What is fiat money? Why is fiat money important in the United States today?
Fiat money is a kind of money that has no intrinsic value. It has value of exchange but no value in use. It is used as money because the government decreed it as valid money and the public willingly accept it in exchange of goods. Normally, fiat money bears “legal tender” feature and includes modern paper currency, coins and checkable deposits.
This kind of currency is very important in today’s modern economies like the United States primarily because it is widely used as medium of exchange. Also, fiat money can be easily controlled by the Fed (the central bank of US and the issuing authority) through the conduct of monetary policy to regulate instabilities caused by business cycles.
Why is the money multiplier considered to be a potential multiplier rather than an indication of exactly how much multiplication should be expected?
The money multiplier is the amount of money the banking system generates with each dollar of reserves. It is calculated as the reciprocal of the required reserve ratio (rr): money multiplier = 1/rr.
Money multiplier is considered as potential multiplier as it is the maximum amount of commercial bank money that can be created by the central bank. That is, in a fractional reserve banking system, the total amount of loans that commercial banks are allowed to extend is a multiple of reserves, which is the reciprocal of the required reserves. This is to say that money multiplier measures the potential or maximum money supply that can be created by the whole banking system.
What are the inherent disadvantages of a barter system?
Barter is the exchange of one good or service for another. An economy that relies on barter will have trouble allocating its scarce resources efficiently. In such an economy, trade is said to require the ‘double coincidence of wants’ or the unlikely occurrence that two people each have a good or service that the other wants. Another inherent disadvantage of barter system is the high transaction costs to traders of spending time and resources in their effort of searching for each other. Also, a barter system lacks the common unit of exchange as well as standardization; this implies that a commodity of high value in one community may not carry the same value in another community, hence causing inefficiency in the economy.
What are money market mutual funds?
Money market mutual funds pertains to open-ended mutual funds that invest in short-term debt securities like treasury bills and commercial papers and are regarded as being safe investments as that of bank deposits with the advantage of higher returns. It is also perceived as important provider of liquidity to financial intermediaries, that is, money market mutual funds are very liquid investment and used by financial institutions to store money that is not currently invested.
Calculate M1 and M2 using details from the table given below.
M1 = Currency+Traveler’s check+Demand deposits+Other checkable deposits (Mankiw, 2001)
= $75 + $25 + $10 = $110
M2 = M1 + Savings deposits + Small time deposits + Money market mutual funds + A few minor categories (Mankiw, 2001)
= $110 + $125 + 75 + $50 + $25 = $385
What is fractional reserve system?
The fractional reserve system is a banking system in which banks hold a fraction of deposits as reserves. Reserves are deposits that banks have received, in the form of cash on hand, but have not loaned out; also, reserves are viewed as funds deposited by banks with the central bank.
If you deposit $8,000 in a bank, calculate how much the bank must keep as required reserves and how much it can loan if the required reserve ratio was 5 percent. If it was 8 percent? 13 percent? 26 percent?
- Reserve ratio = 5%
- Reserve ratio = 8%
- Reserve ratio = 13%
- Reserve ratio = 26%
A central bank like the Federal reserve of Fed of the United States is considered as bank for bankers. Its primary function is to control the amount of bank reserves, thereby determining the country’s money supply and affecting the credit conditions and interest rates in the economy. The central bank’s other functions include managing of exchange markets (e.g. Fed buys and sells foreign currencies on foreign exchange markets on behalf of the government), coordinating international finances, and regulating banks and insuring deposits (i.e., the central bank instills confidence in banks by insuring bank deposits, inspecting the books of banks, and taking over insolvent banks).
The Fed has three major policy instruments namely, open market operations, discount rate on bank borrowing, and legal reserve requirements on depository institutions. Using these instruments, the Fed sets intermediate targets like the level of bank reserves, market interest rates and the money supply. The most important instrument of monetary policy is the Fed’s open market operations.
Inflationary periods in the economy call for the use of contractionary policy. In this policy option, using the open market operations, the central bank sells government securities in the open market to reduce the Fed’s assets and liabilities and thereby reduce the reserves of banks. The effect is the decrease in banks’ reserve base for deposits. People end up with less money and more government bonds.
On the opposite, during recessionary periods, the Fed may opt to use expansionary policy by purchasing bonds from the public. This has the effect of expanding money supply by increasing bank reserves.
Reference
Mankiw (2001). Principles of Economics.
