapter “ money growth and inflation” of your text book explain how inflation starts in an economy? Why multinational companies feel unsafe to invest in those countries that have high inflation rate? Write your answer the light of your text book materials.

Answer 1

Answers

(Q1)

Fractional-reserve banking is the most common form of banking practised by commercial banks worldwide. It involves banks accepting deposits from customers and making loans to borrowers, while holding in reserve a fraction of the bank's deposit liabilities. Bank reserves are held as cash in the bank or as balances in the bank's account at the central bank. The minimum amount that banks are required to hold in liquid assets is determined by the country's central bank, and is called the reserve requirement or reserve ratio. Banks usually hold more than this minimum amount, keeping excess reserves.

Bank deposits are usually of a relatively short-term duration while loans made by banks tend to be longer-term this requires banks to hold reserves to provide liquidity when deposits are withdrawn. Banks, working on the expectation that only a proportion of depositors will seek to withdraw funds at the same time, keep only a fraction of their liabilities as reserves. Thus, they can experience an unexpected bank run, when depositors wish to withdraw more funds than the reserves held by the bank. In that event, the bank experiencing the liquidity shortfall may borrow from other banks in the interbank lending market; or if there is a general lack of liquidity among the banks, the country's central bank may act as lender of last resort to provide banks with funds to cover this short-term shortfall.

Because banks hold reserves in amounts that are less than the amounts of their deposit liabilities, and because the deposit liabilities are considered money in their own right, fractional-reserve banking permits the money supply to grow beyond the amount of the underlying base money originally created by the central bank. In most countries, the central bank (or other monetary policy authority) regulates bank credit creation, imposing reserve requirements and capital adequacy ratios. This helps ensure that banks are solvent and have enough funds to meet demand for withdrawals, and can be used to limit the process of money creation in the banking system. However, rather than directly controlling the money supply, central banks usually pursue an interest rate target to control bank issuance of credit and the rate of inflation.

Tools

All central banks have three tools of monetary policy in common. First, they all use open market operations. They buy and sell government bonds and other securities from member banks. This action changes the reserve amount the banks have on hand. A higher reserve means banks can lend less. That's a contractionary policy. In the United States, the Fed sells Treasurys to member banks.

The second tool is the reserve requirement, in which the central banks tell their members how much money they must keep on reserve each night. Not everyone needs all their money each day, so it is safe for the banks to lend most of it out. That way, they have enough cash on hand to meet most demands for redemption. Previously, this reserve requirement has been 10%. However, effective March 26, 2020, the Fed has reduced the reserve requirement to zero.

When a central bank wants to restrict liquidity, it raises the reserve requirement. That gives banks less money to lend. When it wants to expand liquidity, it lowers the requirement. That gives members banks more money to lend. Central banks rarely change the reserve requirement because it requires a lot of paperwork for the members.

The third tool is the discount rate. That's how much a central bank charges members to borrow funds from its discount window. It raises the discount rate to discourage banks from borrowing. That action reduces liquidity and slows the economy. By lowering the discount rate, it encourages borrowing. That increases liquidity and boosts growth.

In the United States, the Federal Open Market Committee sets the discount rate a half-point higher than the fed funds rate. The Fed prefers banks to borrow from each other.

Most central banks have many more tools. They work together to manage bank reserves.

The Fed has two other major tools it can use. It is most well-known is the Fed funds rate. This rate is the interest rate that banks charge each other to store their excess cash overnight. The target for this rate is set at the FOMC meetings. The fed funds rate impacts all other interest rates, including bank loan rates and mortgage rates.

The Fed, as well as many other central banks, also use inflation targeting. It sets expectations that the banks want some inflation. The Fed’s inflation goal is 2% for the core inflation rate. That encourages people to stock up now since they know prices are rising later. It stimulates demand and economic growth.

When inflation is lower than the core, the Fed is likely to lower the fed funds rate. When inflation is at the target or above, the Fed will raise its rate.

The Federal Reserve created many new tools to deal with the 2008 financial crisis. These included the Commercial Paper Funding Facility and the Term Auction Lending Facility. It stopped using most of them once the crisis ended.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.

(Q2)

explain how inflation starts in an economy?

Inflation is a measure of the rate of rising prices of goods and services in an economy. If inflation is occurring, leading to higher prices for basic necessities such as food, it can have a negative impact on society.

• Inflation is a measure of the rate of rising prices of goods and services in an economy.
• Inflation can occur when prices rise due to increases in production costs, such as raw materials and wages.
• A surge in demand for products and services can cause inflation as consumers are willing to pay more for the product.
• Some companies reap the rewards of inflation if they can charge more for their products as a result of the high demand for their goods.

Inflation can occur in nearly any product or service, including need-based expenses such as housing, food, medical care, and utilities, as well as want expenses, such as cosmetics, automobiles, and jewelry. Once inflation becomes prevalent throughout an economy, the expectation of further inflation becomes an overriding concern in the consciousness of consumers and businesses alike.

Central banks of developed economies, including the Federal Reserve in the U.S., monitor inflation. The Fed has an inflation target of approximately 2% and adjusts monetary policy to combat inflation if prices rise too much or too quickly.

Inflation can be a concern because it makes money saved today less valuable tomorrow. Inflation erodes a consumer's purchasing power and can even interfere with the ability to retire. For example, if an investor earned 5% from investments in stocks and bonds, but the inflation rate was 3%, the investor only earned 2% in real terms. In this article, we'll examine the fundamental factors behind inflation, different types of inflation, and who benefits from it.

Why multinational companies feel unsafe to invest in those countries that have high inflation rate?

International investors face a number of unique risks like political risk to currency risk. Inflation represents another risk very important to understand since it can have a profound impact on the economy. It is true not only in unstable countries, like Zimbabwe where inflation soared out of control, but also developed markets worldwide.

Inflation is often measured using the consumer price index (CPI) indicators, which calculate a currency's purchasing power relative to a diverse basket of consumer goods. The CPI is also divided into sub-indexes and sub-sub-indexes to remove certain outliers, such as energy prices, that may have risen due to other geopolitical factors and may not reflect true inflation.

Inflation is perhaps most pronounced in bond prices. These prices tend to have an inverse correlation with inflation, since higher inflation leads to higher expected yields, and higher yields lead to lower bond prices. Moreover, ongoing inflation depletes the value of the maturity (principal) payment, since that currency's value is becoming increasingly diluted.

The effects of inflation on bonds can be seen in the difference between "nominal" and "real" returns. Nominal returns are the actual yields, while real returns represent the inflation-adjusted yields paid by borrowers to lenders. Since inflation compounds over time, these differences can add up to significant sums over time.

For international investors, sovereign debt and related ETFs that hold sovereign debt around the world are susceptible to changes in inflation. It's important for investors to watch CPI figures (or unofficial private reports for those countries without reliable reporting) for signs of increasing inflation since that can represents trouble ahead for bondholders.

For international investors, central banks that provide liquidity during times of crisis can help boost equities by promoting economic recovery. But inflation that seems out-of-control could result in lower returns in equities. Again, it's important for investors to watch CPI figures (or unofficial private reports) and measure that against economist expectations.

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