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Money Mechanics in the U.S. Essay

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Updated: Apr 11th, 2022

Introduction

Barter system of trade was convenient in the primitive society because production was diversified and subsistence. Only the few commodities that one lacked could be obtained through exchange. However, as time progressed, the society shifted to specialization in the production process.

This necessitated for the need for an accepted medium of exchange to use for purchasing needed product and services. Anything commonly used as a medium of exchange is called money (Ashby 1). Money is a sensitive item in the economy and should therefore be controlled.

If its supply is increased, people will buy in large amounts. During these conditions, orders will surpass the production leading to increased prices. As a result, there will be a sustained raise in the average level of prices, a condition termed as inflation. If the supply of money is low, people will not buy much.

As a result, there will be more inventories. This condition will force some business to lay off some workers leading to unemployment.

To encourage sales, some business will lower prices of their commodities leading to deflation. As a result, there will be a sustained drop in the total output of the nation’s producers, which is a condition called recession (Ashby 2).

The Kinds of Money

Anything can be used as money. Notes and coins are the currency that has been authorized by the government to be used as money. Another kind of money is the checking account balances. Checking account balances involves the use of checks, which are not money.

If check were to be counted as money, it will mean that the balance portion not written on the face of the check is forgotten.

Debit cards, stored-value cards, smart cards, electronic funds transfer, web-based payment system, and credit cards cannot be considered as money and neither can they substitute money. Instead, they used in place of checks (Ashby 4).

Coins, notes, and checking accounts balances are considered as money only if they are included in the measured money supply. If payments for the products and services are substituted with direct transfer of ownership of savings certificates, the saving certificates will be considered as money.

The US Money Supply

The money supply of the United States includes the coins and paper currency apart from the amounts in the vaults in the banks, Federal Reserve banks, and the treasury.

It also includes the checking account balances for the USA dollar apart from those owned by United States treasury and domestic banks. This can be represented by an equation bellow

M = CC + CA

Where M is the money supply, CA the checking account component, and CC the coins and currency.

From the equation, any activity that increases CC and CA increase the money supply and vice versa. The Federal Reserve banks, banks, and the treasure of US are the only entities with legal powers to create money.

The money they create and release are the only money accepted as money. This implies that dollars owed by the bank, Federal Reserve System, and the US treasury are not money.

The supply of money can only be useful if it rises when there is a lot of money available for public spending and when it falls when there is little money for the public to spend. This scenario implies that a deposit of $2000 into an account will increase CA by $2000 and at the same time reduce the CC leaving M unchanged.

This implies that the bank is a store that sells cash and checking account balances. On top of that, the bank also sells financial assets such as, certificate of deposits and loan checking account balance.

Velocity of Money (V)

Velocity of money refers to the average number of times a similar dollar is spent in a year for purchasing domestic output only. This velocity is determined by the people through the spending, earning, and saving behaviors. If money spenders spend it quickly, the velocity is increased and vice versa.

On average, the Velocity of the US dollar is about 7.25. However, this figure seems less because of some factors such dollarization, limitation of V to domestic purchase, and little amount of money circulating in domestic market (Ashby 11).

The velocity of money is allowed by the Federal Reserve System because it aids in determine the amount of money the economy needs. The total expenditure on the current domestic output cannot exceed the quantity of money multiplied by its velocity in one year.

Money Producers and Regulators

The money creation system of the United States is a three-tier system consisting of the treasury department, the Federal Reserve System, and the banking system. They are explored bellow.

US Treasury Department

The treasury is a department within the executive branch of the federal government concerned with the management of the financial affairs of the government. This department has an internal revenue service responsible for the collection of taxes and borrowed funds from treasury bills, which is used for settling its bills.

The treasury is also responsible for the operation of the mint and the bureau of engraving and printing the US’s currency. The coins and notes mint by these agencies are not yet money and thus cannot be spend by the federal government.

They are instead sold to the Federal Reserve banks for purchase by US’s banks. The whole process leads to a modest increase in the supply of money.

The Federal Reserve System

This is a specialized institution mandated with the task of stabilizing and controlling the money and banking system of the United States. Its operation is independent of the congress.

This system was created following the financial crisis of early 1990s (Ashby 18). It has twelve Federal Reserve banks that are owned as private corporations whose stock is owned by banks in their region.

Functions

The federal system regulates the size of the supply of money through manipulation of data on the same. It also serves as banks for the federal government whereby it maintains the checking accounts for the federal government. The Federal Reserve Bank further acts as a banker for foreign government and international agencies.

This bank further works in conjunction with other regulatory agencies that are actively involved in the currency regulation, so as to ensure that all players within this industry operates within the required regulations.

Banks

Banks are institutions which offer transaction accounts whereby check or related instruments can be drawn to make payments. Traditional institutions subsuming commercial banks, savings associations, and credits unions are regarded as banks.

The establishment of banks is ascertained by a charter after certify that the need for the same and the qualification of the institution. Since money is created through the banking system, the Federal Reserve System has to regulate the banking activities within the State.

The depository institutions deregulation and monetary control act of 1980 streamlined the banking system by giving the federal government full control over all banks

Banking Supervision and Deregulation

Although banks are business entitled for profit making through their own goals, they are carefully regulated. The regulation is for several reasons.

They include protecting depositors, stabilizing the monetary system, for protecting the consumer, and to check on the efficiency and competitiveness. They are discussed in details bellow.

Depositor Protection

Majority of the banking services are accessed through an account. When one opens an account with the bank, he deposits some money into the same and thereby becoming a creditor to the bank.

