Running head: FEDERAL RESERVE PAPER 1

Federal Reserve Paper

Sanjeet K. Singh

Eco/212

October 25, 2010

Ronda Jantz
FEDERAL RESERVE PAPER 2

Federal Reserve Paper

Money, Money, Money. What exactly is money? Where does it come from? Who

regulates money? These questions are in the minds of every individual at one point of time or

another. The purpose of this paper is to address what money is, the importance and value of

money and where it comes from. The Federal Reserve and the role that the central bank plays in

monetary policies will also be reviewed.

Money is anything that is generally accepted as payment for goods and services and

repayment of debts. It is an essential quality of money that it should be acceptable as a means of

payment. Following are the important functions of money:

• Medium of exchange - Whatever people usually give in exchange for the things that they

buy is the medium of exchange.

• Unit of account - The unit of account is the unit in which values are stated, recorded and

settled. The differences between this and the medium of exchange may seem subtle, but

there are a few cases in which the unit of account is different from the unit in which the

medium of exchange is expressed.

• Standard of deferred payment - This is the unit in which debt contracts are stated.

Deferred payment means a payment made in the future, not now. Here, again, it is usually

the same as the medium of exchange, but not always. During periods of inflation, people

may accept paper money for immediate payment, but insist on some other medium, such

as real goods and services or gold, for deferred payment -- because the medium of

exchange would lose much of its value in the meanwhile.

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• Store of value - Again, this is something that people keep in order to maintain the value

of their wealth. Again, while it would usually be the same as the medium of exchange, in

inflationary times other media might be substituted, such as jewelry, land or collectable

goods. In this sense, money is "set aside" for the future..

The Federal Reserve System is the central banking system in the U.S. The Federal

Reserve Bank consists of twelve regional banks located in different cities in the U.S. The

key purpose of the Federal Reserve is to manage and regulate banks, execute monetary policy by

buying and selling U.S. Treasury bonds and guide interest rates. The current chairman of the

Board of Governors of the Federal Reserve is Ben Bernanke.

The Federal Reserve System is in also charge of managing the countries monetary

system. The Fed controls the money supply which affects the interest rates and inflation. This is

done by reducing the money supply when inflation is high and increasing the money supply

when rates are too high and there is little or no growth in the economy. As a part of its

responsibility of managing the monetary system of a nation, the Central Bank is issued with the

sole authority of issuing currency notes. The Central Bank performs the all important function of

being the banker to the government. It conducts all financial transactions for the government and

also raises money for the government.

Ultimately the Federal Reserve will need to begin to tighten monetary conditions to prevent the

development of inflation pressures as the economy recovers.

FEDERAL RESERVE PAPER 4

To provide further support for the economic recovery while maintaining price stability, the Fed

has also taken extraordinary measures to ease monetary and financial conditions.

The Fed’s primary mission is to ensure that enough money and credit are available to

sustain economic growth without inflation. If there is an indication that inflation is threatening

our purchasing power, the Fed may need to slow the growth of the money supply. It does this by

using three tools—the discount rate, reserve requirements and, most important, open market

operations. According to the Central Bank’s website, “These tools encompass (1) raising the

interest rate paid on excess reserve balances (the IOER rate), (2) executing term reverse

repurchase agreements (RRPs) with the primary dealers and other counterparties, (3) issuing

term deposits to depository institutions through the Term Deposit Facility (TDF), (4) redeeming

maturing and prepaid securities held by the Federal Reserve without reinvesting the proceeds,

and (5) selling securities held by the Federal Reserve. All but the first of these tools would shrink

the supply of reserve balances; the last two would also reduce the size of the Federal Reserve’s

balance sheet.” (Monetray Policy Report to the Congress, 2010)

The Federal Reserve has taken an expansionary stance by increasing the money supply,

attempting to stimulate the economy. Price stability is currently a central focus of U.S.

monetary policy. Because of well-known policy lags and the need for preemptive policy action,

the Federal Reserve necessarily uses intermediate indictors to help attain its inflation goals. In

pursuit of price stability, the Federal Reserve in recent years has in effect adopted a quasi

(informal) inflation targeting procedure, which has succeeded in lowering and containing

inflation. Currently, there is a good deal of disagreement among economists as well as Federal

Reserve policy makers as to the proper set of intermediate indictors to use in conducting a price

stabilizing monetary policy.

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Monetary policies have the following effects on production and employment within the

economy. By manipulating the real interest rate, the demand for goods and services is affected as

well as unemployment. When the real interest rate is lowered, borrowing money is more

attractive, businesses will increase investment spending, and consumer will buy more durable

goods like houses. In the short run, lower interest rates will reduce the dollar's foreign-exchange

value, which raises prices of U.S. exports.

During periods of elevated unemployment, the central bank must be extremely careful in

making sure the money supply is growing fast enough. The Fed could even try to lower the

unemployment rate by increasing the growth of the money supply. This strategy may temporarily

boost economic activity, but it is not necessarily a long-run cure for high unemployment. More

money in the economy does not always translate into greater prosperity. Wages and prices would

adjust upward to the change in money growth, inflation would negate the effect of the stimulus,

and companies would again stop hiring.

An unemployment rate that is below full employment is one signal to the Fed that the

economy is beginning to overheat. Overheating indicates that inflationary pressures are on the

rise. If workers are in short supply, businesses that want to hire new employees will have to offer

higher wages to attract those already employed elsewhere, thereby increasing production costs. If

the higher wages are not based on greater productivity, many businesses will have to pass them

on in the form of higher consumer prices, thus wiping out the positive effect of the higher wages.

The Fed's role in this case would be to slow the growth rate of money and credit so that the

economy grows at a more sustainable pace.

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By conducting monetary policy in such a way as to keep inflation at low, somewhat

predictable levels, the Fed can help create an environment in which businesses and consumers do

not have to worry about high inflation. Helping reduce uncertainty in the marketplace is one of

the greatest services the Fed can perform for businesses and workers. In a stable economic

environment, business decisions will not be postponed, investment will rise and more people will

be hired. This stability helps keep the economy growing and producing at high levels.

The Fed has a great indirect impact on the nation's labor market. Monetary policy cannot

directly affect the number of jobs or force the economy to operate at full employment, but it has

a huge impact on the economic environment, business activity and, eventually, the labor market.

In fulfilling its mission to foster steady growth in the nation's money supply while anticipating

inflationary and recessionary pressures, the Fed must consider both the short- and long-term

effects of its actions on the health of the U.S. economy.