The Creation Of Money

Running head: Macroeconomic Impact on Business Operations

University of Phoenix

MBA 501

October 4, 2006

As my economics teacher, Tim Hamilton, use to say "The Fed is not the Government!!!!" This leads to the question, what is the Fed? The Federal Reserve Bank, commonly referred to as the Fed was created in 1913 due to numerous bank panics of the time. "Demand for the creation of a centralized banking system was strong after a series of bank panics, in 1873, 1893, and 1907." (Moen & Tallman, 2003) The Federal Reserve is the central banking system of the United States.

The Federal Reserve

The basic structure of the Federal Reserve System includes the Board of Governors, Federal Open Market Committee, Federal Reserve Banks and member banks.

The Board of Governors consist of seven members appointed by the President and confirmed by the Senate. Members are selected to terms of 14 years with the ability to serve for no more than one term. The Federal Open Market Committee comprises the seven members of the board of governors and five representatives selected from the Federal Reserve Banks. The president of the Federal Reserve Bank of New York is a permanent member, while the rest of the banks rotate on a yearly basis. The role of the Federal Open Market Committee, commonly known as the FOMC, is to formulate the nation's monetary policy. "The term "monetary policy" refers to what the Federal Reserve, the nation's central bank, does to influence the amount of money and credit in the U.S. economy. What happens to money and credit affects interest rates (the cost of credit) and the performance of the U.S. economy." (2006)

Some of the main goals of the Federal Reserve in conducting monetary policy is to promote economic growth , full employment, and stable prices. The Federal Reserve sets reserve requirements and supervises the lending activities of commercial banks. Influencing the amount of excess reserves in the banking system that are available for lending is the principle mechanism by which the Fed implements monetary policy. The Fed has three monitary policy tools that affect the amount of excess reserves.

Tools Used By the Federal Reserve to Control Money Supply

The Fed uses three primary tools to control the supply of money. The three tools are open market operations, altering the discount rate, and changing reserve requirements.

In open-market operations the Federal Reserve buys or sells U.S. government securities in the open or secondary market. When the Federal Reserve buys securities, it writes a check on itself. Dealers of these securities then receive payment from the Fed which results in a credit or deposit to the dealers checking account. This deposit increases the checking deposit component of the money supply. By purchasing securities and writing a check against itself, the Fed has increased the amount of money in the economy.

The discount rate is a second policy tool the Federal Reserve possesses. One way a bank can obtain reserves is by borrowing them from the Federal Reserve. "The discount rate is the rate at which the Federal Reserve Bank charges member banks for overnight loans. (2006) The Fed actually controls this rate directly. When the Federal Reserve charges a high interest rate for these borrowings, banks will not borrow as much reserves as when the Federal Reserve charges a low interest rate. With the discount rate, the committee can increase it, decrease it, or leave it unchanged. Increasing interest rates will reduce the amount of money flowing through the economy. Lowering interest rates will increases the money supply. Some analysts "believe that changes in the discount rate will have little direct effect on things because banks can get credit from outside sources fairly easily." (Schenk, 2006)

The third tool the Fed has available is changing the required reserve ratio. The required reserve ratio is the percentage of deposits banks are required to hold either as vault cash or as deposits held at the Federal Reserve Bank. The amount of reserves that banks must hold is calculated as a percentage of the deposits they hold. This percentage is called the required reserve ratio. In equation form, required reserves are computed as:

Required Reserves = (Required Reserve Ratio) x (Deposits)

If the Federal Reserve increases this ratio, banks are forced to hold onto more money in the form of reserves, ultimately affecting the amount available to lend. If the Federal Reserve decreases this ratio, banks will not be required to hold as much reserves freeing up additional money to lend.

In summary, if the FED increases the money supply, then this would show up as an outward shift in the money supply curve in the money market (Table 1). The outward shift could be accomplished by a reduction in the discount rate, open market purchases, or lower required reserve rates.

Table 1.

Decisions about how these three tools will be used are reached by the twelve people serving on the Federal Open Market Committee.

How the Economic Tools Influence the Money Supply and Macroeconomic Factors

GDP, Inflation, and Unemployment

The most powerful entity within the Federal Reserve System in terms of monetary policy is the Federal Open Market Committee. This group sets interest rates either directly (by changing the discount rate) or through the use of open market operations (by buying and selling government securities which affects the federal funds rate). The mission of the FOMC is "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." (2006) Balancing the supply of available money in the market is is a challenging task with big ramifications if done without considerable thought. Supplying too much money into the market can lead to increased spending resulting in inflation and higher prices if production can not keep pace with the aggregrate demand for goods and services. Too little money can reduce spending, thereby dampening the economy fueling a potential recession. In other words, the amount of money circulating in the economy influences spending which in turn affects production, prices, and economic growth. If growth is too fast, the goal