The Money Market Case Assignment

The Money Market Case Assignment

Submit a 4- to 5-page paper that addresses the following questions. Be sure to use references within the paper to support your answers. Show work for all calculations. Are credit cards or debit cards money? Explain your answer.

Assume that the bank holds no excess reserves and that the required reserve ratio equals 10% of deposits. If a customer deposits $5,000, what would be the total increase in checking account balances throughout all banks? Explain the process by which the banking system creates money. In your own words, list the Fed's main policy tools and briefly explain each one. TRUE or FALSE. "When the Fed makes an open market purchase of government securities, the quantity of money will eventually decrease by a fraction of the initial change in the monetary base." Is the previous statement correct or incorrect? Explain your answer.

Use concepts from the modular background readings as well as any good-quality resources you can find. Be sure to cite all sources within the text and provide a reference list at the end of the paper. Length: 4–5 pages double-spaced and typed.

Paper For Above instruction

The determination of what constitutes money is fundamental to understanding monetary policy and banking operations. In the context of modern financial systems, credit cards and debit cards are often considered forms of payment rather than money themselves. Debit cards are linked directly to a depositor’s checking account, which is part of the money supply, hence functioning as a medium to access existing money (M1). Conversely, credit cards do not represent money but are a form of short-term borrowing; they allow consumers to make purchases on credit, which is ultimately settled with money later (Mishkin, 2015). Therefore, debit cards effectively function as money, whereas credit cards do not, aligning with the traditional definitions of money as a medium of exchange, unit of account, and store of value (Friedman & Schwartz, 1963).

When a customer deposits $5,000 into a bank, assuming no excess reserves and a reserve requirement of 10%, the banking system can create additional money through the process of fractional reserve banking. The reserve ratio stipulates that banks must hold at least 10% of deposits as reserves, in this case $500 for the initial $5,000 deposit. The remaining $4,500 is available for lending to other customers. These loans, when deposited in various banks, continue to generate further deposits and loans in a process called the money creation process or the money multiplier (Cecchetti & Schoenholtz, 2020).

The total potential increase in checking account balances across all banks can be calculated using the money multiplier formula: 1 divided by the reserve ratio. With a reserve ratio of 10% (or 0.10), the multiplier is 1/0.10 = 10. Therefore, the total increase in deposits from an initial deposit of $5,000 would be $5,000 multiplied by 10, resulting in a maximum potential increase of $50,000 in the banking system (Mishkin, 2015). This illustrates how the banking system expands the money supply through successive rounds of lending and deposit creation.

The process by which the banking system creates money involves banks accepting deposits, holding reserves, and making loans with the excess reserves. When banks extend loans, they effectively create new money that enters circulation as deposit funds in another bank, perpetuating the cycle. Central to this process is the role of the Federal Reserve (Fed), which influences money supply and monetary policy through several key tools.

The Fed's Main Policy Tools

1. Open Market Operations (OMO): The Fed buys and sells government securities in the open market to influence the level of reserves in the banking system. Purchases inject liquidity, increasing the money supply, while sales withdraw liquidity, decreasing it (Board of Governors of the Federal Reserve System, 2022).

2. Discount Rate: This is the interest rate at which the Federal Reserve lends reserves to commercial banks. Lowering the discount rate encourages banks to borrow more reserves, increasing the money supply, whereas raising it has the opposite effect (Mishkin, 2015).

3. Reserve Requirements: These are regulations on the minimum reserves banks must hold against deposits. Changing reserve requirements directly affects the money multiplier and therefore the money supply. A decrease in reserve requirements enables banks to lend more, expanding the money supply (Cecchetti & Schoenholtz, 2020).

4. Forward Guidance: The Fed communicates future policy intentions to influence financial market expectations and economic behavior, indirectly affecting interest rates and economic activity (Fisher et al., 2021).

Analyzing the True or False Statement

The statement: “When the Fed makes an open market purchase of government securities, the quantity of money will eventually decrease by a fraction of the initial change in the monetary base,” is incorrect. An open market purchase by the Fed injects reserves into the banking system, leading to an increase in the monetary base. This increased base allows banks to expand loans and deposits, thereby increasing the overall money supply. The initial change from the purchase is reinforced through the money multiplier process, resulting in a multiplied increase in the total money supply (Mishkin, 2015). Therefore, rather than decreasing, the quantity of money generally increases following such an operation.

Conclusion

Understanding the distinction between different forms of payment and the mechanisms of money creation is essential in grasping the role of monetary policy in the economy. The process of fractional reserve banking allows banks to expand the money supply significantly from initial deposits, influenced by the reserve requirement ratio and the money multiplier effect. The Federal Reserve's policy tools—open market operations, the discount rate, reserve requirements, and forward guidance—are crucial in managing liquidity, controlling inflation, and stimulating or contracting economic activity. Accurate comprehension of these concepts enables policymakers and stakeholders to better navigate the complexities of the financial system and foster economic stability.

References

• Cecchetti, S. G., & Schoenholtz, K. L. (2020). Money, Banking, and Financial Markets (5th ed.). McGraw-Hill Education.
• Fisher, M. J., Ramussen, J. S., & Stantcheva, S. (2021). The Role of Forward Guidance in Monetary Policy. Journal of Economic Perspectives, 35(4), 49-70.
• Friedman, M., & Schwartz, A. J. (1963). A Monetary History of the United States, 1867–1960. Princeton University Press.
• Board of Governors of the Federal Reserve System. (2022). Monetary Policy Tools. https://www.federalreserve.gov/monetarypolicy.htm
• Mishkin, F. S. (2015). The Economics of Money, Banking, and Financial Markets (10th ed.). Pearson.