MACROECONOMIC DEL 2433

QUESTION 1
ANSWERS :
(Total in millions ringgit)
Personal consumption expenditures (C) 878.2
Gross Private Domestic Investment (I) 322.7
Government consumption and gross investment (G) 400.4
Net Exports (EX – IM) (94.4 - 70.5)
Total Gross Domestic Product (GDP) 1652.2
Less : Depreciation (160.8)
Net National Product (NNP) 1464.4
Less : Indirect taxes minus subsidies (122.4)
National Income 1342
Less : Corporate profits minus dividens (75.3)
Less : Social insurance payments (110.1)
Plus : Personal Interest Income 10.7
Plus : Transfer payments to persons 83.9
Personal Income 1251.2
Less : Personal taxes (150.5)
Disposable Personal Income 1100.7
Therefore ;
a) GDP = 1625.2 millions ringgit
b) National Income = 1342 millions ringgit
c) Personal Income = 1251.2 millions ringgit
d) Disposable Personal Income = 1100.7 millions ringgit
e) The Government Deficit = Didn’t have government deficit. It is because
when (receipts – expenditures), the equal is
surplus (+).
f) Net Exports = Malaysia exports of goods and services – Malaysian
imports of goods and services
= 94.4 – 70.5
= 23.9 millions ringgit
QUESTION 2
“The higher your income is, the higher your consumption is likely to be. People with more income tend to consume more than people with less income”
I) Do you agree with above statement? If yes, describe the relationship between consumption and income.
The higher your income is, the higher your consumption is likely to be. People with more income tend to consume more than people with less income yes I agree with the statement if the one person get lower income like example Vanessa get RM 1000 per month so she consume not very much .she only buy lower price product it is different after she get higher income Vanessa don’t want use local product she want use branded product like Christian Dior , Gucci , Versace so is show relationship between consumption and income. Economic theory often tells us to expect a relationship between two variables, and we may wish to explore this by seeing whether data about the economy confirm or refute or theory. An obvious example is the macroeconomic relationship between consumption and income. Collecting data on these two variables from The Blue Book, we could draw Figure A to investigate the closeness of the relationship , remembering that we expect consumption to increase with income, but with consumption increasing by less than income given that some additional income is used for savings.
Relationship between consumption and income for any change in income, 90 percent of that change affects consumption spending on domestic goods. This means, for example, that if Vanessa income increases $5.50, she will spend 90 percent of this additional income, $4.95 (= 5.50 * .90 ), on domestic goods. Since my MPS = .10, Vanessa will save 10 percent of this additional income, 55 cents (= 5.50 *.10 ). This can also work in reverse. If his income decreases $5.50, Vanessa will reduce his spending on domestic goods and services by 90 percent of this lost income, $4.95 (= 5.50 * .90 ). Since Vanessa MPS = .10, Vanessa will reduce his saving by 10 percent of this lost income, 55 cents (= 5.50 *.10 ). PROBLEM: Suppose Versace decides to increase his purchases of domestic goods $20 over-and-above what he was planning to spend, as found on his consumption schedule. Suppose he spends it all domestically at Fred's store.
Thus, Fred experiences an unexpected increase in income of $20. What will Fred do with this unexpected "windfall"? Since his MPC = .90 , Fred will increase his spending on domestic goods by 90 percent of the change in income or .90 * $20 = $18 , increase his saving by 10 percent of the change in income or .10 * $20 = $2. Suppose Fred spends the extra $18 on domestic goods and services at Karen's store. Now, Karen experiences an unexpected increase in income of $18. What will Karen do with this increased income? And so on, and so on, and so on, ... like this the Relationship between consumption and income if income high level people will buy more and if the income low people will saving and buy not much.
Household with higher income and higher wealth are likely to spend more than household with less income and less wealth . lower interest rates reduce the cost of borrowing , so lower interest rates are likely to stimulate spending .(Higher interest rates increase the cost of borrowing and are likely to decrease spending) Finally, positive expectations about the future are likely to increase current spending, while uncertainty about the future is likely to decrease current spending . In 1990 , for example , household began consuming less partly because of their uncertainty about the outcome of the Persian Gulf Conflict. While all these factors are important , we will concentrate for now on the relationship between income and consumption. In The General Theory , Keynes argued that the amount of consumption undertaken by a household is directly related to its income: the higher your income is , the higher your consumption is likely to be. People with more income tend to consume more than people with less income.
The relationship between consumption and income called the consumption function and for individual household, the consumption function shows the level of consumption at each level of household income.
ii) Define the marginal propensity to consume (MPC) and the Marginal Propensity to save ( MPS) .
The marginal propensity to consume (MPC) is the fraction of an increase in income that is consumed ( or the fraction of a decrease in income that comes out of consumption). The marginal propensity to save (MPS) is the fraction of an increase in income that is saved The marginal propensity to consume (MPC) refers to the increase in personal consumer spending (consumption) that occurs with an increase in disposable income (income after taxes and transfers). For example, if a household earns one extra dollar of disposable income, and the marginal propensity to consume is 0.65, then of that dollar, the family will spend 65 cents and save 35 cents.Mathematically, the marginal propensity to consume (MPC) function is expressed as the derivative of the consumption (C) function with respect to disposable income (Y).
In other words, the marginal propensity to consume is measured as the ratio of the change in consumption to the change in income, thus giving us a figure between 0 and 1. The MPC can be more than one if the subject borrowed money to finance expenditures higher than their income. One minus the MPC equals the marginal propensity to save.It is affected by factors such as the prevailing interest rate and the general level of consumer surplus that can be derived from purchasing.marginal propensity to save (MPS) refers to the increase in saving (non-purchase of current goods and services) that results from an increase in income. For example, if a family earns one extra dollar, and the marginal propensity to save is 0.35, then of that dollar, the family will spend 65 cents and save 35 cents. It can also go the other way, referring to the decrease in saving that results from a decrease in income. It is crucial to Keynesian economics and is the key variable determining the value of the multiplier.
Mathematically, the marginal propensity to save (MPS) function is expressed as the derivative of the savings (S) function with respect to disposable income (Y).
In other words, the marginal propensity to save is measured as the ratio of the change in saving to the change in income, thus giving us a figure between 0 and 1. It is the opposite of the marginal propensity to consume (MPC). In the example above, the marginal propensity to consume would be 0.65. In general MPS = 1 - MPC.
iii) briefly explain the determinants of consumption.
