The Major Powers of the Central Bank Finance Essay

There was a time when money did not exist. Long ago, people at a stage called "subsistence economy" produced only what they needed. Their needs were few but their methods of production were such that they spent most of their living hours in an unceasing battle for personal survival. They had no need for money. Thus, they were engaged in a Barter System. However, the Barter System became very deficient and it was thought wise to introduce money. But who would control the money in the economy, thus the Central Bank came in play.

Statement of Problem

Money has been seen as a stepping stone for many economies as it contributes to the standard of living and facilitated lots of transactions during the past few decades years. However, it needs to be properly supervised or controlled to make sure there is not too much or too little available within the economy. It is therefore important to investigate the major powers of the Central Bank (whom controls the money supply) so that there is a right amount in the economy.

Review of Literature

There are a number of alternative theories of how money is created, and generally emphasize endogenous money - that money is created by internal workings of an economy, rather than external forces - under whose rubric they thus fall. Chartalism, which holds that money is created by government deficit spending, and emphasizes (and advocates) fiat money. Chartalism is a monetary standard in which government-issued tokens are used as the unit of money. In such a system, fiat money is created by government spending. Taxation is employed to reclaim the money and control the total amount of fiat money in existence. Reclaiming most of this issued money via taxation is essential to maintaining its value in exchange. Modern Chartalism theory states that under a fiat money system, net currency is created by government through deficit spending. Because the issued currency is not tied to or backed by a commodity, currency can only be created when the government spends. Government may, or may not, ask for that currency back in taxes. The demand to hold and acquire this government issued currency is driven by taxes levied by the state - which typically can only be paid in the state-issued fiat currency. (G.F. Knapp, 1920's) On the contrary, in the classical view, the central bank of a government creates money by purchasing government notes or bills through open market operations (this will be discussed later). Circuitist money theory, held by some post-Keynesians, who argues that money is created endogenously by the banking system, rather than exogenously by central bank lending. Further, they argue that money is not neutral. (Graziani 1989) Credit Theory of Money. This approach was founded by Joseph Schumpeter. Credit theory asserts the central role of banks as creators and allocators of money supply, and distinguishes between 'productive credit creation' (allowing non-inflationary economic growth even at full employment, in the presence of technological progress) and 'unproductive credit creation' (resulting in inflation of either the consumer- or asset-price variety). Money supply remains one of the most controversial aspects of economics.

Definition of Key Terms

Central Bank - The generic name given to a country's primary monetary authority, such as the Federal Reserve System in the U.S. Usually has responsibility for issuing currency, administering monetary policy, holding member banks' deposits, and facilitating the nation's banking industry. The Money Supply - is liquid assets held by individuals and banks. The money supply includes coins, currency, and demand deposits (checking accounts) or Money supply ("monetary aggregates", "money stock"), a macroeconomic concept, is the quantity of money available within the economy to purchase goods, services, and securities. Monetary policy - is the process by which the government, central bank, or monetary authority manages the money supply to achieve specific goals - such constraining inflation, maintaining an exchange rate achieving full employment or economic growth. Monetarism - is a set of views concerning the determination of national income and monetary economics. It focuses on the supply and demand for money as the primary means by which economic activity is regulated. Monetary theory focuses on money supply and on inflation as an effect of the supply of money being larger than the demand for money. Open Market Operations - are the buying or selling of Government bonds by the Central Bank in the open market. If the Central Bank were to buy bonds, the effect would be to expand the money supply and hence lower the interest rates; the opposite is true if bonds are sold. Reserve Requirements - are a percentage of commercial banks', and other depository institutions', demand deposit liabilities (i.e. checking accounts) that must be kept on deposit at the Central Bank as a requirement of Banking Regulations. Though seldom used, this percentage may be changed by the Central Bank at any time, thereby affecting the money supply and credit conditions. If the reserve requirement percentage is increased, this would reduce the money supply by requiring a larger percentage of the banks, and depository institutions, demand deposits to be held by the Central Bank, thus taking them out of supply. As a result, an increase in reserve requirements would increase interest rates, as less currency is available to borrowers. This type of action is only performed occasional as it affects money supply in a major way.

