The Importance Of The Banking System

It is often said that money makes the world go round. Money plays an important role in a country’s economy. Citizens must have money in order to spend money. Governments can help banks create money. In the United States (US), the Federal Reserve is responsible for controlling the money supply to keep the economy running smoothly. One must fully understand the US money and banking system to fully grasp the money market. Knowledge of items that serve as money, the effects of actions taken by the Fed to the economy, steps the Fed can take to increase the money supply, and causes for too little money or spending in a recession are important in attaining proper comprehension of the US monetary system.
In today’s world, money is used to purchase …show more content…
“Open market purchases increase the money supply; open market sales decrease it” (Pearson, n.d.). Open market purchases occur when the Fed buys government bonds in order to increase the supply of money. For example, the fed purchases a large amount of bonds from the private sector. The party selling the bonds is given a check for the amount purchased. “Checks written against the Fed count as reserves for the bank” (Pearson, n.d.). The Fed sets the reserve ratio for all banks to retain a percentage of deposits. For instance, if the reserve ratio is set at 10%, banks must reserve 10% of all deposits. The remaining 90% is available for loans. If the reserve ratio is indeed 10% in the previous scenario, 90% of the Fed’s check is added to the supply of money available to the public. This is just one of the tools available to the Fed to increase the supply of money in the economy. The Fed cannot take this ability lightly. “The Fed has unlimited ability to create money. It can write checks against itself to purchase the government bonds without having explicit “funds.” Banks accept it because these checks count as reserves for the bank” (Pearson, n.d.). This ability has the potential to be devastating if used improperly. The system could be manipulated because the entire money market of the US can become a shell game. The Fed can basically “float” a check indefinitely, or simply write a check it can’t cash. This still increases the money supply, however, the bank reserves end up being worthless checks from the Fed. Since open market purchases increase the money supply, the statement “When the Fed makes and open market purchase of government securities, the quantity of money will eventually decrease by a fraction on the initial change in the monetary base” is false. There are a total of three tools the Fed can use to increase the money