The determinants of consumption is like the things make people to buy the product like examples for Ali he is very rich so the determinants of consumption for Ali is wealth he have a lot of wealth. Income is not the only determinant of consumer purchases in given year . you can readily understand this if you examine your own behavior . if you have a savings account at a bank , you can use your accumulated savings from past years to finance the purchase of a car or a stereo system this year . if you have accumulated a “fat” savings account from past earnings , you can actually spend more than your current income on consumer purchases during a year by drawing down savings accumulated in past years for that purpose
A person ‘s wealth is the sum of the current values of all assets owned . Examples of such asaets are bank deposits , corporate stock , bonds , and real estate. Do not confuse wealth with income . wealth is a stock of accumulated purchasing power stored up from past income . it’s possible to have a great deal of wealth but very little income . for example , many elderly people have very low incomes and draw on accumulated savings to make consumer purchases and some of determinants of consumption is Household income, Household wealth , Interest rates , Household’ expectations about the future and in the general theory , price , income wealth , prices of related goods and services , tastes and preferences , expectations Keynes argued that household consumption is directly related to its income. The many factors likely to influence a household ‘s demand for a specific product, we have considered only the price of the product itself . other determining factors include income wealth , prices of related goods and so on.
Household income
Household income is one of determinants of consumption because if want to consume any product must have money without money we cannot do anything so income also making big role in for consumption for example zakaria salary is RM 700 so he can consume little only but when he get higher pay RM 2000 Zakaria will consume more and more. A Household income is sum of all the wages , salaries , profits , interest payments , rents, and other forms of earnings received by the household in a given period of time. Income is thus a flow measure : We must specify a time period for it income per month or per year . you can spend or consume more or less than your income in any given period . if you consume less than your income , you save. To consume more than your income in a period , you must either borrow or draw on savings accumulated from previous periods. This is will determinants of consumption.
Household wealth
Household wealth is one of determinants of consumption because if have a lot of wealth we can buy anything we want like Bill Gates the world riches man he can consume whatever he wish for because he have a lot of wealth this is one of determinants of consumption . Wealth is the total value of what a household owns less what it owes . Another word for wealth is net worth the amount a household would have left if it sold off all its possessions and paid off all its debts . wealth is stock measure : it is measured at a given point in time . if, in a given period , you spend less than your income , you save ; the amount that you save is added to your wealth . Saving is the flow that affects the stock of wealth. So wealth also determinants of consumption.
Interest rates
Interest rates is one of determinants of consumption because when Interest rates
are low the more people like to borrow money form bank if the Interest rates is very high is few people only want to borrow money form bank for consume the things they want like they consume car , open new business for that need a lot of money so if the Interest rates are low it very easy for people to pay back if the Interest rates are high nobody want borrow money form bank so this also one of determinants of consumption
Household’ expectations about the future
Household’ expectations about the future is one of determinants of consumption because when people know that next month the diesel oil price will increase very high so strat form now all people will go to buy the diesel oil for the future. One more examples Ali know that in he must buy one house so he no spend money a lot now because he want to saving to future for buying new house so this is will determinants of consumption of people. Expectations about the future may affect Ali demand for a good or service today . For example, if Ali expect to earn a higher income next month , you may be more willing to spend some of your current savings buying ice cream. As another example , if you expect the price of ice cream to fall tomorrow , you may be less willing to buy an ice-cream cone at today’s price.
Prices of related goods and services
Prices of related goods and services is one of determinants of consumption because suppose that the price of frozen yogurt falls . The law of demand says that you will buy more frozen yogurt . At the same time, you will probably buy less ice cream . Because ice cream and frozen yogurt are both cold, sweet , creamy desserts , they satisfy similar desires. When a fall in the price of one good reduces the demand for another good , the two goods are called substitutes. Other pairs of substitutes include hot dogs and hamburgers, sweaters and sweatshirts , and movie tickets and video rentals. Now suppose that the price of hot fudge falls. According to the law of demand , you will buy more hot fudge. Yet, in this case , you will buy more ice cream s well , since ice cream and hot fudge are often used together . When a fall in the price of one good raises the demand for another good , the two goods are called complements . other pairs of complements include gasoline and automobiles , computer and software and this is will make determinants of consumption.
Tastes and preferences
Tastes and preferences is one of determinants of consumption because if you like ice cream , you buy more of it . Economists normally do not try to explain people’s tastes because tastes are based on historical and psychological forces that are beyond the realm of economics . Income , wealth , and the prices of things available are the three factors that determine the combinations of things that a household is able to buy . you know that you cannot afford to rent an apartment at RM 1200 per month if your monthly income is only RM 400. But within these constraints , you are more or less free to choose what to buy. Your final choice depends on your individual tastes and preferences and this will determinants of consumption
QUESTION 3
ANSWERS :
a) Marginal propensity to consume (MPC) and the marginal propensity to save (MPS)
MPC
C = 200 + 0.8y
b = MPC
MPC = 0.8
MPS
MPC + MPS = 1
0.8 + MPS = 1
MPS = 1 – 0.8
MPS = 0.2
Therefore;
Marginal propensity to consume (MPC) in Freedonia is 0.8 and marginal
propensity to save (MPS) in Freedonia is 0.2
b) Graph equation for equilibrium income
AE = C + I
AE = AS
AE = C + I
Y = C + I

100{ C = 200 + 0.8Y
1000 1500 1550 National Income
Saving
S = - 200 + 0.2Y
1000 National Income
- 200
c) The new equilibrium level of income, and the value of the multiplier
i. I = 110
Y = C + I
Y = 200 + 0.8Y + 110
Y = 310 + 0.8Y
Y – 0.8Y = 310
0.2Y = 310
Y = 1550
Therefore;
The new equilibrium level of income is 1550
ii. When $10 increase in planned investment, the equilibrium income will increase.
iii. Multiplier
ΔY = 1 x ΔI
1 – b
= 1 x ΔI
1 – 0.8
= 1 x (110 – 100)
0.2
= 1 x (10)
0.2
= 5 x 10
= $50
Therefore;
The value of the multiplier is $50
d) The saving function for Freedonia
S = -a + (1 – b)Y
= - 200 + (1 – 0.8)Y
= - 200 + 0.2Y
200 = 0.2Y
200 = Y
0.2
Y = 1000
Therefore;
The saving function for Freedonia is 1000. The graph for saving function must be the same as in question ‘b’. It is because, although we use any procedure for equilibrium income, the value of equilibrium income is the same.
