Money supply refers to the amount of money that is circulating in the economy and which is available for spending. It is an important indicator of the economic status of a given country. The Federal Reserve is charged with the responsibility of regulating the money supply and it does this by increasing it if there is a shortage or by decreasing it if it is too much. There are several ways that the Federal Reserve can increase the amount of money supply in circulation. One of these is by lending money to institutions such as banks to increase their capacity to give loans thus increasing the money supply in circulation (Handa 322).
Another thing that the Federal Reserve does is to buy treasury securities through open market operations and these increases the seller’s deposit in the bank thereby availing more money for the banks to lend. These actions have the ability to increase monetary base which is the total amount of a country’s currency that is either circulating among the public or which is being kept in the reserves of central bank (Handa 319). In addition, the banking system can increase the money supply by creating a multiplier that expands the amount of money deposited.
When a bank lends money to an individual or it receives a deposit, the overall effect is transfer of funds from one bank to the other with the bank receiving the deposit getting excess reserves to lend (Handa 14). This leads to multiplication of deposits. For example if a bank receives a deposit of $800 and its fractional reserve is $100, it will lend the excess reserves to a person who will in turn deposit the money in their account in another bank or purchase an item with the money following which the purchaser will deposit the money in a bank account.
This process continues and the overall is a multiplication effect where the original depositor of the money does still have $800 in their account, the depositor’s bank has $800 dollars, the borrower has $700, the seller of the item has $ 700 and the seller’s bank has $700. Financial intermediation refers to a process where agents with monetary deficits and agents with monetary surplus get connected. This process involves use of a financial intermediary and a good example is a bank.
These financial intermediaries are charged with the responsibility of transferring funds from individuals who have more money than they need (savers/lenders) to individuals who have inadequate money to do the activities they desire (spenders/borrowers). These financial intermediaries contribute to economic growth in many ways. To begin with, they mobilize savings from individuals and corporations by promising to keep the money safe as well as promising to pay interest on the money saved (Handa 15).
This provides the financial intermediary with a pool of money which it avails to borrowers who in turn will invest the money thus contributing to economic growth. The economic growth is realized in terms of creation of new businesses thus more employment opportunities, the operations of the businesses are expanded and with this comes increased profits, and economic development due to increased investments. Another way that the intermediaries contribute to economic growth is by reducing the costs of transactions.
Intermediaries such as banks provide a cheap avenue for one to lend money. Similarly, they provide a cheap way for people to borrow money as the information costs are usually lowered (Handa 16). They are able to provide services at a lowered cost due to economies of scale which comes about as a result of the intermediary’s ability to employ qualified personnel to handle different cases at the same cost to the intermediary.
In addition, these trained personnel are able to identify good investment opportunities as well as screen securities to avoid cases of fraud and poor investments that do not benefit the intermediary. Banks are usually heavily regulated as they form an important pillar of any country’s economy. For profit reasons, the banks prefer to have excess reserves and while this is beneficial to the banks and their shareholders, it is not beneficial to the economy (Handa 125). The amount of money held by a bank in form of excess reserves influences money supply.
Banks have to maintain the confidence of their depositors who are their clients and to maintain this confidence the banks prefer to keep some money above the fractional reserve as well as making wise investments and being cautious while giving loans (Handa 125). This helps to ensure that they are not vulnerable to runs. The overall effect of this is reduced money supply. It is the responsibility of the federal bank to regulate the supply of money. In case the money supply is low, it has the ability to expand the money supply. It can do this in several ways.
To begin with, it can buy securities in the open market which will make the prices of the securities to increase (Handa 345). Another thing is that it can lower the federal discount rate as well as lower the federal requirements. Lowering the reserve requirements increases the amount of money that the bank can invest. In turn, this investment increases money supply. Consequently, due to the money expansion strategies the prices of American bonds will increase and this will make the investors to sell the bonds leading to increased supply of U.
S. dollars in the foreign exchange market (Handa 9). This makes the U. S. dollar to lose its value in the foreign exchange market and this is beneficial in increasing money supply as it encourages more exports. According to the above analysis, money supply is an important aspect of any country’s economy and thus there is need for its supply to be regulated if the economy is to grow. Work Cited Handa, Jagdish. Monetary Economics. 2nd ed. New York: Routledge Publishers, 2009. Print.