Economics

Anything accepted as payment for goods and services and repayment of debts is called money. The main functions of money are as follows medium of exchange, unit of account, a store of value, and a standard of deferred payment. When money is used as an intermediary in the exchange of goods and services, it is performing a function as a medium. The use of money as exchange intermediary avoids the double coincidence of wants problem. A unit of account is a general standard numerical unit of measurement of the market value of goods and services. A unit of account is a necessary requirement for the formulation of commercial agreements which involve debt. In order to function as a unit of account, money must be 1) fungible  one unit must be equivalent to any other, 2) divisible into smaller units (value is preserved), and 3) specific weight  size is verifiably countable.

As a store of value, money must be able to be saved, stored, and retrieved, and in general to be usable as a medium of exchange when it is retrieved. The value of money must also be relatively permanent over time. A standard of deferred payment is an accepted way to settle a debt  a unit in which debts are generally denominated. When debts are denominated in money, the real value of debts depends on current macroeconomic factors such as inflation, deflation, and devaluation.

The central bank is a banking institution granted the exclusive privilege to lend a government its currency. Normally, a central bank charges interests on the loans made to borrowers  in jurisprudence, the central bank is the lender of last resort. The central bank, however, has a monopoly on creating the currency of a particular country. Its essential functions are as follows 1) provide money supply, 2) ensure the robustness of the financial system, 3) provide consumers integrated information on government finances, and 4) develop an effective payment system.

Central banks have a number of objectives tactical or macroeconomic (domestic price level and the exchange rate), long-term strategic objectives of financial sector development (development of forms of financial infrastructure), and sectoral or microeconomic objectives.

The specific functions of the central bank are as follows implementing monetary policy, setting interest rates, controlling an economys money supply, managing the countrys foreign exchange and gold reserves, providing regulations in the banking industry, and ensuring the efficacy of interest and exchange rates. How does the central bank manage a countrys monetary system Suppose that the actual inflation rate is greater than the expected inflation rate. The central bank may opt to increase the prevailing interest rate to curb inflation. The bank may also decrease overall money supply. Both policies achieve the same results.

The essential goals of the monetary policy include economic growth, low inflation, and stability of the currency. However, most economists argue that the main contribution of monetary policy is to maintain low inflation in the long-run. It is generally agreed that low inflation provides a necessary base for sustained economic growth and development. In a number of countries, low inflation has proved important for the development of a sustainable microfinance sector. It is also accepted that central banks are most effective in maintaining low inflation and in performing their other proper function independent of government action.

In the United States, the Federal Reserve acts as the central bank. It executes monetary policy by setting a target for an overnight interest rate called the federal funds rate. Low rates are usually taken as a sign of monetary ease. High rates indicate monetary tightness. Changes in the federal funds rate affect short-term interest rates. As a consequences, spending changes. From January 3, 2001 to June 25, 2003, the Federal Reserve reduced the target federal fund rate from 6.5 to 1. However, starting June 30, 2004, the policy was reversed.

From 1994 to 2002, the monetary base contracted. The decline in aggregate reserves allowed for considerable monetary expansion (net effect) as the Federal Reserve increase overall money supply. This led to a decline in demand deposit balances. The shift to positive reserve growth from 2003 to 2004 reflects the fall in the federal funds rate target. The contraction of reserves from 2005 to 2006 reflects the increase in the target for federal funds. With the 2009 global recession in progress, the Federal Reserve has increased money supply and decreased target federal funds rate. The aim is increase aggregate spending and investment in the US economy.

What is the effect of monetary policy on production and employment Contraction of the money supply leads to short-term decreases in both spending and investment. Employment decreases equivalent to the investment multiplier. Note that changes in the money supply have the potential to bring about major changes in the growth of GDP and employment only in the short-run.

An increase in money supply results to an increase in the inflation rate, and a decline in unemployment rate. This may also result to an increase in the budget deficit. Budget deficit raises aggregate demand, as it raises the borrowing requirement of the government. This causes domestic interest rates to rise relative to those in other financial centers. The rise in domestic interest rate makes US assets more attractive to foreigners. This, in turn, increases the demand for dollars in foreign exchange markets to acquire US assets. A more expansive monetary policy centering on a more rapid rate of growth of the money supply initially serves to lower U.S. interest rates relative to those in other financial centers.