Question 4
“Money is anything that is generally accepted accepted as a medium of exchange “. People think the creation of money is mysterious. Far from it! The creation of money is simply an accounting procedure, among the most mundane of human endeavors . you may suspect the whole process is fundamentally unsound, or some how dubious. After all, the banking system began when someone issued claim for gold that already belonged to someone else.
i) briefly explain the weaknesses barter system in economic.
ii) Discuss the characteristics of money
iii) Describe the functions of the federal Reserve ( central bank) and commercial bank.
iv) How the Federal Reserve Controls the money supply .
i) briefly explain the weaknesses barter system in economic
Barter system is exit long time go it because that time not have money they exchange their product for get the things the need for life like examples James have 10 eggs he want rice so he must find the person who want eggs after James find the person who also in eggs and the person have rice like James want and they both exchange their things this call system barter. In finance, the word "barter" is used when two corporations trade with each other using non-money financial assets (such as U.S. Treasury bills). Alternatively, the standard definitions of money could be seen as being too narrow and needing to be expanded to increase near-money assets.
Barter is a type of trade where goods or services are exchanged for a certain amount of other goods or services; no money is involved in the transaction. It can be bilateral or multilateral as trade. It is a word frequently used as a synonym for 'negotiate/negotiation', but this usage is incorrect. A common form of barter during colonial times was tobacco. Also bushels of grain and wampum were popular forms.Barter trade is common among people with no access to a cash economy, in societies where no monetary system exists, or in economies suffering from a very unstable currency (as when hyperinflation hits) or a lack of currency.
A disadvantage of using bilateral barter is that it can depend upon a mutual coincidence of wants. Before any transaction can be undertaken, each party must be able to supply something the other party demands. To overcome this mutual coincidence problem, some communities have developed a system of intermediaries who can store, trade, and warehouse commodities. However, the intermediaries often suffer from financial risk. To organize production and to distribute goods and services among their populations, many pre-capitalist or pre-market economies relied on tradition, top-down command, or community democracy instead of market exchange organized using barter. Relations of reciprocity and/or redistribution substituted for market exchange. Trade and barter were primarily reserved for trade between communities or countries. Barter becomes more and more difficult as people become dispossessed of the means of production of widely-needed goods. For example, if money were to be severely devalued in the United States, most people would have little of value to trade for food (since the farmer can only use so many cars, etc.)
weaknesses barter system in economic
Barter is useful that time but now cannot we now using the money. Money is easy to bring anywhere and is very sophisticated so that we using money now. Barter system have his own weaknesses like examples hard to fine the people want the same product, sometime it not fair, not have demand for the things , people want other product , cannot find people want our product , must go very far to find people who want exchange the product , and so go on.
Hard to find people want same product
In barter system is very hard to fine people want the same product that we want exchange with them it because their need is different with others examples Velansic have 12 fish so he want chicken so he search for the person who have chicken and ask for fish for exchange but velansic cannot find the people who want fish so velansic go to other place and one more thinks if velansic take long time to find the person who want the fish then the fish will be so smelly and the fish cannot be exchange this is big loss for velansic . this is the weaknesses of barter system It very hard to fine the people who want the product we have .
Sometime it not fair
In barter system is sometimes not fair like examples velansay have cow so he need 120 eggs but it hard find and last velansay find one person venelin and venelin need cow because he want cow milk so that is not fair to velansay to give his cow for 120 eggs but velansay not have other choice so he exchange his cow with 120 eggs this is also the weaknesses of barter system.
Not have demand
In barter system must have demand for the things we want exchange if not we cannot exchange our product. No have demand for the product and so they must find the people who need the product or things like vegetable so on because that time they all have their own farm to make a lot of vegetable for eat so that no have demand for the product vegetable this is weaknesses of barter system.
People want other product
In barter system we must find the right person who have product or the things we need for exchange and it is not easy to find the people who have the thinks we need examples venessa have 3 chicken and venessa need fish . venessa want exchange chicken to fish but the problem is ever time go ask people who have fish would they want exchange with venessa but they say they looking for other product. this is also the weaknesses of barter system.
Cannot find people want our product
In barter system hard to find people want our product same time hard to find that people have product we need is very hard to find if find also that person maybe need other product like example Faizal have 10 eggs he need 1 chickin so he find one person Halim have chicken but Halim want vegetable so Faizal must find other person have chicken and need 10 eggs to exchange the product this is also the weaknesses of barter system.
Must go very far to find people who want exchange the product
In barter system hard to find people who will exchange things with so that must go far to search who the people that we can exchange our product it is not very easy work so that sometimes before they fine the right people to exchange the product . the product already rosak, smelly, not in good condition because of this Ali cannot get his 17 eggs because the vegetable he take already in bad condition nobody will take vegetable this is also the weaknesses of barter system
Barter is a type of trade where goods or services are exchanged for a certain amount of other goods or services; no money is involved in the transaction. But now barter system still use in some sector . now we have money it more easy and very fast. People can get the product after pay the amount for take the product. For example Versace Want Dior makeup set so she go to Christian Dior Exclusive Boutique house to consume the makeup set and this is the meaning of barter system .
i) Discuss the characteristics of money
Money is as medium of exchange , or means of payment, money is generally accepted by buyers and sellers as payment for goods and services.
Money is the set of assets in the economy that people regularly use to buy goods and services from other people. The cash in wallet is money because you can use it to buy a meal at a restaurant or a shirt at a clothing store . by contrast, if you happened to own most of Microsoft Corporation , as Bill Gates does , you would be wealthy , but this asset is not considered a form of money . you could not buy a meal or a shirt with this wealth without first obtaining some cash . According to the economist’s definition, money includes only those few types of wealth that are regularly accepted by sellers in exchange for goods and services. Money is something you’ve been familiar with throughout your life . In fact, you may already consider yourself an expert on the subject . You regularly use money to measure the value of things you own. You also have some of it ( in the form of currency) in your pocket and in bank accounts . money is power of world now.
The characteristics of money
The liquidity property of money makes money a good medium of exchange as well as a store of value.
Medium of exchange
When an object is consistently used as an intermediate object of trade, as opposed to direct barter, then it is regarded as a medium of exchange. The utility of such an object in simplifying the process of trade leads to direct demand for the object.Either coercion or faith is necessary in order for a single object to become or to remain dominant in this function.When people are coerced to use or, alternatively, they trust an object and demand it in order to exchange and trade, then this object is considered money.
Money is one of those things we have difficulty defining even though we know it when we see it. What has emerged as an acceptable approach to defining money is to define it by the functions it performs, which is good since the functions have remained constant even though the actual "things" used as money have changed. Above all else, money is a medium of exchange. You have certainly used money to pay for your food at the supermarket, to pay for the movies, or to buy gas for your car. We use money when we buy and sell commodities or services.
Unit of account
When the value of a market good is frequently used to measure or compare the value of other goods or where its value is used to denominate debts then it is functioning as a unit of account.A debt or an IOU can not serve as a unit of account because its value is specified by comparison to some external reference value, some actual unit of account that may be used for settlement. Unless, of course, the debt or IOU is also an accepted medium of exchange, in which case we have money.
