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Chapters 1-3 of “Money Mechanics” by David Ashby Report (Assessment)

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Updated: Jan 18th, 2021

Lending rates

If a customer deposits money in a bank, his account in the bank increases by the deposited amount. Out of this cash, the bank should keep a certain percentage of money and transfer the rest to its reserve fund account with federal banks. The retained amount of money in the commercial bank is the primary reserve (Ashby 56). The bank doesn’t need to retain the specified amount of money. It can retain more than that amount. The extra cash retained is known as the working reserve, and it helps in absorbing the shock that may arise during increased net withdraws. However, the banks have the right to establish the extra amount of money they will retain (Ashby 58).

Banks also have secondary reserves. Secondary reserves come from purchasing securities from the U.S. treasury (Ashby 59). Bank uses extra money accrued from service charges and excess deposits in buying securities. From the excess monetary reserves accrued, commercial banks lend to their customers as loans. They lend loans at a certain interest rate charged by the bank and from which the bank makes some more extra money.

Conversely, banks can only lend an amount equal to their excess cash reserves. Lending increases the money supply in the economy. Thus, FRS encourages banks to decrease their lending rates when it wants to increase the money supply in the economy. On the other hand, when FRS wants to reduce the amount of money supply, it instructs commercial banks to increase their lending rates. In case the bank lends out more amount of money than its excess reserve fund, the extra amount of money comes from the working reserve of the bank. However, lending of money from the working reserve can cause the banks’ required working reserve to fall below the required level by bank agency laws (Ashby 64).

Commercial banks use various ways to make excess reserve funds. The banks can decide to reduce their working reserve, and the money obtained is transferred to the excess reserve fund in accounts in FRS (Ashby 72). On the other hand, if banks reduce their purchase of securities, this also results in excess funds. On the other hand, banks can also lose their excess reserve fund if they wish to. One of the ways is by increasing the working reserve.

A bank can raise the working reserve than that required by the law although this may have to be approved by FRS. The other way is increasing the buying of Treasury securities with excess funds. In case the decline in excess funds is insufficient to service the bank’s operations, it can borrow from FRS or other banks to increase the amount to the required levels.

Controlling money supply in the economy

The FRS uses various tools in controlling the supply of money in the economy. One of the methods used is open market operations. Open market operations occur through the selling and buying of securities from the US treasury market (Ashby 80). The securities are also open for purchase by commercial banks. When the committee meets to decide on the sale of securities, they send the agreed information to Federal Reserve Bank located in New York.

This is the bank concerned with the sale of U.S. Treasury securities. When open market purchases are more, there is a rise in the money supply. Alternatively, if sales are more, the money supply reduces. Open market operations also help in controlling the commercial banks’ reserve funds. Commercial banks that want to raise their reserves can borrow money from the federal funds market. This is a market created by FRS for helping ‘needy’ banks.

Since short loans to banks from the federal funds market attract interest, banks have to work out a plan that will reduce their borrowing tendencies. Commercial banks achieve this by balancing the costs of borrowed reserve against the cost of the working reserve (Ashby 84). A rise in the cost of working reserve causes a higher rise in the cost of borrowed reserve. On the other hand, a fall in the working reserve leads to a less decline in the cost borrowed reserve.

The discount rates charged by the federal funds market normally helps in controlling the commercial bank working reserves. However, to some extent, they may also affect the money supply. When the demand for loans is high, banks reduce their working reserve to increase excess reserve funds.

This reduction of working reserve increases their financial muscles by offering more credit to customers. Since banks reduce their working reserve, the lending interest for loans must be able to cover the discount rate charged when they borrow reserve funds to increase their working reserve. Alternatively, when FED wants to reduce the lending rates, it raises the discount rates to commercial banks and increases sales in the open market operations. This aids in reducing the loan lending rates by commercial banks to their customers (84).

Monetary policy is another method used by FRS in regulating the money supply in the economy. Money supply works in two ways; either easing or tightening the money supply (Ashby 95). Easing money supply occurs when FRS reduces the discount rate, and this causes a rise in the lending rate to banks. Moreover, it leads to an increased employment rate. An increase in the money supply causes a rise in the inflation rate. Consequently, tightening the money supply works in the opposite direction. It involves raising the discounting rate which in turn causes a rise in interest rates for loans given by commercial banks. It also helps in reducing the inflation rate but causes a decline in the employment rate in a country.

Commercial banks

Commercial banks act as financial intermediaries between people who have excess money and those who have a deficit. People with excess money deposits in banks and those with a deficit go to banks seeking loans. A bank charges a higher interest rate on the loan than the interest it pays to the person depositing money (Ashby 113). This difference in interest charges is the money that goes to the banks as payment for the intermediation service.

