Essentially, the banking system creates money through a series of loans and deposits of its excess reserves. Money creation begins when the Central Bank, in this case the Federal Reserve, purchases government securities in the open market. The securities purchased by the Fed from a financial institution are credited to that financial institution’s bank account. This increases the reserves available in the bank of the financial institution where the securities were bought. A fraction of the new reserves have to remain in the bank to comply with reserve requirements but the excess reserves can be loaned by the bank to a borrower.
The borrower then deposits the loan to another bank which ultimately increases the excess reserves of the second bank. The series of loans and deposits continue, each time increasing the reserves of a new bank by a smaller amount. The total amount of money created in this whole process is equal to the sum of all the increased reserves in all the banks involved. The money creation process in the banking system is limited by currency drain (when a borrower decides to withdraw the loan in cash instead of depositing it to another bank) and reserve ratio requirements.
42. Is the Federal Reserve insulated from political pressures in any way? Please explain your answer. The Federal Reserve’s structure was designed in such a way that monetary policies can be crafted with as much insulation from political pressures as possible. First of all, the Fed enjoys a certain degree of independence in that its policies can be implemented without the need for ratification from another government body. Second, the funding for the Fed comes from independent sources and thus is not subject to congressional appropriations.
If the latte r were the case, the Fed may have to adjust its monetary policies to suit the short-term political agenda of the Congress. However, the independent sourcing of funds allows the Fed to operate without giving much regard to political favorability. Finally, the term of the Fed’s Board of Governors lasts for 14 years. The long term in office, coupled with staggered appointments of the governors, minimizes the political pressure that can be exerted on the Fed by any individual, political party or branch of government. 43.
Why might the Fed want to decrease (or more accurately, slow the growth of) the money supply? Please explain your answer. The Fed’s primary objective is to ensure steady growth in the economy while promoting stable prices. An increasingly growing money supply, on the other hand, increases the propensity of consumers to purchase goods. This can promote increased production in the economy. However, if left unchecked, the demand for commodities may surpass the available supply and can lead to uncontrollable inflation. The latter is undesirable because it produces a lot of economic distortion and uncertainty.
For instance, one negative result of unstable inflation is the uncertainty of future prices which prompts many consumers to save their money instead of spending it. Reduced spending has an adverse effect on the profits and continued operations of many businesses. Moreover, investors would want to place their money on investments that would hedge their risks from inflation (for example, on commodities such as gold), instead of placing their money on productive investments that drive economic growth. All these hurt economic productivity.
Thus, the Fed would want to slow the growth of money supply. 64. Use the equation of exchange to explain the impact of an increase in the money supply if velocity and output are stable. Please explain your answer. The equation of exchange is as follows: M ? V= P ? Q , where M is the money supply; V is the velocity of money (or the number of times money is used to purchase goods or services); P is the price level; and Q is the quantity of goods and services that are produced in the economy. The equation can be rearranged as follows: P = (M x V) / Q.
If money supply is increased while both the velocity and output are stable, the price level increases. This phenomenon is usually referred to as inflation. Intuitively, if the money circulating in the economy increases, consumers find themselves with a higher purchasing power. However, if the production level as well as the number of monetary transactions remain the same, the demand for goods becomes greater than the supply. According to the law of demand and supply, the prices of goods will naturally increase in order to regain balance.
In this scenario, the economy finds itself in an inflationary status. 65. Why do high interest rates so adversely affect the demand for housing and, yet have so little influence on consumer demand for strawberries? Please explain your answer. Housing prices are extremely expensive and so a consumer who would want to buy a house would need to loan money from a bank in the form of a mortgage in order to fund the purchase. The consumer would have to pay the principal and the interest of the loan for a certain number of years.
Thus if the interest rates are high (which essentially means that the cost of borrowing money is high) many consumers shrink from the idea of buying a house, perhaps postponing the decision until interest rates reach lower levels. This reduces the demand for housing. On the other hand, strawberries are affordable goods that can be purchased on a daily basis. Consumers do not need to borrow money to be able to buy strawberries. Thus, interest rates do not have much effect on consumer demand for strawberries.