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ECON 2105 Assignment 4

By Derek Ruiz,2014-02-09 10:03
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ECON 2105 Assignment 4

Michelle Cheng

The Federal Reserve: Why that dollar in your pocket is more than just a piece of paper

Summary:

    Paul Krugman once wrote, “ If you want a simple model for predicting the

    unemployment rate in the United States over the next few years, here it is: It will be what Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God”. The influence of the Federal Reserve is colossal. The Federal Reserve, an institution that is not directly accountable from the voting publics, has the power to control the money supply of the United States and able to use monetary policy to compensate or avoid the economic downturns. And it can inject money into the financial system after sudden shocks or raise the interest rates to tighten the credit tap.

    The Fed is made up of twelve Reserve Banks spread across the United States and a seven-person board of governors based in Washington. It regulates commercial banks, supports the banking infrastructure, and makes the plumbing of the financial system work. The Federal Reserve job requires great aptitude since the Fed is responsible to maintain the right amount of credit in the economy. If the economy grows more slowly than it is capable of, then we are wasting economic potential: workers who might have jobs are unemployed. However, the Fed have to uphold a steady growth rate of the economy to prevent overheating the economy and lead to a bubble.

    The Fed control American’s money supply through interest rate, the price of money, by altering the supply of funds available to commercial banks. These monetary decisions are made by the Federal Open Market Committee (FOMC), which consists the President of the Federal Reserve Bank who also acts as the chairman of FOMC. The FOMC solely creates new money in the United States and delivers the new money to commercials banks to trade for government bonds. An example will be Citibank swapped $100 million of bonds for the same value of cash which leaves Citibank with plenty of cash to loan out to public. And whoever borrows the funds can spent it somewhere thus creating the multiplier effect that may ultimately increase the money supply by ten times as much.

    Clearly what the Fed given, the Fed can take away. The Federal Reserve can raise interest rates and require the bank to exchange $100 million of cash by returning the government bond. As banks bestow the cash, the money supply shrinks that create a cascading effect: slower economic growth. Meanwhile, the Fed’s goal is to facilitate a sustainable pace of economic growth yet fiscal policy may offset the monetary policy’s objective.

    To economists, money is quite distinct from wealth. Wealth consists of all things that have value- houses, cars, commodities, human capital. Money is merely a medium of exchange; in theory, if barter works, money is not even necessary. As time passed by, money has evolved to make trade easier through the five means of money: 1. Medium of exchange, 2. Means of exchange, 3. Unit of account, 4. Portable and durable, 5. Store of value. Nevertheless, money is just papers in your wallet or in your bank account. That is why the modern definition of money steps in: money has purchasing power. Dollars have value because people accept them. A dollar is a piece of paper whose value derives independently from our confidence that we will be able

    to use it to buy something we need in the future. Since paper currency has no inherent worth, its value depends on its purchasing power- something that can change gradually over time.

    A paper currency has value only because it is scare. Massive inflation will distort the value of money and has potential to take away our wealth. Under moderate inflation, any wealth held in cash will lose value over time. Even less risky investment still won’t able to protect us from inflation because their low interest rates may not be able to keep up with the inflation. Undeniably, fixed income individuals are the worst off. Inflation also redistributes wealth arbitrarily. Unexpected inflation is good for debtors and bad for creditors. Indeed, inflation also distorts taxes. An example will be the after-tax revenue gains from the stock market may counterbalance the inflation rate. Since inflation is not predictable, individuals and firms are forced to guess about future prices when they make economic decisions. When lenders fear future inflation, they build in a cushion.

    Even though government should use all means to restore the steady growth rate, this might not be the case. Corrupted government might see inflation as a way to pay off their long term debt because they pay back much less due to debtors’ gain in inflation. Moreover, the

    government who is unable to raise tax can indirect tax their citizens through printing more money. With more money supply in the market, the government successfully devalue the money stays in the people’s wallet, thus taxed the people. Inflation is bad with deflation being

    much worse due to assets prices are falling, so as consumers feel poorer and less inclined to spend. When consumers stop spending, the economy stops growing.

    Overall, the Federal Reserve is responsible for the country’s monetary policy with an ambition of steady economic growth. Money has a value because of its purchasing power and others are confidence that the ‘money’ can use to buy something else in the future. The Fed is

    closely related to our spending habit, since it controls the credit tap of the economy. Done right, it facilitates the growth of the economy; done wrong, it causes whole economy to suffer. Most important is that the Federal Reserve can work hand-in-hand with the Congress to promote the well being of Americans as to secure our wealth in long term.

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