Banks also face competition for the money they give out as loans. This may arise from the interest rate for buyers of securities to finance their purchases. An increase in loan competition causes banks to raise their interest rate due to the high demand. Consequently, when the competition decreases banks reduce their interest rates. Thus, interest rates vary depending on demand for loans although there is a limit set by law beyond which the rates cannot rise.

Open market purchases in the treasury cause a rise in the demand for bonds. This causes a rise in prices of the bonds which also results in reduced interest rates because of easing monetary policy applied. In case the Fed constricts the monetary policy, banks’ excess reserves decrease. Therefore, banks have to find alternative ways of increasing their excess reserve. The methods used include increasing the loan interest rates to lower loan applications or raising the interest on deposits to attract more deposits. Commercial banks also set the minimum interest rate that can be charged even to an extremely valuable bank customer. The prime rate is this minimum rate set by the bank (Ashby 116).

Bonds form another means to invest for long term investments. They have a defined period of maturity and interest rate accrued at a specified period such as one year. At the end of maturity time, the person gets the face value amount and the interest rate earned. However, a person who buys bonds can sell them off before the maturity time. The prevailing interest rate on the bond determines its selling price. In case the interest rate is higher than at the time of purchase, the price of the bond will be lower. Consequently, if the interest rate is lower than at the time of buying, the selling price of the bond will be higher (Ashby 120).

Short-term bonds normally have low-interest rates than long-term bonds. Short-term bonds are bonds that have a maturity of up to one year. Long term bonds have a maturity of more than one year to thirty or more years. Short term bonds have a wide fluctuation range than long term bonds. Short term bonds prices are higher when the interest rate is low and long term bonds prices are high when interest rates are high.

Fed uses a money multiplier to regulate the money supply in the economy. Money multiplier helps in determining the reserve fund that should be retained by banks and discount rates charged by the Fed. Money and velocity of money (M and V) are directly proportional to the interest rates. An increase in the interest rate causes a subsequent rise in M and V while a fall in the interest rate causes a decline in M and V (Ashby 128).

Gross Domestic Product

Gross Domestic Product (GDP) represents the total value of goods produced in a country in a given year. GDP is calculated against the price index which is a ratio of prevailing year price of goods against a set base year. A change in the amount of output from a country results in a subsequent change in GDP, in the same direction of change. A change in the price of goods and services has no direct change in GDP. Moreover, changes in interest rates also do not have any direct influence on GDP.

However, a change in interest rate may result in an indirect change to GDP. This is because interest rates cause changes in the outputs of a country which in turn causes a change to the GDP. Changes in incomes paid from the profits of firms’ causes a change in Gross Domestic Income (GDY). This is because GDY is the sum of all incomes paid in a country. Additionally, a change in GDP results in an equal change in GDY since income is a result of profits earned. Thus, GDP does not comprise unsold goods and services (Ashby 143).

Aggregate Planned Expenditure (APE) represents the total demand for goods produced in a country excluding imports. APE only considers locally produced goods since GDP also consider locally produced goods. However, in the calculation of APE, the equation adds foreign consumption of local goods but excludes imports. A change in GDP results in a subsequent change in APE in the same direction of change in GDP although the change is not equal. APE is negatively related to interest rates. APE decreases when the interest rate rises. Similarly, a fall in interest rates causes a rise in APE but the change is slow. Changes in prices of products do not have any direct effect on APE levels (Ashby 148).

Aggregate Supply Funding (ASF) sets the upper limit upon which income will be distributed for spending in a given year. The product prevailing amount of M and V of money helps in determining the ASF after dividing with the price levels of products. Therefore, a rise in M and V causes an increase in ASF. Likewise, a decline in M and V causes a decrease in the purchasing power of consumers represented by ASF. ASF is also negatively related to interest rates. A fall in interest rates causes a rise in ASF while a decline in interest rate leads to a rise in ASF (Ashby 155).

Aggregate Demand Funding (ADF) determines the amount of money required to purchase products in the market. ADF is approximately the same as APE since there is only a slight variation in their results. The closer APE is to GDP the better is ADF. This means consumers will be able to access at least a dollar to purchase products in the market. The dollar represents the minimum amount of money required to buy products after calculating ASF. Thus, if the margin between APE and GDP is large, there is a little amount of money to purchase products as distributed through ASF (Ashby 158).

Works Cited

Ashby, David. 2009. Money Mechanics: Monetary Economics Reengineered with an Attitude and a Policy Agenda, Week 2 Lecture: Money and Banking. Web.

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