Module 3. The Money Market
1.
Debit and credit cards have some commons and differences. The main similarities between these types of plastic are security of funds and personal information; convenience in reducing the amount of cash carried; ability to pay in almost any country of the world; an option to withdraw money at ATMs; internet purchases and on-line banking services. However, there cards have more differences than commons.
Debit cards allow their owner to use money he put on the account, but no extra loan is offered additionally. Most debit cards are free of charge, unless they are prepaid ones. The only fees possible are applied in case of overdraft. The money deposited with the card provider help the client to limit his spendings by the sum he actually has. Contrary to debit cards, credit ones allow the customer to use a certain amount offered by a card issuer. The owners of these cards are usually supposed to pay annual fees, they are also charged in case of late payouts, over-limits, and, of course, interest rates. Sometimes, banks or other financial institutions may require to deposit a certain amount of money or purchase an insurance, before opening a credit line.
Deciding, which type of cards is the best option one should consider his actual needs and solvency. In case person’s wishes are way beyond his abilities to pay out, it is better to resist a temptation of over spending, and stick to what he actually can spend. Although, if there is a need to have a safety net, but a person is sure he will be able to pay his debts, a credit card can be a great solution.
2.
Banks are specific financial intermediaries that are defined by their functions, which are to collect money in a form of deposits so that to distribute them later in a form of loans. This function allows banks to participate in a so-called secondary money creating process. Some non-banking financial institutions are now acting similar to the banks, by offering their clients both, deposits and loans; yet, they do not have great impact on the money supply (Macroeconomic Principles, 2012, par.9.2). Meanwhile, banks increase money supply through a multiplying effect, described below.
Reserve ratio (R) = 10%, hence the bank actually received $5, 000 of Checkable deposits, $500 of which should be reserved, and $4,500 can be used further for loans. Lets assume $4,500 were given as a loan to another customer purchasing some goods from the customer#3, while the customer #3 decided to deposit his money. As a result, $4,500 will be brought to the bank, and added to the Checkable deposits: $5,000+$4,500. Reserves will increase by $450+$500 = $900, and $4,500-$450=$4,050 will be used for further loans. To make the calculations shorter, Money multiplier is used. In this particular case it equals 1/R=1/0.1=10. After a customer deposited $5,000, reserves increased by $5,000, thus Change in Reserves = $5,000. Therefore, change in money supply changed as follows: 10*5,000 = 50,000 USD.
Banks and non-banking financial institutions create about 90% of all money supply. This happens not by issuing new banknotes but through a multiplying effect. Financials create new money with a help of loans, deposits, and interest rates, as it was shown in a sample above. Reserve ratio is used by the government to control the process, i.e. the higher reserve ratio is, the lower is a multiplying effect, and vice versa.
3.
The Federal Reserve System (The Fed) has a vast number of functions. As a bank of banks and bank of the government it regulates financial institutions, issues money, and regulates the national economy by a variety of tools. As a lender of last resort, the Fed provides loans to those institutions, which cannot borrow from other banks, and their collapse may shake the economy. It acts as a banker’s bank in a way that 12 member banks serve other financials, similar to the way usual banks assist average customers. This helps to mitigate risks and to monitor the financial system. The Fed also issues banknotes and coins, along with Treasury bills, notes and bonds, as per government’s request. All actions, the Fed makes in order to regulate money supply are named a monetary policy.
Thus, the Fed uses the following tools:
(1)Reserve ratio (reserve requirements) – defines the amount that each financial institution has to keep in reserve against deposits in their accounts. The higher the reserve ratio is set, the less loans financials can issue, and the lower reserve requirements are, the more loans will be offered, hence, money supply will be increased; (2) discount rate – is an interest rate that banks are asked to pay for the loans borrowed from the Fed. Similar to the reserve ratio, if a discount ratio increases, money supply will be shortened, as banks will not be able to borrow extra money and vice versa; (3) open market operations – through trading the government securities in the financial market the Fed increases or decreases money supply. For example, if Treasury bills, notes or bonds are being sold, extra money are taken from the market; once it is needed to increase money supply, the government will pay upon the maturity.
4.
The statement is false. Once the government purchases the Treasury securities an extra amount of money comes to the market. This amount equals to the value of the derivative and interest (a coupon). Definitely, money lose their value in time, but the borrower also seeks his benefits, thus barely will purchase a bond or any other security without any profit expected upon the maturity. However, open market operations are the key instrument of the Fed’s monetary regulation mainly due to slow increasing of the money supply; which prevents rapid inflation and uncontrolled market shifts.
As it was mentioned before, the Fed purchases securities in order to inject new reserves and increase money supply through the bank lending and public (both, individuals and business) deposits. However, buying securities in the open market is also used for the purpose to lower the federal funds rate. Mostly, short –term securities are traded to achieve a the goal set, however, the Fed may also buy long-term bonds so that to influence longer term interest rates, like those, related to mortgages (Macroeconomic Principles, 2012, par.9.3).
References
Macroeconomic Principles (2012) 9.2 The Banking System and Money Creation. Retrieved from: http://2012books.lardbucket.org/pdfs/macroeconomics-principles-v2.0.pdf
Macroeconomic Principles (2012) 9.3 The Federal Reserve System. Retrieved from: http://2012books.lardbucket.org/pdfs/macroeconomics-principles-v2.0.pdf
