Question

The federal reserve system, also known simply as the fed, is the central bank of the united states. the fed has several important functions such as supplying the economy with currency, holding deposits of banks, lending money to banks, regulating the money supply, and supervising the banking system. explain how the federal reserve and the banking system creates money (i.e., increases the supply of money). is this an inherently inflationary practice? explain the factors that affect the demand for money.

Answer 1

As the central bank of the country The Federal Reserve is entrusted with a variety of duties namely:

Supplying currency.

The Federal Reserve has the primary responsibility of issuing currency according to the changing needs of the economy.

Act as banker’s bank.

As a bankers band the central bank keeps deposits of the other commercial banks and lending money to them when they are in emergencies.

Banker, agent and advisor to the government.

As a banker to the government the Federal Reserve carry out all services to the government like a commercial bank do to his customer. It keeps the banking account of the Fed. It lends money to the government and advice the Fed on economic matters.

Custodian of the foreign balance of the country.

The Federal Reserve has the duty of managing country’s foreign reserve.

Center of clearance and settlement of banks.

The Federal Reserve act as the clearing house of the commercial banks in the country.

Controller of money supply or credit.

The control of money supply is the most important function of the Federal Reserve. It increase or decrease the volume of money supply according to the changing needs of the country. For controlling money supply it uses the various monetary measures. The following methods are used by the Federal Reserve in order to increase the money supply.

1. Open Market Operation.

Open Market operation is the method of purchase and sale of bonds issued by the U.S treasury. When the Federal Reserve wants to increase the money supply it buys the treasury bonds from the public. Such an act has the effect of injecting more money to the economy.

2. Reserve requirements

Every commercial bank in the country has to keep a part of their deposit as cash reserve and the rest they can lend out. If the Federal Reserve wants to increase the money supply it lowers the reserve requirements. With lower reserve requirements the commercial banks are able to lend more and this will increase the money supply in the country.

3. Discount rate.

As the banker’s bank the Federal Reserve has the duty of lending to commercial bank during emergencies. The Federal Reserve lend out to the commercial bank by charging an interest rate. This rate is known as discount rate. At the time of increasing money supply the Fed reduce the bank rate which make easy for the commercial banks to borrow from the Federal Reserve and lend more to its customers. Such an act increases the money supply.

The monetary policy of the Federal Reserve is contra cyclical. During times of deflation the Federal Reserve adopts a cheap money policy. The cheap money policy enables the commercial banks to lend more as the customer demand for borrowing increase. This is definitely inflationary in nature. The increase money supply will create more demand for goods and services which in turn rise the price level. This is a targeted inflation in order to lift up the economy from recession.

The demand for money arises from three needs of the people. They are transaction, precaution and asset demand. The transaction and precaution demand for money is controlled by the level of income and price level. At higher level of income more money is demanded for transaction and precaution. During times of price hike more money is needed by the people for transaction purpose to maintain their usual level of standard of living. But the asset demand for money is influenced by the rate of interest. This demand for money is to make advantage from the fluctuations in bond price. At a high rate of interest people demand less money for these speculative motives. At low rate of interest people demand more money for speculation.

Thus in short the basic factors that affect the demand for money are the level of income, price level and the rate of interest.