Banks and the Money Supply
Banks perform the business of buying and selling cash to their customers. The amounts involved in these transactions must be equal to the reserve requirement stipulated for the banks. The reserve requirement is less than the customers’ deposits and is established to ensure that banks do not eat into the pockets of the customers. They can only transact using money that truly belongs to them and a portion of the customers’ deposits. This should support all the net withdrawals that customers can make because customers have the right to take all their deposits. Once the bank obtains deposits from customers, it is allowed to retain the reserve requirement, and the rest of money is saved in a different institution. However, the bank also adds an extra amount of money apart from the money deposited to give it a working reserve. This extra amount of money is required to accommodate cases in which customers withdraw more money than they have deposited. This extra amount may go beyond the reserve requirement which may lead to insufficient funds. Working reserves prevent such occurrences and act as a backup to the reserve requirement. These two make up the primary reserves.
Banking is a revenue and profit generating business. These cannot be wholly achieved from the commissions charged for the services given. They use a portion of money not included in the working reserves to invest in treasury securities, which can be liquidated easily if and when required. This money is referred to as the secondary reserve; it serves to increase revenue apart from what is obtained from the primary reserves. This is not an optional activity, but it is a requirement by the banks regulatory agencies. Once some secondary reserves are invested in the treasury securities, the rest of the money is used in lending. Banks cannot lend more than their excess reserves because they risk being insufficient from withdrawals. Lending results in increased money supply, in a nation, and it can be used to increase or decrease the amount of money in circulation. The excess reserves can be obtained either from collecting loans without lending or borrowing money from other banks that have excess reserves.
The lending process involves the transfer of money from the excess reserves to the primary reserve. This is to ensure that the increased money in the customers’ account balances is accounted for without altering the primary reserves. This automatically restricts the amount of money that a bank can lend; the maximum amount should be equal to the excess reserves. However, based on the assumption that 50% of the money lend out will be deposited back into the accounts by other customers, the primary reserve and the excess reserve is bound to grow again. This will provide an opportunity for the bank to lend more and the cycle continues thus allowing the bank to give more loans.
Fig 1.Money circulation
The excess reserves increase when the amount of net deposits exceeds the number of net withdrawals. In cases where banks operate on a small working reserve which is risky, they can obtain excess reserves from selling the treasury securities. There are cases in which banks lose their excess reserves and are not able to lend. The money paid back from loans is used to raise the bank reserves. Therefore, the bank stops lending until it raises enough excess reserves. This results in reduced money supply, in the market. Hence, the bank can regulate the amount of money in the economy by applying this process.
The Federal Reserve and the Money Supply
A bank’s excess reserves are significantly influenced by the customers’ deposits. In cases where these deposits go down due to external conditions experienced by customers, excess reserves go down, as well. This may be unemployment or off peak seasons in the customers’ source of income. When this happens, the banks lose out on their bank reserves and obtain these from other sources. This is where the Federal Reserve System comes in to lend the banks money enough for their reserve requirements until the situation gets back to normal.
Open market operations involve sales and purchases of outstanding treasury securities. Sales by Fed increase the money supply while purchasing by Fed decreases it. The sale and purchase of these securities is a continuous cycle in which the U.S treasury sells securities to dealers who in turn sell to the market. These include households and businesses or even institutions. The same dealers buy from the parties they sell to when they wish to sell. So whether, the sellers deposit their money in their accounts or keep them, money supply still increases because it is released from the Fed.
The Fed also influences the reserve requirements. For instance, it adjusts the total deposits details every year to maintain the required reserves at 7%, which is lower than the expected 10%. This gives the banks extra money in their excess reserves. If the excess reserves are used to support customer loans, money supply increases. However, if used as working reserve, then the bank may not generate revenue. Fed has the power to control the money supply by increasing the reserve requirements. This forces the banks to stop lending and use the money obtained from the paid loans to grow their excess reserves. When no loans are issued, then money supply comes down.
