Chapter 7 Blog- “Creating Money Supply”

Link: http://www.bworldonline.com/content.php?section=Opinion&title=Creating-money-supply&id=30602

Summary:

This article discusses how the money supply increases the U.S.  Many people believe that the supply of money grows when the government physically prints out more money out such as paper bills and metallic coins.  However this only represents 8% of the total currency circulating in the whole U.S. economy.  The government only prints out money when the old paper bills and coins are wearing out.  The process of injecting or withdrawing money is the change of money of supply which is referred to as monetary policy.  The most important factor in money flow in an economy is its “velocity”.  For example, if a $100 bill is used by 20 people in a year, its velocity is 20.  This is equivalent to the number of times that the bill has changed hand in a certain period of time.  Recently there was an article in the Asian Wall Street Journal which shows how the New York Federal Reserves Bank creates money in the U.S. economy.  The New York Federal Reserve Bank first writes a check for $100 million to buy securities from a brokerage house (a company who buys stocks and securities).  The brokerage house now has $100 million to increase its cash and it deposits that amount into its own bank (Bank A).  The bank will then keep 10% of its cash, and it will lend out the rest of its cash ($900,000).  Then a small company comes into Bank A and borrows $100,000.  The company deposits this money into their own bank (Bank B).  Bank B now has $100,000 in cash and it puts 10% as reserves ($10,000) and 90% for lending to other businesses ($90,000).  Now another business borrows $10,000 and puts it in its own bank (Bank C).  This chain can go on and on.  In these series of transactions, these banks have created $190,099,000.  Therefore loans are the major source of creating money in the U.S. economy.  Last year, Bernanke, the chairman of the Federal Reserve, announced that the Fed was planning to purchase $600 billion of government securities which resulted in adding $5.4 trillion in the U.S. economy.  Many people believe that adding more money in the economy will increase the growth of the U.S. economy but however in the past few years, the U.S. dollar has been decreasing.  The reason for this is because there was a decrease in demand for the U.S. dollar.  The worth of the dollar is determined by its attractiveness.  Wild changes in the supply of U.S. dollar in the pass few years have caused the U.S. dollar to suffer its downfall.

Connection:

This article relates to many concepts in the textbook.  For example, this article relates to the Fisher equation of exchange (MV=PT).  In the past few years, the U.S. had an increase in money supply when the Fed purchased $600 billion of government securities.  The bank gained this amount of cash and used it to make it loans.  After many loans were made by different individuals and companies, money was created as a result.  Money supply has a direct relationship with GDP.  If money supply increases, the GDP increases as well.  Another concept that relates to this relationship is velocity.  Velocity in economic terms is defined as the number of times that each unit of money supply changes hands during a given period.  In the past few years, banks have increased the velocity of money by giving out loans to different individuals.  This action increases the velocity of money and it helps circulate it throughout the economy.  Velocity is also directly related to GDP.  If velocity of money increases, the GDP increases as well.  As a result, we can form an equation between money supply, velocity and GDP.  If both money supply and velocity causes GDP to increase, we can say that MV=GDP (M= money supply, V= velocity).  This article also discusses how money is created by banks.  Banks receive cash from selling securities.  Most of the cash they receive will be used for loans to other individuals but a small portion of the money is kept in the bank to serve the purpose of reserves.  After a series of loans, more and more money will be created.  We can use the formula, ΔM= excess reserves / reserve ratio.  With this formula, we can calculate the change in money supply.  For example if we take the excess reserves in the article ($900,000) and divide it by reserve ratio (10%=0.1), we can calculate the change in money supply.  If we divided $900,000 by 0.1 we get a change in money supply of $9 million.  The action taken by the bank to change the money supply is referred to as monetary policy.  However the increase in money supply has caused the U.S. dollar to drop.  According to the law of supply, when supply increases, prices decrease.  This law also plays a factor in the value of the U.S. dollar.  When supply of money increases, the value of the dollar decreases as well because the attraction has decreased.  As a result, in the past few years, the U.S. dollar has declined even below the Canadian dollar.

Reflection:

Overall, in my opinion I think it’s a good idea to increase the supply of money.  The increase in supply of money will cause the rate of interest to decrease.  Lower interest rates would encourage more borrowing and less saving by the public.  This increases circulation of the money within an economy and therefore it will increase the level of GDP.  U.S. is a good example of this because it has been increasing the supply of U.S. money.  As a result of this, U.S. has one of the lowest interest rates in the world and it is the world’s leader of having one of the highest GDP.  Therefore this will have a positive affect on the economy of the United States.  However, on the other hand, there are some disadvantages of increasing the supply of money.   Increasing the money supply can be a disadvantage to one’s economy as the value of the currency will decrease if the money supply increases.  According to the law of supply, if the supply increases, the price will decrease.  This law also plays a role in currency in money.  If there is a larger supply of money, the worth and value of the dollar will decrease.  U.S. in the past few years had increased its money supply and as a result, the U.S. dollar declined below the Canadian dollar.  The U.S. dollar no longer has a huge attraction as before and therefore the value of the U.S. dollar has decreased.  However having a lower dollar can have its advantages too.  If the currency of the U.S. dollar decreases, more people will buy American products because its currency is lower.  Overall I believe that increasing the supply of money is good for an economy because it has more advantages than disadvantages.