Money, Creation & Control, And Monetary

Policy 1
Running head: MONEY, CREATION & CONROL, AND MONETARY POLICY

Money, creation & control, and monetary policy

Anand Vaneswaran
Antonia Poarch
Elvyn D. Ulloa Mella
Faraz Shah
International Economics/ECO561
June 21, 2010
Christian Teeter

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Money
Money, It is the centrifugal force that makes the world go round. The role of
money assumes many functions, but there are a few functions that take more prominence
than others: a medium of exchange, a unit of account, and a store of value (Brue &
McConnell, p.232, 2004). The number one function of money is that it serves as a
medium of exchange to purchase or sell any number of goods and/or services.
Companies no longer pay employees with goods or products in exchange for services
rendered much like consumers are no longer able to barter to obtain resources from
producers. In this day and age, money is the system of exchange utilized in all facets of
the economy.
Money also operates as a unit of account just as feet and inches are units to
measure height and Celsius or Fahrenheit are used to measure the temperature. Brue &
McConnell (2004) note that money aids rational decision making by enabling buyers
and sellers to easily compare the prices of various goods, services, and resources
(p.233). Money allows the value of one good to be easily comparable to another. Money
also acts as a store of value. The store of value function allows one to save money and
have it readily accessible to use it as needed rather than depleting it all at once. For many
people money is often the preferred store of value for short periods because it is the
most liquid (spendable) of all assets (Brue & McConnell, p.233, 2004).

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People often store their money in checking accounts in commercial banks or
credit unions. Checkable deposits, therefore, are simply monies deposited into checking
accounts. Checkable deposits are liabilities (not assets) for banks, and do not constitute
as part of the economys money supply. Banks must maintain reserve ratios which are a
certain percentage of a banks checkable deposit liabilities by law. Not only do banks
accept deposits of monetary nature, they also loan money under the parameter clearly
outlined in a promissory note to the issuing bank. For each deposit that is made, banks
set aside a certain percentage, and the remaining portion is set aside in an excess reserve.
Then, the bank is able to loan money in its excess reserve to other borrowers who must
then have the money deposited into their checking account where a reserve ratio is
subtracted from the amount deposited. The borrower must repay the loan within a time
frame noted in the promissory note to the bank, in addition to loan rate established upon
issuing.
Central Banks versus other Banks
Stable central banks and other banks, such as commercial banks, are essential to a
nation as they form the backbone of a solid financial structure that will ensure the nation
wealth, economic growth and ultimately prosperity over a period of time. In market
economies, the banking system plays a critical role in gathering funds from the public
and in channelizing these credit resources to their most effective uses. Economies with
minimal or underdeveloped banking systems will find capital formation, productivity and
growth inhibited. An effective banking system can contribute over time to economic
growth (Federal Reserve Bank of Minneapolis, 2010).

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A central bank, unlike other banks, is a nations principal monetary authority. In
the United States, the Federal Reserve System controls the money supply and sets
policies that can affect the rate of inflation and interest rates. It also provides loan to
major banks in times of financial crisis. It is different from a commercial bank in that a
commercial bank is generally only involved in loans and depository services for
businesses. A commercial bank provides check, savings and money market accounts to
its customers. Furthermore, it raises funds by accepting deposits from businesses and
individuals who invest their savings. Commercial banks then lend these funds to those
that need money to buy goods and services.

Most commercial banks are privately

owned. A summary of a typical commercial banks activities is as follows:

Opening and providing bank accounts

Lending money
Dispensing cash over branch counters and ATMs
Buying and selling foreign currency
On the other hand, a central banks main aim is to promote and maintain a sound

monetary, credit and financial system in the country. It does not provide direct banking
facilities to the public, but rather serves as a bank for commercial banks and the
Government. A summary of a central banks activities is as follows:

Printing and issuing of the United States dollar banknotes and coins
Regulating commercial banks
Serving as the banker of commercial banks and the Government
Formulating and implementing the countrys monetary policy
Providing advice on economic policies to the Government
Build public confidence by stabilizing domestic currency.

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An unstable currency is bad for the economy because it is inflationary and can
cause scarcity and depletion of resources. As a result, many people may convert their
savings into foreign currencies during and after conflict, usually Euros or dollars. Others
will hoard cash in their homes. Suppressing this trend is often unsuccessful and may not
be a priority. With time, domestic currency will eventually be used in local transactions
and in paying taxes to the government. Host nation governments have a number of
options for stabilizing their currencies, including using preexisting currency, introducing
a new national currency, or borrowing foreign currency from another country. The most
suitable approach will depend on the political situation but should seek to address supply
bottlenecks, shore up reserves, strengthen institutions, and create a domestic market.
Stabilize the exchange rate through a foreign exchange market
An organized foreign exchange market that allows countries to buy and sell
currency aids stabilization. Develop transparent policies for participation in foreign
exchange auctions. Following violent conflict, the exchange rate is often overvalued
because of restrictions on imports and other distortions that favor those with access to the
foreign exchange at the official rate. There are several policy choices for foreign
exchange. When the value of the currency is known, countries can either peg their
currency to a major international currency or continue to let their currency float. By
submitting to external discipline, pegging a currency foregoes autonomous monetary
policy, which can be beneficial in countries trying to stabilize inflation and restore
credibility after the conflict. An open exchange rate, however, may make sense for
countries with insufficient reserves to maintain a fixed exchange rate.
Set realistic targets for inflation rates. Inflation is often high in war-torn economies.

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This may be the case because the government resorted to printing money to fund
its military costs, among other factors. Stabilizing inflation is important to restore public
confidence in the value of domestic currency, invite greater investment, and provide
businesses with a guide for what to produce and in what quantities. However, it is
important not to go too far. Focusing on managing reserves and debt may be
more realistic and effective. Imposing traditional economic reform agendas used in
ordinary developing countries may not be appropriate for a country that has just
undergone violent conflict. The effect could be to exacerbate social polarization and
political disintegration. Neither actors nor institutions in these countries tend to respond
to traditional policy prescriptions the way one might expect in a country that is already on
a strong path to development.

Build the institutional capacity of an independent and credible monetary authority.

A credible monetary authority typically exists in the form of a central bank that is
able to implement monetary policy decisions without political influence. In cases where it
is necessary to develop a central bank, think about reducing the printing of money,
replenishing foreign currency, jumpstarting foreign exchange operations and setting up
accounting and statistical systems. Training and technical assistance are also important
for both high-level officials and central bank staff.
The primary functions of a central bank include the following:

Controlling the emission of domestic currency

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Restoring the payments system

Facilitating or serving as a market for foreign exchange

Supervising commercial banks.

Central Banks
Money acts like an asset, which can be immediately substituted for other assets or

products. Money plays three basic roles, it is a medium of exchange, it is a unit of

account, and it acts as storage of personal wealth. Money helps us in the exchange
medium to go out and trade products by buying and selling them without having to give
up another fixed asset in return. This eliminates the need to carry a sack full of other
products that were used to do trade in the past. The way money is used as a unit of
account is at a specific time position we use money to agree to payback debts that we
owe for home renovations or college tuitions after graduating. The value of the loan
depends on how the prices of goods and services fluctuate over time. This is why money
is used to buy an asset of the fixed kind, which will appreciate over time, for example
property or land.

The main function of the Bank of England is to make sure that there is monetary
stability in the country. This means that the prices of items at sold and labor rate at the
dealers stays constant, with low rate of inflation, and consumer confidence in the pound
sterling. Stable prices are defined by the Government's inflation target, which the Bank
seeks to meet through the decisions taken by the Monetary Policy Committee (Monetary
Policy, 2010, Bank of England). According to International Monetary Fund (IMF)

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website, GDP for United Kingdom increased from $11,535.943 Billions in 2007 to
$11,759.620 Billions in 2008 (IMF, 2010).
The primary goal of any central bank is to look after the future value of money as
it deals with its purchasing power. When inflation goes up, it reduces the value of money,
just like we are seeing in China these days. This is why the central banks enact a sound
monetary policy, which has a directive to make non-inflationary economic growth. The
value of money is greatly influenced by the interest rate that is set by the Federal Reserve
in United States of America or by the Bank of England for United Kingdom. As we saw
in week-six quiz #8, when banks borrow money from the Fed, they actually increase the
money supply in the market. The supply of money also decreases as the Fed sells
securities. Banks have to keep at least 20% of the required reserves. The rate of change of
interest rate lets the monetary policy shifts towards the quantity of money provided rather
than its price (Monetary Policy, 2010, Bank of England). The banks have to create money
in order to define their liabilities, because these liabilities are defined in the form of
money. However, we have to remember that money cannot be just created without having
any production factor or financial asset to back it up with. This is why we always hear
that we just cannot create money, because it will devalue our currency and not help the
economy revive in the long run, because there are no assets backing it up.

References

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1. A History of Central Banking in the United States. The Federal Reserve Bank of
Minneapolis. Retrieved from
http://www.minneapolisfed.org/community_education/student/centralbankhistory/
bank.cfm on June 20, 2010
2. Bank of England. Threadneedle Street, London EC2R8AH. Retrieved June 15,
2010, from http://www.bankofengland.co.uk/monetarypolicy/index.htm
3. International Monetary Fund. Retrieved Jun 15, 2010, from
http://www.imf.org/external/pubs/ft/
4. Macroeconomic Stabilization, retrieve from United States Institute of Peace
http://www.usip.org/guiding-principles-stabilization-and-reconstruction-the-webversion/sustainable-economy/macroeconomi