When a bank experiences net withdrawals, it is likely to run out of money since it has limited primary reserves. This forces the bank to borrow from the Federal Reserve System. Banks deliberately maintain a large working reserve and forego the interest that would be gained if this money was used for lending to avoid borrowing. This is applicable if the interest penalties on borrowing are more than the expected loss experienced if loans are not issued.
When Fed increases its lending rate, banks opt to increase their working reserves to avoid these high rates. This is only possible through transferring the excess reserves to working reserves. When working reserves are reduced, the bank lacks money to lend. Therefore, it depends on the loans being paid to avoid insufficiency in terms of working reserve. The bank is only able to start lending once these loans are paid such that some of money can be transferred to excess reserves. If Fed lowers the interest rates, banks are encouraged to borrow and support customer loans as long as the revenue generated is more than the cost of paying the borrowing penalties.
When the demand for loans is high, banks raise their lending rates and maintain low working reserves. This is not risky because the money obtained from the interest in loans is used to expand the working reserve. Fed can control this by simply raising the lending rate and purchasing treasury securities. Similarly during the low demand for loans, banks lower their interest rates. Fed can regulate this by lowering the rate and selling treasury securities to encourage deposits. This raises the working reserve for banks thus they do not require borrowing. From this analysis, increase in feds lending rates leads to reduced money supply while decrease leads to increased money supply.
The monetary policy is essential in economic growth. Fed influences this by providing a solution for the need for more money by the nation. This is done by reducing the lending rates, open market purchasing and decreasing the reserve requirements. This provides the banks with excess reserves and they reduce their rates and lend more. Once people access money, they have the power to invest thus create jobs, goods and services to improve the economy. However, if this is not controlled, it may lead to inflation; therefore, Fed tightens the monetary policy by selling treasury securities, increasing reserve requirements and lending rates. Therefore, depending on the situation, Fed eases and tightens the monetary policy to grow the economy or avoid inflation.
Interest and Credit
Banks act as intermediaries to equal distribution of money among the people who have insufficient, just sufficient and excess money. This is done indirectly through attracting those with excess money to bank with attractive interest rates. Once these ones save, the money lends this money to the ones with just sufficient and insufficient at an interest. This results to money distribution. These attractive interest rates are possible due to the competition involved in obtaining money from those with excess. These rates are free and are controlled by the market, they can go as high as the market conditions allow. The Fed system indirectly controls these rates. To increase these rates, Fed purchases treasury securities, reduces reserve requirements and decreases the discount rates. When this is done, banks gain excess reserves and use them to buy cash from the public. This cash is consequently used for lending loans. Alternatively, when Fed sells treasury securities, increases the reserve requirement and increases the discount rates, the bank’s excess reserves decrease, thus they may offer lower rates for the public.
Prime lending rate is wholly determined by the banks mostly the market leaders set this rate and the rest of the banks follow. The nature in which banks and other borrowers present their packages is what determines where the majority of the lenders go. For the banks, they keep adjusting these rates to ensure that they obtain a balance between the funds they acquire and the demand for loans. Banks and other institutions obtain money by selling bonds which mature after a given duration, say a year. If interest rates increase, capital losses are experienced because the expected values go down. On the other hand, when interest rates go down, the expected values go up if they are sold before maturation thus the banks experience capital gains. From a buyer’s perspective, long term bonds have higher rates due to the risk involved. Short term bonds have lower rates and are more preferable for buyers. From a banks point of view, shorter maturation periods will lead to more capital gains and less risks as opposed to the treasury bonds that mature after a longer period. Interest rates are indirectly proportional to maturity duration and can be represented as below.
Fig. 2:The relationship between the interest rates and the duration for the bond maturation period
This concept is not enforced, but it occurs automatically given that banks are profit making organizations. They are driven by the perceived best interest for the banks. A banks output is depended on loans and the marginal revenue. They involve the cost of administration, the excess reserves and the customer deposits. Of the three tools fed applies to control the money supply, only the sales and purchase of treasury bonds affect the money supply directly. For the other tools, money multiplier has to be applied for them to have an effect on money supply. This concept does not require enforcement but rather the driving force for banks in manipulated. This is the profit making nature which entices banks to lend more so as to maximize profits. So for every dollar lend out at a given rate, there is a given the amount that is paid back as interest. This leads to increased lending; however, if Fed eases the monetary policy the excess reserves reduce and therefore the ability to lend is decreased. This consequently results in decreased lending. If lending is decreased, then the acquiring more money by buying bonds is not viable because there is less demand for loans. This means that the bank will buy the bonds at an exceptionally low rate considering that there is no need of increasing its excess reserves.