For example, if in some culture people are inclined to measure the worth of things with reference to goats then we would regard goats as the dominant unit of account in that culture. For instance we may say that today a horse is worth 10 goats and a good hut is worth 45 goats. We would also say that an IOU denominated in goats would change value at much the same rate as real goats.
Money is also useful as a unit of account. All prices are denominated in terms of a monetary unit, dollars, yen, or marks for example, which allows one to minimize the information needed to make price comparisons. Rather than having to keep track of all pair-wise values, 20 packs of cigarettes for one sweater, which can be traded for 4 CDs, which means that 1 CD equals 5 packs of cigarettes, you need only know the prices of the products denominated in terms of a monetary unit. A pack of cigarettes equals $2.50 while the sweater and CD cost $50 and $12.50.
Store of value
When an object is purchased primarily to store value for future trade then it is being used as a store of value. For example, a sawmill might maintain an inventory of lumber that has market value. Likewise it might keep a cash box that has some currency that holds market value. Both would represent a store of value because through trade they can be reliably converted to other goods at some future date. Most non-perishable goods have this quality.Many goods or tokens have some of the characteristics outlined above. However no good or token is money unless it can satisfy all three criteria.
Money also shares an important property with other financial assets, it is a store of value. If you sell something today, maybe your labor for a salary or wage, you receive money you can use to purchase something in the future. Money acts as a bridge between the present and the future - it stores value just as a refrigerator stores food to be used at a later date. To function as a store of value, people must have confidence in the money, which is why you will find the word "trust" on the bills that circulate as money in the US.
A standard of deferred payment
To function as money, the monetary item should possess a number of features:
To be a medium of exchange:
· It should have liquidity, easily tradable, with a low spread between the prices to buy and sell
· It should be easily transportable; precious metals have a high value to weight ratio. This is why oil, coal, vermiculite, or water are not suitable as money even though they are valuable. Paper notes have proved highly convenient in this regard.
· It should have a low transaction cost while being used to offer a cost advantage over bartering.
To be a unit of account:
· It should be divisible into small units without destroying its value; precious metals can be coined from bars, or melted down into bars again. This is why leather, or live animals are not suitable as money.
· It should be fungible: that is, one unit or piece must be exactly equivalent to another, which is why diamonds, works of art or real estate are not suitable as money.
· It must be a specific weight, or measure, to be verifiably countable.
To be a store of value:
· It should be long lasting, durable, it must not be perishable or subject to decay. This is why food items, expensive spices, or even fine silks or oriental rugs, are not generally suitable as money.
· It should have a stable value; a value intrinsic in itself, such as a luxury item, scarce, or rare.
· It should be difficult to counterfeit, and the genuine must be easily recognizable. These reasons are why paper, or electronic credits, are often not desirable as money.
This is characteristics of money
iii) Describe the functions of the federal Reserve ( central bank) and commercial bank.
As the Nation's Central Bank, the Federal Reserve is granted special privileges and so assumes the responsibilities and characteristics of such a bank. It monopolizes the issuance of paper money, serves as banker for both the government and commercial banks, and acts as lender of last resort. The latter, in turn, calls for bank regulatory responsibilities. Since Federal Reserve operations work to centralize reserves (Federal Reserve notes and deposits form a large portion of bank reserves), they entail responsibility for reserve management and hence monetary policy. Two critically important macroeconomic functions of the Central Bank, therefore, are the maintenance and achievement of price and financial system stability (i.e., stable monetary policy and the provision of lender-of-last-resort services).
In public debate prior to passage of the Federal Reserve Act, some private-sector bankers expressed concern that a central bank governed by a Board of Governors appointed by the government would not be sufficiently responsive to the needs of the financial community. Certain agrarian interests, on the other hand, felt that an independent central bank would yield too much control over monetary affairs to the private banks. As a result, the Federal Reserve System was structured with two levels of authority--the Board of Governors, located in Washington, D.C., has a centralized and supervisory public influence over the Reserve Banks, while the individual Reserve Banks maintain narrower control over their own day-to-day operations.
These functons of the Federal Reserve authorities are sometimes called "central banking" functions. Practically every modern country has an institution for the performance of such functions. In Canada, it is the Bank of Canada; in England, it is the Bank of England; in France, it is the Bank of France. In the United States, however, there are twelve Federal Reserve Banks embraced in a regional system, and the coordination of their activities is effected through the Board of Governors in Washington.
The duties of the reserve authorities fall into two main groups. One group includes duties which relate primarily to the maintenance of monetary and credit conditions favorable to sound business activities in all fields—agriculture, industrial, commercial. They call for policy decisions from time to time rather than routine activity. They involve lending to member banks, open market operations, fixing reserve requirements, establishing discount rates and issuance of regulations relating to these other functions.
The other group includes duties which relate primarily to the maintenance of regular services for the member banks of the Federal Reserve System, the United States Government, and the public. These services are principally the following: holding member bank reserve balances; furnishing currency for circulation; facilitating the clearance and collection of checks; supervising member banks and obtaining reports of condition from them; acting as fiscal agents, custodians, and depositaries for the United States Government.
These regular services engage by far the greater part of the time and attention of the officers and employees of the twelve Federal Reserve Banks. They will be described with more detail in the chapter immediately following. In later chapters the monetary and credit functions of the Federal Reserve authorities will be discussed.
The Federal Reserve System is a quasi-governmental, decentralized central bank. It is composed of a central Board of Governors in Washington, D.C., twelve regional Federal Reserve Banks located in major cities throughout the nation, numerous member banks and other entities (see below). Ben Bernanke serves as the current Chairman of the Board of Governors of the Federal Reserve. The Federal Reserve System was created via the Federal Reserve Act of 1913 which "established a new central bank designed to add both flexibility and strength to the nation's financial system." The legislation provided for a system that included a number of regional Reserve Banks and a seven-member governing board. All national banks were required to join the system and other banks could join. The Reserve Banks opened for business in November 1914. Congress created Federal Reserve Notes to provide the nation with an elastic supply of currency. The notes were to be issued to Reserve Banks for subsequent transmittal to banking institutions in accordance with the needs of the public. It includes a system of eight to twelve regional reserve banks, owned by its commercial member banks and supervised by the Federal Reserve Board. The board and its chairman are appointed by the president and approved by the Senate.
The Federal Reserve is Central Bank is one of the country's most powerful economic institutions. The Federal Reserve is relevant for Congress not only because the Constitution gives monetary powers to Congress but also because Congress created the Fed and, therefore, has critically important responsibilities for Federal Reserve oversight. Congressional oversight of the Federal Reserve and monetary policy is important because:
· Monetary policy can dominate fiscal policy in certain circumstances.
