Money Mechanics
Introduction
Any society has the option of adopting barter trade. This will be especially possible if the society willing to adopt barter trade produces almost all products and services that are required within the society. In this scenario, different producers will have to link with each other in a manner that will enable them to exchange their goods and services. Barter trade involves the exchange of goods for goods thus for two people to trade, the first person must have what the second person needs, and the second person equally must have what the first person needs. However, this may be tiresome and time-consuming and invites the need to adopt specialization.
Specialization leads to more productivity as it allows one to concentrate on what he/she is best at. In modern society, many people opt to produce just what they require and purchase the rest from sellers. They purchase the desired products and services using a commonly acceptable medium of exchange known as money.
In the economic field, the definition of money may be varied. Economists argue that money is not always a medium of exchange. To be precise, when people work they do not get money as a medium of exchange but they get income. These two terms, money and income, though they seem similar, they are used in different concepts.
The supply of money is a very sensitive issue that needs to be checked on. This is because when there is more money in circulation people will tend to purchase a lot. This leads to low bargaining power on the side of the buyer which may lead to inflation. On the other hand, when the money in circulation is too little, it leads to high bargaining power by the buyer. This leads to reduced sales and eventually recession.
Kinds of Money
Paper and coin currency issued by the government are mostly used to buy desired goods and services, thus they can be referred to as money. Other forms of money however exist and include checking accounts which consist of all transaction accounts. Checks and similar instruments like negotiable orders of withdrawal and share drafts may not be classified as money but rather they are just means of acquiring money. A credit card also is not money but just a means used to transfer checking account balances. This applies to a debit card as well.
Currently, the only kinds of money in the United States are paper currency, coins, and checking account balances. Others are just means used to transfer money. It is important to note that not all paper currency, coins, and checking account balances are considered money but only those measured in the money supply.
The United States Money Supply
In the United States, the only bodies that have the power to create money are Central Banking System, the United States Treasury, and banks. United States money supply includes all issued coins and paper currency other than the amount stored in the central banking system, secure places in banks, and U.S. Treasury (CC) plus checking account balances excluding those owned by other domestic banks and the United States Treasury(CA).
Supply is denoted by (M), thus: M = CC + CA
An increase in either CC or CA leads to an increase in M and vice versa. The current totals are estimated to be: $1995 billion (M) = $974 billion (CC) + $1021 billion (CA)
When two people exchanges one kind of money for another a problem may arise. For instance, if some cash was deposited, meaning an increase in CA, but the execution fails to indicate a decrease in CC, M will automatically increase which is ideally not the case. Similarly, if one cashes a check with a certain amount, there will be an increase in CC because the cashed money is now added into the measured money supply and a similar amount will be reduced in CA. This means that there will be no change.
When we make a cash deposit in our accounts, this money ceases to be ours and becomes the possession of the bank and the bank, in turn, pays us by increasing our checking balance account by the same amount. We can therefore define a bank as an institution that sells cash and checking account balances as well as other financial assets.
Velocity of Money
In this case, it refers to the average frequency with which a dollar is spent each year for the purchase of a current domestic product. This is determined by the way we spend our money. Increased spending leads to increased velocity. A dollar is estimated to be spent on average 1.66 every month for the purchase of domestic output. However, this is not necessarily true as it could be more than this because there is more cash circulating outside the United States due to various reasons like dollarization and also the fact that the dollar is used for other purchases, other than the purchase of the current domestic product.
The velocity of the money (V) multiplied by the quantity of money (M) helps the government to determine the total expenditure on the current domestic output:
Total Domestic Output Expenditure = Velocity of Money (V) Ă— Quantity of Money (M)
The value of the products and the magnitude of velocity helps the government to know the amount needed to have effective sales.
Money Producers and Regulators
Three bodies are in charge of money creation namely: United States Treasury Department, the Federal Reserve System, and the banking system.
Treasury Department
This is a department within the federal government responsible for managing government financial affairs. They collect taxes and use these funds to pay federal government bills. They are also responsible for regulating the agencies that manufacture the nation’s coins and paper currency notes.
The Federal Reserve System
It was established by the National Monetary Commission in 1913 after a series of financial panics. The twelve Federal Reserve Systems operate independently though they are created and managed by the federal government. Their operations yield enough money to cater to the overall costs and in case there is an excessive amount it is handed over to the treasury. Board of Governors sets policy for the Federal Reserve System.