Analysis

Money can be defined as anything that is generally accepted as a medium of exchange and settlement of debt. Functions of Money Medium of Exchange: anything that is readily acceptable as payment. Unit of Account: serves as a unit of account to help us compare the relative value of goods. Store of Value: a way to keep some of our wealth in a readily spendable form for future needs. Method of Deferred Payment: Allows people to delay paying for goods or settling debt, even though goods or services are being provide immediately. Definition of Money Supply The following definitions of money supply are based on U.S. definitions. Types of Money They are two types of money:- Commodity Money: something that performs the function of money and has alternative, nonmonetary uses e.g. gold, silver, cigarettes. Fiat Money: something that serves as money but has no other important uses e.g. coins, currency, check deposits. Money in an Economy Money Stock is the quantity of money circulating in the economy. The different ways of measuring the money stock in an economy are: M1: Currency (coins and paper money) in the hands of the public + all demand deposits in deposit taking financial institutions + travelers checks + other checkable deposits M2: M1 + savings deposits + small time deposits (less than $100,00) + money market deposit accounts + other short term investments. M3: M2 + large time deposits (more than $100,000) M2 + M3 are considered near or quasi money since they cannot be easily used to purchase a good or service.

NB:

In the US is regarded as the narrowest form of money supply. The defining characteristic of this form of money is that it can be easily used to directly purchased goods and services. In England, the narrowest form of money supply is defined as M0 while the broadest is M4. M0: notes and coins in circulation, plus banks' balance at the Bank of England. M2: M0 + residents' sterling retail deposits with banks, building societies and National Savings. M4: M2+ both time and sight with banks and building societies. M4c: M4 + all foreign currency deposits held in UK banks and building societies by the UK non- bank private sector. In Guyana, the money supply is divided basically into two categories i.e. narrow and quasi money. Narrow money can be seen as M1 while narrow and quasi money together makeup M2 (broad money). Central Bank A country's central bank is often seen as the bankers' bank and is supposed to be independent of the government. The Central Bank is important because of the following functions: issuing currency setting reserve requirements lending money to banks provides for checking collection or clearing between banks fiscal agent to the government supervision of financial institutions controlling the money supply The major powers of the Central Bank that enable it to affect the Money Supply are:- Required reserve rate is lowered: The Central Bank can lower required reserve rate which raises the multiplier effect of high powered money (cash). The cash stays in the banks and each dollar can support more loans/demand deposits. For example, the required reserves went from 20% to 10 %, bank ACM would only need to hold $10,000 in reserves for the initial injection of $100,000. The other $90,000 would be loaned out so at each stage in the multiplier chain, the banks would be loaning out more funds and the eventual increase in the money supply would be larger. Discount interest rate decreases: The Central Bank can lower the discount rate and lower the costs for banks holding low excess reserves which will lower the excess reserve rate. If the Central Bank lowers the discount rate, or sets a lower federal funds target, this can be accomplished if the Central Bank injects funds into the system which will drive down the price of those funds - interest rates Publics' holding of cash changes: The Central Bank can raise confidence in banking system which will lower public's desire for holding cash. If you look at the high-powered money the Central Bank can inject into the system, a dollar in the hands of an individual is simply a dollar of money supply. A dollar in reserves at the banks, however, can support some multiple expansions of checking accounts. For example, when the required reserve rate was 10%, the $100,000 cash injection the system ultimately resulted in a $500,000 increase in checking account balances. Thus, if the Central Bank can move dollars from people's pockets to banks, this will increase the money supply. In the Great Depression, one of the real problems was people lost confidence in the banks and took their cash out of the banks, a pattern that caused the money supply to decrease. When people want cash, the reserves in the banks fall which creates a bigger drop in demand deposits. The result is a net decrease in the money supply. For this reason you would expect every Christmas season the money supply would decrease as consumers want to hold more cash. To offset this, the Central Bank will need to get more cash into the system. Open market purchases: this is the Central Bank's primary tool of monetary policy. The Central Bank can buy or sell government securities. For example, the Central Bank will contact its broker and announce it wants to buy $100,000 of government securities. The increase of $100,000 cash into the system will result in an increase in the money supply of $500,000. If the Central Bank wants to increase the money supply it will buy government securities, while if it wants to decrease the money supply it will sell government securities. The supply of money can only increase if the money is first "printed" by the issuer of money, usually the government central bank. The central bank "prints" coins and bills and electronic money (as mentioned in the functions of the Central Bank).

Conclusion

The researcher has concluded that the Central bank plays a significant role within the economy in controlling the supply of money. If the Money Supply is not properly attain to recessions and inflations will occur which will hinder the economic activities that the government is engaged. Furthermore, the major powers of the Central Bank, which were mention earlier, are important in regulating the supply of money.

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