· Inflation is determined by monetary policy.
· The Federal Reserve influences interest rates.
The Today, the Federal Reserve's responsibilities duties fall into four general areas:
· conducting the nation's monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices
· supervising and regulating banking institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers
· maintaining the stability of the financial system and containing systemic risk that may arise in financial markets
· providing certain financial services to the U.S. government, to the public, to financial institutions, and to foreign official institutions, including playing a major role in operating the nation's payments systems
· Federal Reserve stabilizes the financial system.
The main tasks of the Federal Reserve are to:
· Supervise and regulate banks
· Implement monetary policy by open market operations, setting the discount rate, and setting the reserve ratio
· Maintain a strong payments system
· Control the amount of currency that is made and destroyed on a day to day basis (in conjunction with the Mint and Bureau of Engraving and Printing)
· Clearing interbank payments.
· Regulating the banking system
· Assisting banks in a difficult financial position.
· Managing exchange rates and the nation’s foreign exchange reserves
· Control of mergers between banks.
The Central Bank
In the United States the supply of money outside of coins minted by the Mint can ONLY increase if the private banks issue more by loaning into circulation through Fractional Reserve Bank Lending Practices. Subsequently paper notes are increased ONLY as they are printed by the BEP on behalf of the Federal Reserve Fractional Banking System and are swapped at par value by the Federal Reserve Bank with Private Banks for their already issued electronic credits, which are then expunged (some believe retained) from the system by the Federal Reserve Bank. Thus, these printed money tokens (notes) merely replace already issued electronic credits on a one-for-one basis.
The larger definitions of the money supply, M1, M2, and M3, are types of deposit accounts. The first balance sheet item in a bank is usually deposits. Of the money in a bank deposit, depending on reserve requirements, either the whole sum or some fraction of it can immediately be lent out. The borrower can buy an asset and the seller of that asset can place the proceeds in another money supply constituent deposit. The money supply has just increased, because both the original and secondary deposits count as part of the money supply. That money can therefore continue to increase many times over. The Federal Reserve decides the level of "reserves of depository institutions".
Monetary policy has effects on employment and output in the short run, but in the long run, it primarily affects prices.
[edit]
The balance sheets
This is what money supply growth may look like starting with 1 new dollar of deposits. The money is moving from left to right. The Central Bank injects money from its reserve into the economy by buying a government bond from Bank 1 for $1, Bank 1 lends the proceeds to Person 1, who buys an asset from Person 2, who deposits the proceeds at Bank 2, who loans it to Person 3, who buys a service from Person 4, who deposits the proceeds in Bank 1, and the money supply becomes $3.[4]
Central Bank
Assets
Gov. debt (to B1)
$1
Liabilities
-
-
Bank 1
Assets
Loan (to P1)
$1
Liabilities
Deposit (from P4)
$1
Person 1
Assets
Investment (to P2)
$1
Liabilities
Loan (from B1)
$1
Person 2
Assets
Deposit (to B2)
$1
Liabilities
-
-
Bank 2
Assets
Loan (to P3)
$1
Liabilities
Deposit (from P2)
$1
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Bank reserves at Central Bank
When a central bank is "easing", it triggers an increase in money supply by purchasing government securities on the open market thus increasing available funds for private banks to loan through fractional reserve banking (the issue of new money through loans) and thus grows the money supply. When the central bank is "tightening", it slows the process of private bank issue by selling securities on the open market and pulling money (that could be loaned) out of the private banking sector. It reduces or increases the supply of short term government debt, and inversely increases or reduces the supply of lending funds and thereby the ability of private banks to issue new money through debt.
The operative notion of easy money is that the central bank creates new bank reserves (in the US known as "federal funds"), which let the banks lend out more money. These loans get spent, and the proceeds get deposited at other banks. Whatever is not required to be held as reserves is then lent out again, and through the magic of the "money multiplier", loans and bank deposits go up by many times the initial injection of reserves.
However in the 1970s the reserve requirements on deposits started to fall with the emergence of money market funds, which require no reserves. Then in the early 1990s, reserve requirements were dropped to zero on savings deposits, CDs, and Eurocurrency deposits. At present, reserve requirements apply only to "transactions deposits" - essentially checking accounts. The vast majority of funding sources used by Private Banks to create loans have nothing to do with bank reserves and in effect create what is known as "moral hazard" and speculative bubble economies.
These days, commercial and industrial loans are financed by issuing large denomination CDs. Money market deposits are largely used to lend to corporations who issue commercial paper. Consumer loans are also made using savings deposits which are not subject to reserve requirements. These loans can be bunched into securities and sold to somebody else, taking them off of the bank's books.
The point is simple. Commercial, industrial and consumer loans no longer have any link to bank reserves. Since 1995, the volume of such loans has exploded, while bank reserves have declined.
In recent years, the irrelevance of open market operations has also been argued by academic economists renown for their work on the implications of rational expectations, including Robert Lucas, Jr., Thomas Sargent, Neil Wallace, Finn E. Kydland, Edward C. Prescott and Scott Freeman.
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Arguments and criticism
One of the principal jobs of central banks (such as the Federal Reserve, the Bank of England and the European Central Bank) is to keep money supply growth in line with real GDP growth. Central banks do this primarily by targeting some inter-bank interest rate (in the U.S., this is the federal funds rate) through open market operations.
A very common criticism of this policy, originating with the creators of GDP as a measure, is that "real GDP growth" is in fact meaningless, and since GDP can grow for many reasons including manmade disasters and crises, is not correlated with any known means of measuring well-being. This use of the GDP figures is considered by its own creators to be an abuse, and dangerous. The most common solution proposed by such critics is that money supply (which determines the value of all financial capital, ultimately, by diluting it) should be kept in line with some more ecological and social and human means of measuring well-being. In theory, money supply would expand when well-being is improving, and contract when well-being is decreasing, giving all parties in the economy a direct interest in improving well-being.
This argument must be balanced against what is nearly dogma among economists: that the control of inflation is the main (or only) job of a central bank, and that any introduction of non-financial means of measuring well-being has an inevitable domino effect of increasing government spending and diluting capital and the rewards of gainfully employing capital.
POLICY OPERATIONS
The Federal Reserve conducts monetary policy principally using open-market operations (purchases/sales of securities) to alter bank reserves and influence short-term interest rates, but it also can employ the discount rate and changes in reserve requirements as policy tools. In so doing, the Federal Reserve uses the Fed funds rate as its key policy instrument. Movements in this rate (relative to other rates) in turn influence a wide array of financial and economic variables with differing time lags. These movements, for example, influence financial market variables (such as other interest rates, foreign exchange rates, commodity prices, and yield spreads), monetary and credit aggregates, measures of economic and business activity, and eventually broad measures of inflation. Because of the long time lags involved between adjustments to Federal Reserve instruments and ultimate policy goals, monetary policy makers look for those variables that are both reliably influenced by Fed policy moves and in turn predictably related to subsequent movements in policy goals; i.e., they look for reliable intermediate guides to policy.
Over the years, controversies about monetary policy have often related to debates over which variables best serve as intermediate policy guides or targets. In the past, for example, Keynesian economists prescribed target variables such as unemployment or interest rates whereas monetarist economists prescribed monetary aggregates as targets. Both of these types of targets, however, have proven unreliable. Currently, the Federal Reserve has no single explicit intermediate policy target. Rather, it uses an eclectic approach, but undoubtedly has paid more attention to movements in financial market variables than previously was the case.
CONGRESSIONAL OVERSIGHT OF MONETARY POLICY
Detailed knowledge of the intricacies and fine points of monetary policy operations, however, is not necessary for successful congressional oversight. Rather, the keys for Congress are to clearly establish a viable objective for the Federal Reserve and to ensure the Central Bank is fully accountable for achieving this goal. This can be fostered by establishing appropriate incentives for monetary policy makers as well as mandating enhanced reporting and disclosure requirements related to progress in achieving stated objectives. Oversight, therefore, should promote policy transparency which can help to promote the credibility of a given monetary policy.
Notably, congressional oversight of the Federal Reserve need not imply increased political influence on monetary policy, especially if explicit, objective policy goals such as price stability are established for the Central Bank. Such oversight can actually work to minimize political influence by ensuring Executive Branch sway over monetary policy reflecting their appointments to the Board of Governors is kept in check.
Federal Reserve Functions
The importance of congressional oversight of the Federal Reserve cannot be overemphasized. These functions are important, for example, because they imply that the Federal Reserve controls and hence is responsible for the management of total spending or aggregate demand as well as inflation. In carrying out its monetary policy management (via manipulating reserves), the Federal Reserve influences interest rates—especially short-term rates—as well as foreign exchange rates and other financial market prices. And in times of financial crisis, the Federal Reserve's lender-of-last-resort function stabilizes the entire financial system. The significance of these important considerations is briefly summarized in turn.
· Management of Aggregate Demand: Monetary Policy Dominates Fiscal Policy.
Most economists recognize that total spending or aggregate demand is determined more by monetary policy than by fiscal policy. In other words, if Congress passes tax or spending legislation intended to affect total spending or aggregate demand, these effects can be fully offset or outweighed by changes in monetary policy. Indeed, accurate counter-cyclical fiscal policy—altering budget deficits to manage economic activity or aggregate demand—is now seen as neither possible nor desirable. Economists no longer agree on even the direction of the economic effects of changing budget deficits,[1] yet all agree that changes in monetary policy do have predictable and potent effects on aggregate demand and economic activity.
This implies that changes in monetary policy are often a major factor in movements of the business cycle; many booms and recessions are directly related to changes in monetary policy. Conversely, stable economic activity is often the result of appropriate, stable monetary policy. For example, in recent years the Federal Reserve deserves credit for instituting a restrained, non-inflationary policy, which not only has helped to stabilize the economic cycle but has helped to stabilize most financial markets as well.
· Inflation is Determined by Monetary Policy.
Federal Reserve monetary policy is also the key determinant of inflation. It is well known that, among other economic effects, inflation can adversely affect savings, distort investment decisions, and be used by government to enhance its tax revenue and reduce its real debt. Inflation works to distort the signals of the price system, the signaling mechanism of a free market economy. Partly for this reason, recent research has shown that higher inflation is associated with lower economic growth. Accordingly, the only lasting contribution monetary policy can make toward fostering long-term economic growth is to promote price stability. Consequently, there is a growing consensus among experts that price stability should be the key objective of monetary policy. Congress can, of course, mandate this objective to the Federal Reserve.
· Interest Rates Are Influenced by the Federal Reserve.
The Federal Reserve also influences interest rates which affect key interest-rate sensitive sectors of the economy such as housing, autos, and investment. More specifically, the Federal Reserve influences interest rates by manipulating reserves. Short-term rates are more directly influenced by Federal policy because its reserve operations involve purchases and sales of short-term government securities which influence bank reserves. Nonetheless, long-term rates are also influenced by monetary policy. Among other influences, for example, long-term rates are affected by changes in inflationary expectations as well as expectations of Fed policy. Nonetheless, the only way monetary policy can sustain lower long-term rates is to promote price stability, thereby removing the influence of both inflationary expectations as well as uncertainty premiums. Certainly, Congress has reason to ensure the provision of lower long-term rates in this way.
· The Federal Reserve is the Lender of Last Resort.
During financial crises, provision of lender-of-last-resort services can stabilize the financial system. The Central Bank, being the ultimate supplier of system-wide reserves, can satisfy sharp increases in reserve or liquidity demand, thereby preventing systemic liquidity shortages and stabilizing the financial system. Failure to provide this function as, for example, occurred in the Great Depression of the 1930s, can be disastrous. On the other hand, liquidity provision prevented any serious financial system fallout from the sharp 1987 stock market crash and 1989 stock market decline. The Federal Reserve (and by inference the Congress) has responsibility to ensure that lender-of-last-resort safeguards are adequate and in place in case of unforseen financial shocks.
Functions of the commercial bank
A commercial bank is a type of financial intermediary and a type of bank. It raises funds by collecting deposits from businesses and consumers via checkable deposits, savings deposits, and time (or term) deposits. It makes loans to businesses and consumers. It also buys corporate bonds and government bonds. Its primary liabilities are deposits and primary assets are loans and bonds.This is what people normally call a "bank". The term "commercial" was used to distinguish it from an investment bank. Since the two types of banks no longer have to be separate companies, some have used the term "commercial bank" to refer to banks which focus mainly on companies. In some English-speaking countries outside North America, the term "trading bank" was and is used to denote a commercial bank.
Financial intermediary
The term financial intermediary may refer to an institution, firm or individual who performs intermediation between two or more parties in a financial context. Typically the first party is a provider of a product or service and the second party is a consumer or customer.
In the U.S., a financial intermediary is typically an institution that facilitates the channelling of funds between lenders and borrowers. That is, take deposits from savers (the lenders). From the pool of deposited money they may lend directly to borrowers. This may be in the form of loans or mortgages. Alternatively, they may lend the money indirectly via the financial markets.

