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In the current world, money is the medium of exchange. It is generally aligned with the quantity of goods produced in order to avoid inflation and deflation. Along with money, gold is another vital part of our financial infrastructure and is also a measure of wealth and prosperity. Historically it has been observed that mankind has shown poor money management skills
An increase in production or a rise in prices of existing goods should be equal to purchasing power of the people. If a country enters into an inflationary phase, then people may not be able to afford the increase in prices and will reduce their standard of living thus affecting the retailers selling goods and services, who in turn will cut down orders from wholesalers and wholesalers will ask manufacturers to cut down production. Manufacturers look into their own profit margin and cuts down employment. Similarly a business trying to increase production or trying to expand must find funds for this. But these extra funds needed for the expansion may not be available to the business and thus they might look to borrow. When such borrowing occurs, the business is actually spending beyond its current means of income.
People hold money for “precautionary motive” and to n invest this idle/extra cash to earn dividends and interests. The capital market facilitates the transfer of money from someone with excess cash to someone with low cash. However if there is no assurance of getting money back lenders will be more cautious in lending money and will charge a high rate of interest.
Money comes in two forms—coins and currency. The Government prints and mints coins and notes but cannot control the amount of money in circulation in the economy and in what form we want to hold money .When money supply rises all fingers point to the banks. If the bank pays money to Mr. X then Mr. X’s bank balance will increase without withdrawing from any other depositor. Total volume of the deposits will also increase.
But bankers themselves have the difficult task of matching withdrawals to deposits and always holds a reserve (some extra cash) when net withdrawals are increasing than net deposits. The banker forms a timeframe in his mind about the time of deposits and withdrawals. His next step is to increase the cash reserve of the bank. For this he carries a “ secondary reserve” Its likely for him to buy U.S. Treasury obligations with a short maturity so that he can get the money back in a short time . If he needs cash before maturity, he will try to find a buyer for these securities and will sell at a price higher than buying price. To ascertain a constant amount of money at his disposal, the banker will allocate resources between marketable securities and loans. He also compares the cost of maintaining a portfolio of securities to the cost of running a loan and credit department as his ultimate motive is to cover the bank’s operating expenses and also retain a profit for the bank’s stockholders. A bank can buy securities to earn interest whenever it has money to do so but it cannot obligate anyone to borrow money . Contrary to this, when loan demand is high bankers will refuse to buy securities. So both instruments are attractive in its own way. Usually the bank stops borrowing money when a recession sets in and people have low credit scores. Also it doesn’t loan money to people who cannot repay it back and reduce the bank’s deposits. The loans and investments of the commercial banks follow from its deposits and for the entire banking system deposits are created by loans and investments.
Following the banking crisis of 1907 the Federal Reserve system (Fed in short)was formed by the Congress in 1913. The genius of this system lies in serving both private and public interests. The Federal Reserve System regulates the quantity of reserves in proportion to deposits of the member banks and acts as a banker’s bank as they hold the cash reserves of commercial banks as deposits. The system facilitates the transfer of money from one bank to another without any physical transfer of funds. The Fed is also the main depository of the United States Treasury. The Treasury also carries Tax and Loan Accounts with commercial banks. These account take the social security taxes. With increase in taxes and balance the Treasury issues a “call’ and the balance of the commercial banks at the Fed will reduce and the balance of the Treasury will increase, the Treasury balance of the commercial banks will go down.
The Fed has direct control on the rate of spending in the economy. The Fed can prevent a situation of money panic (where everyone is a seller and no one is a buyer) and the situation of an inflation (everyone a buyer and no sellers). If a commercial bank is short on reserves the Fed can buy its securities to maintain the bank’s cash position. No other commercial bank in the economy loses any cash and the Fed gets the money back in the form of deposits by the bank gaining reserves. It also plays vital roles in the bond market, influences prices and business activities by persuading banks to hold either less cash and more securities or by holding more cash and less securities, depending on the prevailing economic scenario.
By 1935, the Banking Act entrusted upon the Board of Governors of the Federal Reserve System to change the member bank’s reserve requirements.