Similarly, if the Fed tightens the monetary policy, the bank will require excess reserves for lending; therefore, will buy bonds at a high rate. Through these processes, the issue of money multiplier is voluntarily applied by institutions who seek to maximize profit making while keeping their cost of operation low. In as much as the rates of lending are increased demand is bound to be high because less money is in circulation. Loans follow the demand and supply forces of a market. When supply is low, demand is high and vice versa.
The economy works at controlling the quality and amount of goods and services offered and those that the buyers are willing to buy. It is possible for this to occur without any imposed control. This is common in the private sector where economies are market oriented. The possible by changes in interest rates, changes in prices, employment rates or even the output expected make this automatic coordination possible. The rate at which goods and services are produced, demand for the goods and services as well as supply determine the changes likely to be experienced in the economy. These three factors must balance and in case of an imbalance, this is evident in the economy through such things as unemployment. When the economy is affected, Fed controls this by either easing the monetary policy or tightening it. This ensures that there is no inflation or an economic strain.
The gross domestic product is not affected by changes in price and interest rates. This only affects output indirectly and is evident through changes in the economy for instance increase in employment. The coordination process ensures that consumers receive the right goods and services in the right quantity. They should match the consumer needs at the expected prices. This process should coordinate automatically without the need for a central coordination and planning. For it to go through automatically, Price changes at the same rate as the value of output. They change in the same rate and direction; therefore, the gross domestic product does not change. However in as much as the GDP does not change, it is affected by these changes indirectly. This is explained by the market value which consists of both the cost and the profits included in a commodity. Prices affect income and income is directly proportional to the GDP. Therefore, the product prices can be controlled by the banking institutions through money circulation.
Aggregate planned expenditure (APE) involves all the goods and services that are consumed in a nation. This includes the commodities that are imported in the country. APE, therefore, is significantly influenced by changes in gross domestic product although they all increase towards the same direction. The macroeconomic coordination is affected since APE takes time to change after the change in GDP. When it comes to the consumption of goods and services, the effect on the changes in interest rates may be felt, but they rarely affect the consumption. However, when the interest rates s fall, imports increase and so does APE. Similarly, when the interest rates rise, APE rises but its impact on the macro economic coordination is small. APE goes in the opposite direction of the interest rates. Given that a rise in interest rates by the banks translates to increased money supply, consumers are likely to spend less thus APE and interest rates go in the opposite directions.
On the other hand, the aggregate supply of funding is the opposite of APE; it determines the amount of purchases that are accomplished from the money supplied. Given that, increased money supply means excess reserves, the increase in interest rates leads to increased purchases. When the interest rates fall, it means that there will be less money in circulation which also translates to decrease in purchasing. Decrease in purchasing means that consumers will opt to spend less and save more in the banks. If this happens, banks increase their working reserves which consequently lead to sustainable lending without the need to borrow from Fed.
The macro-economic coordination substantially relies on the GDP, APE and the funding of demand and supply. When there is an imbalance in these concepts, then the coordination process is negatively affected. When sales go down due to temporally changes in income and the market situation, the expenditure response may not have an effect on the change in income immediately. This take time; therefore, other influences should be considered before the level of consumption is declared as low. The number of purchases done can never be more than the supplies provided inclusive of exports and imports. Chances that money may lay idly are eliminated since other lenders who are not banks are encouraged to lend their money and generate revenue from the interests charged.
Ashby, David B. Money Mechanics Monetary Economics Reengineered with an Attitude and a Policy Agenda. 2009. Web; http://home.teleport.com/~doctorashby/09MoneyContents.pdf