Types of financial intermediary
Financial intermediaries can be:
· Banks;
· Building Societies;
· Credit Unions;
· Financial adviser or broker;
· Insurance Companies;
· Life Insurance Companies;
· Mutual Funds; or
· Pension Funds.
Deposit may refer to:
In finance:
· deposit, a specific sum of money taken and held on account by a financial institution (e.g. a bank) as a service provided for its clients. Financial institutions that take deposits are required to be regulated in virtually all jurisdictions.
· A deposit is also money paid by someone who rents or lends a good, e.g. a car or a shopping cart. The money is returned when the good is returned, after deduction of any rent not paid yet, and compensation for small damage. In some cases, the deposit may not actually be collected, but a preliminary hold may be placed on a credit card which functions as a deposit. Small deposits are sometimes required on beverage containers in order to promote recycling, a policy adopted in Oregon, among other U.S. states
The functional approach to economic analysis has a long history in economics. Frank Knight described the basic economic functions as answers to a set of questions that any society must answer--what to produce, how to produce it, and how to distribute the output. As part of the financial system, banks enable their customers to transfer resources across time and space. More specifically, the financial system performs six broad functions:
1. Conducting exchange: clearing and settling claims
2. Funding large-scale enterprises: resource pooling
3. Transferring purchasing power across time and distance
4. Providing risk management: hedging, diversification, and insurance
5. Monitoring performance of borrowers: mitigating adverse incentives
6. Providing information about the relative supply and demand for credit
Commercial banks perform all of these functions, but other organizations clearly do so as well. In a well-functioning economy, people make payments, save for the future, and insure themselves. There is no presumption that existing corporate forms will survive. (Remember the goldsmiths.) For economic reasons, combinations of products may exist at a certain time within one industry, such as "commercial banking," or "insurance underwriting." However, there is no guarantee that one type of heavily taxed, heavily regulated industry granted a particular "charter" will survive--quite the opposite.
Consider a simple example: the savings account. This financial product transfers purchasing power from the present to the future. But this savings function can be accomplished in other ways; for example, by investing in common stock. There are risk differences between the instruments: the savings account comes with a guarantee of principal, and in that regard is safer than stock. Buying a put option, however, can remove that element of risk from the stock. The functions provided by the savings account remain the same (transferring purchasing power into the future, reducing risk), but they need not be provided by a depository institution.
Something like this has happened with mortgages. At first, people purchased a house using the family's retained earnings (no financial intermediary); later the funds would come from a mortgage loan financed by the savings of other families in the same community (depository financial institution); now the purchase is financed by a non-bank loan ultimately funded by investors in the mortgage-backed securities market. Using this functional perspective, a bank (or the business of "banking") is a particular combination of functions. Functionally, a commercial bank is a business that funds itself with liquid liabilities and makes illiquid loans. Legally, a commercial bank is a corporation that receives a banking charter and is subject to the rules and regulations thereof.
This statutory definition prompts two important observations. First, the functional definition of "banking" is not synonymous with the legal definition. Thus, a financial holding company owning a finance company, a venture capital firm and a money market mutual fund has a fair claim to be called a "bank." Likewise, a chartered bank that specializes in global custody arrangements or serves as a clearinghouse for credit cards is functionally not a bank. Second, "commercial banks" need not exist, and may disappear. Someone will perform the functions now provided by banks: on the liability side, payments, pooling, and risk management; and on the asset side, resource transfers and risk management. But this particular combination need not necessarily survive, just as the particular combination of making metal jewelry and taking deposits no longer exists.
In the future, firms may serve customers by bundling certain financial services that are not currently combined, or they may merge banking-like services with non-banking-like services, such as tickets to concerts and sporting events, and vacation planning. These firms may have electronic delivery vehicles and be accessed through the Internet. In the end, prosperous firms will be those that find ways to deliver services the public wants. Some activities that today we regard as inappropriate, difficult, or illegal for banks will most likely change, and sooner than we expect.
Already, in New Zealand, the government is moving to end the distinction between corporations chartered as commercial banks and those incorporated for other business purposes. Customers of public utilities, such as the telephone company, may be able to carry interest-bearing balances and instruct the utility to credit the account of other merchants. Indeed, the government may even move to allow some non-banks to have settlement accounts at the Reserve Bank of New Zealand. What, then, is a bank?
iv)How the Federal Reserve Controls the money supply .
The Federal Reserve controls the size of the money supply by conducting open market operations, in which the Federal Reserve engages in the lending or purchasing of specific types of securities with authorized participants, known as the Fed's primary dealers. All Open Market Operations in the United States are conducted by the Open Market Desk at the Federal Reserve Bank of New York with an aim to making the federal funds rate as close to the target rate as possible. For a detailed look at the process by which changes to a reserve account held at the Fed affect the wider monetary supply of the economy, see money creation. The Federal Reserve controls the size of the money supply the have three tools are available to the Fed for changing the money supply that is 1. changing the required reserve ratio 2. changing the discount rate and 3. engaging in open market operations
The Expansion and Contraction of Bank Reserves
The ability of member banks to lend is largely dependent upon the volume of their reserves; they are required to keep their reserves on deposit with the Federal Reserve Banks; and the Federal Reserve authorities are empowered to extend Federal Reserve Bank credit for the expansion of these reserves. Therefore, the Federal Reserve authorities, through the medium of bank reserves, are able to influence the extension of member bank credit.
There are three prominent factors that, in the absence of operations by the Federal Reserve authorities, may render bank reserves inadequate in amount. One is an increased demand for borrowed funds, which, as banks increase their loans and investments in response to it, result in an expansion of bank deposits without a corresponding expansion of reserves. The second is an increased demand by the public for circulation currency; as the currency is withdrawn, it reduces both the reserves and the deposits of banks by the same amount, but the reduction in reserves is relatively greater than the reduction in deposits, since reserves are smaller than deposits. The third is a drain of gold out of the country, a condition which, like withdrawals of currency, effects a reduction of reserves relatively greater than the reduction it effects in deposits. Payment of federal taxes by the public and purchases by the public of new issues of Government securities also tend temporarily to reduce bank reserves, but these reductions are soon offset, when the Government disburses the funds it has received.
When any of the factors renders member bank reserves insufficient, an occasion arises for Federal Reserve Bank credit—that is, for funds which the Federal Reserve authorities are empowered to supply for the specific purpose of replenishing or increasing member bank reserves. This need may be confined to relatively few banks or it may affect banks in general. It may be met through loans to individual banks or through open market purchases, depending on prevailing credit conditions and policies.