By 1967, the member banks of the Federal Reserve system were required to keep 16.5% of their demand deposits as reserves. The original use of reserve requirement was to make each member bank have adequate resources but later this became a tool for controlling the supply of money. The discount policies and open market operations also influence the total reserves. However, small city banks are more likely to hold excess reserves than reserve city banks. Although the free reserves change according to different business cycles it fails to provide any correct prediction of the trend in monetary policy. Past history shows that the Fed as the savior for reserve losing commercial banks. This is done by open market purchase of securities. But where does the Fed get the reserves? Does it not suffer from “negative excess reserves” like commercial banks? The answer lies in the Federal Reserve Act of 1913 when a paper currency called the Federal Reserve Note which are irredeemable obligations came into play which is constantly used by the Fed when Fed needed money. As for example in 1967, 9 out of 10 dollars were Federal Reserve Notes. The Fed never loses reserves while paying out currency.
Till 1968, The Federal Reserve Notes could not exceed 4 times the gold certificate holdings. These certificates were backed by gold held in the Treasury vaults at
From 1938 to 1945 the economy was characterized by 4 periods: the pre- World War II years, the post war years, Inflationary years from V-J day to the Korean War and thereby an era of rising interest rates, tightening money and gold outflows. The war years were characterized by an excessive outflow of currency accompanied by the increase in interest rates .The post war years saw a rise in demand for consumer goods due to excessive money supply . The years from 1945 to 1948 faced widespread inflation with consumer prices rising 33% and wholesale prices rising by 51% whereas from 1942 to 1945 wholesale prices rose only by about 7%. By 1950 with the shortage of short term securities The Federal Reserve lost their control on money supply and was called the “engine of inflation”. However, The Korean War made things better. The Fed was relieved from buying the residual Government securities which led to the formation of the Federal Reserve “Accord” of April 1951. The main motive of the “Accord” was to avoid the creation of a redundant money supply to finance the spiraling price rises of the 1950’s. From 1958 to 1960 the rise in GNP was 10 times higher than the rise in money supply. Consequently, interest rates of long term bonds rose by 50% with increasing demand for money. With the rise in commercial bank borrowings they passed strict laws to restrict loans. By 1951 the excess reserves of the commercial banks reached a peak of $1 billion which was facilitated by the Fed’s ability to buy government securities and reducing the reserve requirements of member banks.
From 1965 to 1966 there was a decline in unemployment, banks lost their free reserves due to excess borrowing and the interest rates rose to 4.5% which was the highest since 1929. From 1962 to 1965 as a result of the Vietnam War defense expenses accelerated to $10 billion. The pressure on the money markets was led by two actions of the Fed: the yield on Government bonds were above 4.25% which led to a rise in the yield and quantity of Treasury bills. Secondly, the rising cost of Vietnam War was financed by selling assets of Export Import banks and the Federal National Mortgage Association which commanded for a higher rate of interest as these were less familiar than money market instruments.
The rise in corporate borrowing led to an increase in loans by the commercial banks. The Fed followed an expansionary policy and total reserves of member banks increased by leaps and bounds from 1965 to 1966 . In April 1966, the Fed through the Open Market Committee meetings set a brake to the expanding money supply. But the expanding money supply overcame all breaks with the increasing reserves of the commercial banks from April to October. Financial tensions were reflected in the interest rates with an increase of 1% from April to October for U.S. Treasury bills and the unchanged 4.5% rate of the commercial rates from 1960 to 1965 reached a staggering height of 6% during the first seven months of 1966. Borrowing rates of long term funds in the bond market were also at its highest since 1920. As short and long term securities of the Federal National Mortgage Association and other top quality organizations provided a higher interest rate people substituted their holdings of mutual savings banks, insurance policies for these security issues. At the backdrop of these developments residential construction showed a record decline at the beginning of 1966 since the World War II. Things turned around by the spring of 1967— borrowings from the Fed declined and there was monetary inflows into savings institutions and commercial banks. This was accompanied by a decline in interest rates of short term Treasury issues and long term Government bonds.
There are three main lessons that one can learn from tight money crisis of 1966 :- (1) Tight money creates a definite demand for money which is impossible to satisfy., (2) While tight money stops access from some sectors money is still available at a higher cost from other sectors., (3) