But, to an economist, money is defined as anything that serves as commonly accepted medium of exchange or means of payment, such as currencies, coins, and checking accounts. Money is an item that buyers give to seller when they want to purchase goods and services. Money is an item that people can use to transfer purchasing power from the present to the future.
Money is the most liquid asset among other assets such as stocks, bonds, houses, and land. Liquidity is the ease with which an asset can be converted into economy’s medium of exchange. Although money is the highly liquid asset, but there is a cost of holding money rather than depositing your wealth in any interest- bearing asset.
All these items are called money because they can directly used to buy goods and services. This is the money held in people’s pockets and circulates daily in the markets and this money is held outside banks.
M1: Transactions Money
M2: called Broad Money/ Asset Money/ Near Money
Banks and the SS of Money
A Central bank is a government agency or an institution designed to control, regulates and stabilize M-SS inside an economy, as well as oversees and control the banking system. A Commercial Bank is a financial intermediary that transfers funds from one group (Lenders) and lend it to another group (Borrowers). In doing this, they create financial instruments such as checking, saving and time accounts or deposits.
But the most important instrument is Bank Money or checking accounts that represents the bulk of M-SS of the economy and held at commercial banks. Excess reserves: are those fractions of reserves that are held in the form of cash on hand held at the banks desk to perform the daily bank operation such as withdrawal and loans. Legal reserves: are those fractions of reserves that are deposited by the commercial banks at the Central Bank according to a ratio called LRR (Legal Reserve Ratio).
The main function of Legal Reserves is not to make bank deposits safe and liquid or payable on demand but their main function is to enable the Central Bank to control the amount of Demand deposits of commercial banks that represent a major part of the M-SS of the economy.
The Federal Reserve System and its organization
In every economy, there exists one Central Bank (called the Federal Reserve System in USA – often referred to as the FED) run by a Board of Governors. Only in USA, the FED consists of 12 regional Feb Banks located in NY, Chicago, and other major cities. The Central bank is a public government agency designed to control, regulate and stabilize M-SS and oversees the banking system operations inside the economy.
The Federal’s Independent
The Fed is also allowed to print money and to issue government securities (Bonds) to maintain its mission.
The Federal’s Structure
- Chairman of the Board of Governors
- Board of Governors
- FOMC (Federal Open Market Committee)
- The Board of Governors
- Approves discount rate
- Sets reserve requirement
- Directs regulatory operations
- Directs open Market operations
- Advises on Discount Rate
- Advises on reserve requirement
At the top position of the Fed is the Chairman of the Board of Governors. He acts as the public spokesman for the Fed and testifies regularly about the Fed policy, and exercises enormous power over. He is often accurately called the second most powerful man of the economy after the president.
The Chairman is generally a Banker or an economist who works full time at the job. It consists of 7 members nominated by the president and confirmed by the government to serve monetary policy. Members of the board are generally bankers or economist who works full-time at the job.
The board members meet with the Chairman and operate under the fed’s chairman to formulate and carry out the monetary policy. The key decision making body in the Fed is the FOMC (Federal Open Market Committee). This committee controls the single most important tool of monetary policy which is the Open Market operations.
Balance Sheet of the Federal
The Fed’s Tools of Monetary Policy
Open Market Operations 2. Discount Rate Policy
Reserve Requirements
Open Market Operations
To see how an OM operation changes banks deposits and reserves, let us suppose that the Fed wants to apply an OM operation to face inflation inside the economy. When the Fed sells TBs to public, people will end up with less money and more government bonds in their hands. Banks deposits decrease by a multiplied amount of $1 billion within the limits of the M-SS multiplier,.
What happens to M-SS when the Fed sells TBs?(Continue). This OM operation of selling TBs in the open market is called Monetary tightening or Contractionary Monetary Policy. It involves setting the interest at which member banks can borrow reserves from the Fed. When the Fed makes loans to banks, these loans are call. Borrowed reserves) given to Banks by the Fed at an interest rate called the (discount rate). Although Banks Reserves and Deposits increase as the Fed decrease the discount rate, but the Fed cannot consider this policy as a precise instrument to increase or decrease M-SS in a specific amount. That is why this policy is not fully used by the Fed as a precise monetary instrument in achieving a stable M-SS in the economy.
However, sometimes even though the Fed is increasing discount rate, the banks will continue to borrow from the Fed for different external reasons. The same is the case with respect to increasing discount rate in order to discourage borrowing. The Fed will only expect that banks will increase borrowing by decreasing the discount rate, If the Fed wants to increase M-SS, all it can do is lower discount rate.
2-Discount Rate Policy
Reserve Requirement
Involves changing the LRR on Banks deposits by the Board of Governors of the Fed. If the Fed wants to make money tight very quickly, it can increase the LRR for banks, thus decreasing the M-SS creation and.