Functions of Money

Banks and Money Creation

• The money multiplier is the number by which a change in the monetary base is multiplied to find the resulting change in the quantity of money.
• Change in quantity of money = Money multiplier X Change in monetary base.
• The money multiplier is determined by the required reserve ratio (r) and by the currency drain (c). c: an increase in currency held outside the banks, tells us the portion of currency which people will hold as cash for their expanses after they borrowed from the banks. r is the required reserve ratio which determined by the Federal Reserve. Banks are required to hold r portion of their total deposit as their required reserve.
• RR: Required Reserve = Total deposit x r
• ER: Excess Reserve = Actual reserve - Required Reserve
• Maximum new loan amount of the banks is equal to the excess reserve held by the banks.
• Money multiplier = 1/ {1- (1-r)(1-c)}
• Maximum change in checkable deposits = Money multiplier X Change in reserves from the initial injection
• For example, A deposits $1000 in Bank X. The current required reserve ratio (r) is 10%, c is 25%
• Money multiplier = 1 / {1- (1-10%)(1-25%)} = 3
• Maximum change in checkable deposits = 3 X $1000 = $3000
• When c=0, Money multiplier = 1/r, this is the simple money multiplier.

Federal Reserve System

• The Federal Reserve System, established by Congress in 1913, regulates the money supply and banking system in the U.S. Its principal components are the following:
• 1. Board of Governors: controls and coordinates the activities of the Federal Reserve System. The seven governors are appointed by the president and confirmed by the Senate to staggered 14-year non-renewable terms. The president designates one member of the board as the chair for a four year, renewable term.
• 2. Federal Open Market Committee (FOMC): is made up of the seven governors plus five presidents of Federal Reserve District Banks (the president of the New York district has a permanent seat; the other four places rotate among the remaining 11 district banks). FOMC has the authority to conduct open market operations, which is the buying and selling of government securities for the purposes of manipulating the money supply.
• 3. Federal Reserve District Banks: assist the Board of Governors in overseeing the banking system and controlling the money supply, the system was divided into 12 geographic districts and each district is overseen by a Federal Reserve District Bank.
• Functions of the Federal Reserve Systems are:

• 1. Control the money supply
• 2. Supply the economy with paper money
• 3. Provide check-clearing services
• 4. Hold depository institution’s Reserves
• 5. Supervise member banks
• 6. Serve as the Government’s banker
• 7. Serve as a lender of last resort
• 8. Serve as a Fiscal Agent for the Treasury.