Question

A) What are three major functions of money?

     B) How does the FED increase the amount of money in the banking system?

     C) What are the three main parts of the FED?  What does each do?

     D) Explain the meaning of central bank independence

Answer 1

A) Key Functions of Money

1. Medium of exchange: money allows goods and services to be traded without the need for a barter system. Barter systems rely on there being a double coincidence of wants between the two people involved in an exchange
2. Store of value: this can refer to any asset whose “value” can be used now or used in the future i.e. its value can be retrieved at a later date. This means that people can save now to fund spending at a later date.
3. Unit of account: this refers to anything that allows the value of something to be expressed in an understandable way, and in a way that allows the value of items to be compared.

B) The Federal Reserve System manages the money supply in three ways:

Reserve ratios. Banks are required to maintain a certain proportion of their deposits as a "reserve" against potential withdrawals. By varying this amount, called the reserve ratio, the Fed controls the quantity of money in circulation. Suppose, for example, it orders banks to hang on to an extra 1 percent of their deposits. They would then have 1 percent less to lend. One percent may not sound like a lot, but it translates into billions of dollars that are siphoned out of the economy.

Discount rate. When banks temporarily overcommit themselves, they occasionally have to borrow from the Fed to secure the necessary funds to meet their reserve requirements. The interest rate charged for these loans is the discount rate, and it too affects the money supply. If the Fed raises the discount rate, banks cannot afford to borrow as heavily as before and have to curtail their lending and raise their own interest rates. That results in less money flowing into the economy. Conversely, if the Fed relaxes its discount rate, financial institutions have more dollars for their customers. Seen from this perspective, the discount rate has a snowball effect: Raising it means that other interest rates go up as well and, other things being equal, economic activity slows down; lowering it has the opposite effect.

Open-market operations. By far the most important of the Fed's activities are open-market operations, the buying and selling of government securities. After Congress approves an increase in the national debt, the Treasury Department prepares a mix of bonds, bills, and notes that it auctions to private dealers who are authorized to trade government securities. When it wants to influence economic activity, the Fed buys or sells these assets through its Federal Open Market Committee (FOMC) or open-market desk, as it is commonly known.

C) The Federal Reserve System has three components:

• Board of Governors: The Board of Governors directs monetary policy. Its seven members are responsible for setting the discount rate and the reserve requirement for member banks. Staff economists provide all analyses, including the monthly Beige Book and the semi-annual Monetary Report to Congress.
• Federal Reserve Banks: The Federal Reserve Banks work with the board to supervise commercial banks and implement policy. There is a Fed bank located in each of the 12 Fed districts.2
• Federal Open Market Committee: The FOMC oversees open market operations. That includes setting the target for the fed funds rate, which guides interest rates. The seven board members, the president of the Federal Reserve Bank of New York, and four of the remaining 11 bank presidents are members. The FOMC meets eight times a year.

D) Central bank independence (CBI) is usually understood as the central bank’s ability to control monetary instruments. On the other hand, CBI can also be seen as a set of restrictions on the government’s influence on the management of monetary policy by the central bank.CBI has tended to occur in countries with histories of high levels of inflation and in more democratic countries. More independent central banks are usually more transparent, which correlates in turn with institutional quality. Greater independence of central banks is also associated with lower levels of inflation.