Functions of the Federal Reserve System
They regulate the supply of money by coming up with improved analytical and control techniques as well as developing new ones. They also serve as banks for the federal government as they maintain the treasury checking account. The third function is that they act as a banker for numerous foreign governments and bodies like the World Bank. Fourthly, together with other regulatory bodies, ensure that banks are operating by the set rules and regulations. Lastly, they serve as a banker’s bank since other banks maintain reserve accounts with this bank and they also offer valuable electronic fund transfers and check-clearing services.
Banks
To start a bank, one must obtain a charter. For a charter to be granted, one must convince a chartering agency that inadequate banking services exist in the area and that he/she has expertise in the financial sector.
Federal charters impose various restrictions on members. Besides this, they have direct control over member banks. For instance, the authorized commercial banks to keep their reserves in non-interest earning accounts in the Federal Reserve Bank. As a result, banks started dropping their federal charters and opted for state charter which allowed them to keep their reserves in the interest-earning account as this helped them to tap considerable interest from their reserves. This was a great advantage as they were able to overcome the problem of high-cost loans. In response to this, the Depository Institutions Deregulation and Monetary Control Act of 1980 was passed by congress to give Federal Reserve System more powers.
Banking Supervision and Regulation
Banks need to be regulated because of various reasons which include the need to protect the depositor as he/she is exposed to the risk of losing the money if it is not well managed. The other reason is to enhance a stable monetary system which will help bankers to anticipate crises and know the right action to take. The third reason is the need for an efficient and competitive banking system because healthy competition and efficiency are crucial in this era and lastly, the need to protect depositors from exploitation by these banks.
Principal Regulators
Principal regulators are composed of the following agencies: the Office of the Comptroller of the Currency (OCC) which is an agency within the treasury department responsible for supervising commercial banks with federal charters; the second agency is the Federal Reserve System which supervises and regulates all commercial banks which are members of the Federal Reserve System as well as financial holding companies; the third agency is the Federal Deposit Insurance Corporation (FDIC) which is responsible for insuring deposits held by commercial banks; the forth agency is Office of Thrift Supervision (OTS) which supervises and regulates federally chartered saving associations; the fifth agency is the National Credit Union Administration (NCUA) which is responsible for supervising and regulating federally chartered credit unions, and lastly, the State Banking Agencies which together with the help of FDIC supervises and regulates all financial institutions that are not members of the Federal Reserve System.
The Treasury and the Money Supply
Taxes and Loans from Public
To avoid interference with the nation’s credit market and money supply, the treasury has created tax and loan accounts in all banks across the country where tax payment from various individuals are deposited as well as payment of securities issued by the United States treasury. The treasury then transfers these funds from the tax and loan accounts to its checking account in the Federal Reserve Bank of that area to pay the government’s bills.
This causes a reduction of the same amount in banks in that area and eventually a reduction in loan-able funds. In turn, the treasury draws checks to make the bill payment. The banks then take the checks and add the amounts to the checking account balance of the customers and then demand compensation from Federal Reserve Bank, which in turn reduces treasury account balance by the same amount and increases banks’ reserve accounts by the same amount. This causes restoration.
The table below illustrates the whole process.
Tax and loan accounts help the government to reduce the loss of money caused when people send money that exceeds government spending in an area. It should be noted that there is no increase in money supply or bank reserves when the government spends money received through taxes or sold securities.
Creation of Coins and Currency
The treasury operates the United States mint that manufactures coins and the United States Bureau of Engraving and Printing (BEP) which print out paper currency. This new money that they produce is not yet money. The treasury then sells these new coins and currency to the twelve federal banks and this helps the treasury to get revenue. When a customer makes several withdrawals from their accounts, cash reserves go down and this forces the bank to purchase more cash from Federal Reserve Banks.
The banks are then charged by Federal Reserve Banks by reducing their reserve account in Federal Reserve Banks. This does not increase the money supply. The table below illustrates the Treasury creation of cash:
Bank Loans to the Treasury
Sometimes treasury borrows by auctioning securities and if purchasers are banks, they pay using the reserve. However, banks prefer to use their reserve money by giving loans to customers rather than buying securities as securities do not generate much money compared to interests from loans which yield good money. Treasury securities will increase the money supply but will not change the bank reserves.
The table below illustrates this:
Treasury Borrowing from the Federal Reserve
This is a very rare case and it does not happen in the United States. This is because when the government borrows from the federal system, it can cause hyperinflation. However, when it happens, the Federal Reserve buys securities from the treasury. This causes an increase in both money reserves and money supply. The table below illustrates what happens when the Federal Reserve lends to the treasury:
Treasury borrowing has little effect on money supply because they rarely borrow from a bank or Federal Reserve. Federal government budget deficits are therefore inflationary depending on circumstances.