However, the customer is exposed to default risk because the bank may fail to honor withdrawal request. This may happen when the banks become insolvent. Thus supervision guards the customer from the same.

Monetary System Stability

Financial transactions involve different instruments like checks, credit cards, cash machines among many. For effective functioning of the same, they need to be accurate, efficient, and fast (Ashby 22). Given the bulky nature of the transactions, supervision is done to enable their smooth operations.

Efficient and Competitive Banking System

Efficient operation of banks is aided by healthy competitions. Banks compete on various fronts such as interest on loans and efficiency of the services offered. In a market where banks are too many, it may not be possible for some banks to realize economies of large scale.

This calls for regulation to check on the same. Also, regulation is extended on the competition between banks and institutions offering loan-able funds to ensure that the competition is smooth and healthy.

Consumer Protection

Regulation and supervision is done on banks to ensure that they do not discriminate the public and at the same time to ensure that the public is protected from unscrupulous traders.

Principle Regulators

There are some agencies that have been given powers to regulate and supervise all banks. They bear the ability to levy fines, suspend or remove bank officials, issue cease-and-desist orders, and revoke charters.

In order for uniform regulations, Federal Financial Institution Examination Council was created by the Congress in 1978 for these purposes.

This council draws its membership from the following organs: Office of the Comptroller of the Currency, Federal Reserve System, Federal Deposit Insurance Corporation, Office of Thrift Supervision, National Credit Union Administration, and State Banking Agency.

The Treasury and the Money Supply

Taxes and Loans from the Public

The management of the money of the nation is under the professional hands of the Federal Reserve System. This means that the treasury performs its activities with minimal effects on the credit market and money supply.

Therefore it (the treasury) has created tax and loans accounts in all banks. In the event of paying government bills, the treasury transfers some of the money from the loans account to the nearby Federal Reserve Bank.

This mean that banks loses similar amount of money hence reducing their loaning kitty. However, this is restoring by making a bill of payment.

The treasury writes a check that is taken by the banks, which in turn demands for compensation for the face value from the Federal Reserve Bank. In this way, the banks would have restored their loanable amount.

This process can be illustrated bellow.

BANK FEDERALRESERVE
Assets Liabilities Assets Liabilities
Treasury gets revenue from taxes or bonds Checking account balances reduces by $2000

Treasury tax and loan account increases by $2000

Treasury transfers funds to the federal reserve bank Bankreserve account reduces by $2000 Treasury tax and loan account reduces by $2000 Bank reserve account reduces by $2000

Treasury checking account increases by $2000

Treasury spends the funds Bank reserve account increases by $2000 Checking account balances increases by $2000 Bank reserve account increases by $2000]

Treasury checking account reduces by $2000

From the table, it can be seen that the government receives money for the tax or sale of bonds and spends them without a tilt on the bank reserve or money supply.

It should be noted that if the dates for tax receipt and floating of bonds doe not coincides, the nation will suffer a credit crunch. However, the utilization of tax and loan accounts avoids such happening.

The expenditure by the federal government, which is drawn for tax and bonds, does not affect the supply of money in the bank’s reserves because the same is replenished by sell of bonds and payment made by the government.

Coins and Currency Creation

The treasury is in charge of the US mint, which is used for manufacturing the US coins. It is headquartered in Washington DC. The treasury is also in control of the Bureau of engraving and printing, which prints the paper currency.

The notes are sold for a cost while the coins are sold for their face value to the 12 Federal Reserve banks. The printed notes and coins are not yet money until they go into circulation.

They can only go into circulation after the reserves in the banks runs low, prompting purchase of new ones. The process is illustrated in the table below.

BANK FEDERAL RESERVE
Assets Liabilities Assets Liabilities
Treasury sells cash to the federal reserve system Cash increases by $5000 Treasury checking account increases by $5000
Federal reserve sell cash to the bank Cash increases by $5000

Bank reserve account reduces by $5000

Cash decreases by $5000 Bank reserve account reduces by $5000
Customer withdraws the cash Cash decreases by $5000 Customer Checking account balances decreases by $5000
Treasury spends revenue from sale of cash to the federal reserve Bank reserve account increases by $5000 Customer Checking account balances increases by $5000 Bank reserve account increases by $5000

Treasury checking account decreases by $5000

For the case of torn or deformed coins and notes, replacement is done without increasing or decreasing the amount.

If the bank lends to the treasury, the following table illustrates the situation

BANK FEDERAL RESERVE
Assets Liabilities Assets Liabilities
Treasury borrows Treasury bonds increases by $5000 Treasury tax and loan account increases by $5000 Cash increases by $5000 Treasury checking account increases by $5000
Treasury transfers funds Bank reserve account reduces by $5000 Treasury tax and loan account decreases by $5000 Cash decreases by $5000 Bank reserve account reduces by $5000

Treasury checking account increases by $5000

Treasury spends funds Bank reserve account increases by $5000 Customer Checking account balances increases by $5000 Bank reserve account increases by $5000

Treasury checking account decreases by $5000

If the Federal Reserve lends o the treasury, the following scenario will arise

BANK FEDERAL RESERVE
Assets Liabilities Assets Liabilities
Treasury borrows Treasury bonds increases by $5000 Treasury checking account increases by $5000
Treasury spends funds Bank reserve account increases by $5000 Customer Checking account balances increases by $5000 Cash decreases by $5000 Bank reserve account increases by $5000

Treasury checking account decreases by $5000

Work Cited

Ashby, David. Mechanics of Money. Monmouth: Western Oregon University Press, 1996.Print.

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