Changing the required reserve ratio
The required reserve ratio establishes a link between the reserves of the commercial bank and the deposits (money) that commercial bank are allowed to create and if Fed wants to increse the money supply , the Fed can decrease the required reserve ratio, which allows the bank to create more deposits by making loans is How the Federal Reserve Controls the money supply. When the Fed increases the required reserve ratio, the banks must hold more reserves. To increase their reserves , the banks must decrese their lending , which decreases the quantity of money. When the Fed Decreases the required reserve ratio, the banks may holds less reserves. To decrease their reserves , the banks increase their lending, which increases the quantity of money.
Changing the discount rate
The discount rate is the interest rate that banks pay to the Fed to borrow from it. And bank borrowing from the fed leads to an increase in the money supply . The higher the discount rate, the higher the cost of borrowing , and the less borrowing banks will want to do. Moral suasion is the pressure that was exerted in the past by the Fed on member banks to discourage them from borrowing heavily. On january 9, 2003 the fed announced a new procedure that sets the discount rate above the rate that banks pay to borrow in the pivate market. It is thus clear that the Fed is not using the discount supply on a regular basis. How the Federal Reserve Controls the money supply. When the Fed increase the discount rate , the banks must pay a higher price for any reserves that they borrow from the Fed. Faced with higher cost of reserves , the banks try to get by with smaller reserves. But with a given required reserve ratio , the banks must also decrese their lending to decrease their borrowed reserves. So the quantity of money decreases . when the Fed decreases discount rate, the banks pay a lower price for any reserves that they borrow from the Fed. Faced with lower cost of reserves, the banks are willing to borrow more reserves and increase their lending. So the quantity of money increases.
Although the discount or interest rate which the Federal Reserve Banks charge their member banks is generally lower than the rate which commercial banks charge their customers, banks do not make it a practice to borrow from the Federal Reserve Banks for the purpose of gaining a profit by lending at a higher rate, nor has it been the policy of the Federal Reserve authorities to encourage borrowing for such purpose. When member banks borrow, it is for the immediate reason that they need to in order to avoid a deficiency in their reserves. The Federal Reserve authorities may raise or lower the discount rate from time to time, accordingly as it seems advisable to impose restraint upon the lending activities of banks or to encourage such activities.
During the earlier period of the System's operation—that is, until very recent years—member banks had no excess reserves and in the aggregate were substantially in debt to the Reserve Banks. Under such circumstances, changes in the discount rates, which made this indebtedness either more or less expensive, were the principal instrument by which the Federal Reserve authorities gave effect to credit policy. In recent years, however, banks have had a large volume of excess reserves, there has been little occasion for them to borrow from the Federal Reserve Banks, and the discount rates have not had the importance they formerly had. Since 1934 they have been maintained at a low level. Throughout the entire year 1938 discount rates on eligible paper were 1 per cent at the Federal Reserve Bank of New York and 1½ per cent at the other eleven Federal Reserve Banks, whereas in the 1920's they varied from 3 per cent to 7 per cent at different Federal Reserve Banks at different times.
The Federal Reserve Bank discount rates are more closely related to the so-called open market rates than to rates on the loans that banks make to their customers. Open market rates include the rates on commercial paper, bankers' acceptances, Treasury bills, stock market call loans, and other forms of obligations that may be bought and sold in the open market or called without regard to the borrowers' convenience. Open market rates are more sensitive to Federal Reserve credit policy or to market developments than are the rates banks charge their customers, because it is open market paper that banks usually purchase first when they have an excess of funds and dispose of first when they need funds. The relationship between open market rates and Federal Reserve Bank discount rates tends to be close when banks are borrowing and less close when they are not borrowing.
Open market operations
Open market operations is the purchase and sale by the Fed of government securties in the open market ; a tool used to expand or contract the amount of reserve in the system and thus the money supply . Open market operations is by far the most significant tool of the Fed for controlling the supply of money. An open market purchase of securities by the Fed results in an increase in reserves and an increase in the money multiplier times the change in reserves. An pen market sale of securities by the Fed results in a decrease in reserves and a decrease in the supply of money by an amount aqual to the money multiplier times the changes in reserves. Open market operations are the Fed’s preferred means of controlling the money supply because they can be used with some precision., are extremely flexible , and are fairly predictable. How the Federal Reserve Controls the money supply
The Open Market Desk has two main tools to adjust the monetary supply, repurchase agreements and outright transactions.To smooth temporary or cyclical changes in the monetary supply, the desk engages in repurchase agreements (repos) with its primary dealers. Repos are essentially secured, short-term lending by the Fed. On the day of the transaction, the Fed deposits money in a primary dealer’s reserve account, and receives the promised securities as collateral. When the transaction matures, the process unwinds: the Fed returns the collateral and charges the primary dealer’s reserve account for the principal and accrued interest. The term of the repo (the time between settlement and maturity) can vary from 1 day (called an overnight repo) to 65 days, though the Fed will most commonly conduct overnight and 14-day repos.
Since there is an increase of bank reserves during the term of the repo, repos temporarily increase the money supply. The effect is temporary since all repo transactions unwind, with the only lasting net effect being a slight depletion of reserves caused by the accrued interest (think one day of interest at a 4.5% annual yield, which is 0.0121% per day). The Fed has conducted repos almost daily in 2004-2005, but can also conduct reverse repos to temporarily shrink the money supply.In a reverse repo the Fed will borrow money from the reserve accounts of primary dealers in exchange for Treasury securities as collateral. At maturity, the Fed will return the money to the reserve accounts with the accrued interest, and collect the collateral. Since this drains reserves, reverse repos temporarily contract the monetary supply, except, again, for the extremely small lasting increase caused by the accrued interest.
The other main tool available to the Open Market Desk is the outright transaction. Outrights differ from repos in that they permanently alter the money supply. Outright transactions overwhelmingly involve the purchase of Treasury securities in the secondary market.In an outright purchase, the Fed will buy Treasury securities from primary dealers and finance these purchases by depositing newly created money in the dealer’s reserve account at the Fed. Since this operation does not unwind at the end of a set period, the resulting growth in the monetary supply is permanent. The Fed also has the authority to sell Treasuries outright, but this has been exceedingly rare since the 1980's. The sale of Treasury securities results in a permanent decrease in the money supply, as the money used as payment for the securities from the primary dealers is removed from their reserve accounts, thus working the money multiplier (see Money creation) process in reverse. How the Federal Reserve Controls the money supply. When the Fed buys securities in a open market operation, the monetary base increase, banks increase their lending , and the quantity of money increase when the Fed sells securities in a open market operation, the monetary base decreases , banks decreases their lending , and the quantity of money decreases open market opertions are used more frequently than the other two tools are the most complex in their operation.This is a explain the how the Federal Reserve Controls the money supply
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