3.1 Assess the factors contributing to the establishment of general and specific rates of interest.
Interest rates are the prices that individuals or institutions pay for the use of various financial assets. General interest rates apply to a cross section of individuals and have the most influence on the economy of a country. The government through the central bank aims at monitoring and influencing the direction of general interest rates. Specific interest rates on the other hands are narrowed down to apply to a specific financial instrument or a small group of financial instruments . These specific interest rates do not affect the macroeconomic outlook of a country by a huge degree. There are mainly two types of interest rates i.e short term interest rates and long term interest rates which are distinguished by the length of their repayment periods. Long term interest rates are the prices paid for the financial assets that have been acquired and which have long maturities (Colander 2010, pg 312). Some bonds have maturities of years or decades and hence interest earned on them may be classified as long term interest rate due to the extended period that they are held. The loanable funds market is the name given to long term financial assets. Financial assets acquired by individuals or financial institutions and which have short maturities are paid for using the short term interest rates (Colander 2010, pg 312). The other name given to short term interest rates is money.
3.2 Explain the role of the Federal Reserve System in the designing and implementing Federal Reserve Systems.
The money supply in an economy is determined by the central bank which acts as a banker’s bank. The United State’s central bank is the Federal Reserve. The central bank offers loans to commercial banks if they need the money. The Federal Reserve controls monetary policy because it has the ability to create money. The Federal Reserve has various functions such as conducting monetary policy, supervising and regulating financial institutions, being a lender of last resort to most commercial banks within its jurisdiction, provide banking services to the government of the United States, issue currency and coins, providing financial services to commercial banks such as credit and saving services. By decreasing the reserve requirement on banks, the Federal Reserve can increase the supply of money and hence increase the money multiplier. It can do the reverse and subsequently decrease the money multiplier (Colander 2010, Pg 345). Fed funds rate may increase if the Fed sells bonds and hence decreases reserves. Conversely, by buying bonds in increases the reserves and hence the fund rates decrease.
3.3 Analyze how the money multiplier effect facilitates creation of money.
1/r is the simple money multiplier. It measures the amount of money created for every dollar deposited in a bank system when the public holds no currency. ‘r’ represents the reserve ratio and the higher the reserve ratio, the lower the money multiplier and less money will be created. In order to find out the money created, multiply the money multiplier by the original deposit. Then deduct the original deposit from the answer obtained. The simple money multiplier assumes that only banks have the capacity to hold currency which is false. When individuals and firms hold currency, the money multiplier replaces the simple money multiplier and is (1+C)/ (r + C) where C is the ratio of money held by the public to money held by banks as deposits, and r is the percentage of deposits held by banks as reserves (Colander 2010, Pg 319-324).
References
Colander, D. C (2010) Macroeconomics (8th ed). Boston, MA: McGraw-Hill/Irwin
