This term paper contains the definition of purpose and functions of money. It also gives wide explanation of how central bank manages the monetary system of a nation. Discusses the recent monetary policies in US and how the federal reserve is helping to achieve that. Covers the effects of the monetary policies on the production in the economy and employment.
The purpose of money is to make business easier through elimination of the barter trade. Money is a medium of trade which is acceptable to be used in payments for goods and services, and in paying back debts. Through this function of acting as a medium of exchange, it solves the great problem of a barter trade and the idea of double coincidence of needs. It’s also the medium used to measure and give the correct value of goods and services, which means that it’s a unit of account (federalreserve.gov). For money to act as a unit of account it must be capable of being divided into smaller units without loosing its value, and those divided units must be seen as equivalent to any other. Money should also have a specific measurement which should be used for verification. The amount of money used to purchase a commodity becomes the price of that product. Money acts as a store of value which is reliably kept and may be taken back when needed and as useful as before.
The Central Bank is a special banking body with authorities to lend a government of the nation its money. It also lends its money to other commercial banks when the need arises. Central bank uses several tools to control the nation’s monetary system. They includes: the power to change the interest rate on the money it’s lending out. When it decides to put a higher interest rate this makes the money more expensive and hence few people to borrow thus reducing the amount of money in circulation. The central bank may also decide to lower the interest rate causing an opposite effect. Secondly, central bank has the power to control the level of the required reserve in every bank (federalreserve.gov). This is the percentage of the loaned money that each bank should be holding at its position, at any given time. If there is a lot of money in circulation, central bank increases the level of the reserve requirement to discourage banks from lending more money. If there is less money in circulation central bank may decide to reduce the level of the reserve required.
Central bank also ensures the security and effectiveness of other banking institutions by protecting the consumer’s rights of borrowing money. It also ensures a stable financial system and preparing to tackle all types of risks which may be encountered in the financial market. Central bank influences the monetary policy through governing the monetary and the credit status in the economy to increase job opportunities, stabilize prices and maintenance of long term rates of interests (Makiw, 2007). It may also adapt the tool of discount window lending; central bank has the power to lend money to different financial institutions within a nation, through this it can decide to call in the already existing loans or in other cases extend more loans. Through this they can change the magnitude of the money in circulation. Finally, another tool central bank can use is the open markets operations if there is a lot of money in circulation it may decide to sell bonds to the public in exchange of money , or other times may decide to purchase those bonds from the public.
The recent monetary policies in the United States aims at reducing the required reserves so as to increase the targets sets for the federal money, this exercise began in the middle of 2004. They also aim at applying the use of monetary base so as to recover and acquire continuous growth of the economy (federalreserve.gov).To confirm thus new direction the Federal Reserve has reduced the interest rate on the loans. Monetary policies affect the economy’s production through changes of interest rates. When the interests rate changes it imposes some effects on the consumption level of goods and services to individuals as well as organizations. The demand and the supply of goods and services is also affected. This is through the changes in costs of borrowing money, difficult to obtain loan from a bank, reduced purchase of household items etc. for instance when the rates of interests are low people are in a position to borrow money and invest more, purchase production machines, purchase household items and increase the productivity. As the people tend to purchase more households, this increases the value of what they own marking an increased wealth which encourages them to spend more. However, if the interest rate is high it will be hard for people to invest or venture into new businesses. Lower interest rate as well encourages spending.
Moreover, as people continue spending, the demand of the produced goods and services increases thus increasing the level of production and creation of more job opportunities (Makiw, 2007). Further, the businesses spends more on capital goods so as to match the demands on the increased factory capacity, this on the other hand increases the consumption of goods and services due to the Increased income to individuals and firms.
Reference
Makiw, N.G. (2007). Macro Economics. International Monetary Fund.
Mankiw, N.G. (2008). Principles of Economics. Cengage Learning. Web.