Question

Discuss the functions of money, how banks create money in the U.S., and how the Federal Reserve influences money and credit using monetary policy.

Answer 1

The three functions of money are:

1) Store of value: Money plays the role of the most liquid asset i.e. measures how easily assets can be spent to buy products and services. Money’s value can be retained over time and is a convenient way to store wealth.

2) Unit of account: Money acts as the common standard for measurement of the relative worth of goods and service.

3) Medium of exchange: People have requirements and wants that they cannot produce themselves. Thus the money can be used for buying and selling of products and services. If money doesn't exist goods would have to be exchanged through the process of barter system.

In United States, the banks create new money whenever they advance loans. When bank makes loans from excess reserves, it create checking account deposits. Monetary policies are the actions taken by central banks to control the monetary as well as financial status with the goal of attaining low inflation and sustainable growth in the economy. The techniques that are used by the central bank under monetary policies to alter the money supply include the reserve requirements, discount rate, and the open market operations. Broadly, there are two types of monetary policy namely - Expansionary and Contractionary. Expansionary monetary policy is used by FED when it wants to expands (increase) the supply of money to stimulate the economy. An expansionary monetary policy will stimulate investment and consumption spending, and also reduce interest rates thus leading to aggregate demand curve to shift right. Contractionary monetary policy is used by FED when wants to contracts (decrease) the supply of currency of the nation. This decreases the money supply, increases interest rates and reduces the aggregate demand