Money and banking systems

¶ … monetary multiplier?

The economics textbook definition of the "money multiplier" assumes lending banks automatically expand their credit money supply to a multiple of their aggregate, or saved reserves of money. The Federal Reserve requires all banks, after the crash of 1920, to keep a certain amount of money in reserve in relation to the money lent by the bank. In the U.S. The required reserve ratio usually hovers around ten percent, implying that the money supply should be about ten times larger than the aggregate reserves of banks. The significance of the multiplier is that the more banks are required to keep in reserve; theoretically the less they will be able to lend. Thus, in its basic form, that multiple is equal to the reciprocal of the required reserve ratio. The theory behind the requirement also assumes the FED issues loans in compliance with the multiplier, although this is often not the case. However, some economics believe that although predicative after the fact, because the multiplier varies so little in the U.S., it has little present predicative power before loans are issued. (Hummel, 2004)

The FED rarely changes the reserve requirement. In fact, it is the least used monetary policy tool because changes in the reserve requirement significantly affect the way financial institutions operate. Reserve requirement changes are seen as a sign that monetary policy has swung strongly in a new direction. (EEP, 2003)

What are the components and the functions of all of the Federal Reserve System?

The Federal Reserve System is controlled by a federal governmental agency known as the Board of Governors, located in Washington, D.C. The FED has twelve regional banks located in major cities throughout the nation. The two major governing components share responsibility for supervising and regulating certain financial institutions and activities. From a financial perspective, they provide banking services for depository institutions and to the federal government. Legally, they are responsible for ensuring consumers receive adequate information and fair treatment in their business with the banking system. A major component of the System is the Federal Open Market Committee (FOMC), made up of the members of the Board of Governors, the president of the Federal Reserve Bank of New York, and rotating presidents of four other Federal Reserve Banks. This branch oversees open market operations, the main tool used by the Federal Reserve to influence money market conditions and the growth of money and credit. (FED, 2004)

What are the tools that are available to handle either recession or inflation?

The major tools at the FED's disposal to control the economy are manipulation of the money supply, raising and lowering the discount rate and the interest rates, and sales of government securities. As the money supply grows, so does the demand for goods and services. When more money is available spend, consumers spend more. When the production of goods and services can't keep up with the growth in demand, there is inflation. Thus, in times of inflation, the FED contracts the money supply, but to encourage spending and production it increases the money supply. To increase the money supply, as it did recently, the FED can decrease interest rates, making it easier for consumers to spend by borrowing money. Higher interest rates make it more attractive for consumers to save money. Less influential tools are to require banks to hold more money in reserve, by raising the reserve requirement to encourage the economy to contract, or lowering the reserve requirement, thus encouraging banks to lend money and consumers to borrow. The discount rate is the interest rates the FED charges financial institutions for short-term loans of reserves. But the Fed's primary tool for fighting inflation and recession is open market operations. "Acting through banks and government securities dealers, the Fed buys and sells U.S. government securities on the open market to influence short-term interest rates and the growth of money and credit. When the Fed determines that too much money and credit are available in the market and inflationary pressures are rising, the Fed will sell securities to banks and dealers. As a result, banks have less money to loan to the public. With excess money and credit taken out of the financial system, inflationary pressures are reduced, thus stabilizing the economy.

If too little money is available in the financial system, which could lead to an economic slowdown or recession, the Fed buys securities. The funds the Fed uses to purchase the securities will eventually arrive at local banks, which then have more money to lend. This process moves money into the financial system and stabilizes the economy." Thus, through both the selling and buying of securities, the goal is a stable economy with higher employment and production, steady growth and overall stable prices. (EEP, 2003)