Environmental Analysis

Introduction

The Federal Reserve (Fed) and monetary policy -- two names that go hand-in-hand in the controlling of money supply to influence interest rates and assist the economy in achieving price stability, full employment, and economic growth. This paper will go into detail analyzing the creation of money and the tools the fed uses to control/influence money supply, monetary policy and impacts. Step one, of course, is the creation of money in the first place.

Money Creation

Money is defined as any item that is generally acceptable to sellers in exchange for goods and services, (McConnell and Brue, 2004). Money also serves as a standard of value for measuring the relative worth of different goods and services and as a store of value. Money is normally the standard of deferred payment (to settle a debt). To the uninformed, money is strictly currency; however, money can also be in various forms of financial deposit accounts, such as demand deposits, savings accounts, and certificates of deposit. In modern economies, currency is the smallest component of the money supply. Money is not the same as real value, the latter being the basic element in economics. Money is central to the study of economics and forms its most convincing link to finance. The absence of money causes an economy to be inefficient because it requires a coincidence of wants between traders, and an agreement that these needs are of equal value, before a barter exchange can occur. The efficiency gains through the use of money are thought to encourage trade and the division of labor, in turn increasing productivity and wealth, (Wikipedia, 2007).

Money creation is the process by which the money supply of a country is increased. Government has several ways, in coordination with the country's commercial banks, to increase or decrease the money supply of a country. If a country follows a fractional-reserve banking regime, as virtually all countries do, not all the money in circulation needs to be backed by other currencies, physical assets such as gold, or government assets. Fractional-reserve banking refers to the common banking practice of a bank issuing more money than holding in reserves such as banks loaning customers many times the sum of the cash reserves than held. Instead, the bank uses the non-currency portion of money as backing for loans, mortgages, and other assets, (Wikipedia, 2007).

The view is that government and banks create money out of nothing. This is nothing more than IOUs or as commonly called, “money made out of thin air.” Anyone who owes taxes, dues, fees or obligations can return the note and have said debt canceled. Such money is said to be fiat money. Fiat money does not have any intrinsic value as a commodity and is essentially a debt of the government or bank. Like any other debt from a creditworthy borrower, these IOUs are assets to those who hold them. Thus these evidences of debt are usually well suited and widely used to settle accounts. The fact that the note can be transferred to others makes it perfect for effecting private exchanges. Consequently, Federal Reserve Notes and other paper money are unbacked IOUs. The fact that they are IOUs is the very thing that makes them suitable to be money. The principal criticism rests on the determination of the money supply. The supply of money is a dependent variable, not an independent one. The demand for credit determines the quantity of money, or at the very least bankers and borrowers share the responsibility. Causality is thus reversed. Bankers can, if they so desire, respond without limit to demands for credit. They are not tied by a fixed amount of pre-existing assets, (Congress Report No. 96-672E, 1996).

Tools Used by the Fed to Control/Influence Money Supply, Monetary Policy and Impacts

As noted earlier, monetary policy is the central bank’s changing of the money supply controlling of money supply to influence interest rates and assist the economy in achieving price stability, full employment, and economic growth, (McConnell and Brue, 2004). The tools the Fed uses to control money supply are open-market operations, discount rate, and reserve requirements. Using these tools, the Fed influences the demand for and supply of balances that depository institutions hold on deposit at Fed banks (the key component of reserves) and thus the federal funds rate. The federal funds rate is the interest rate charged by one depository institution on an overnight sale of balances at the Fed to another depository institution. Federal rate changes trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit in the economy, and a range of economic variables, including employment, output,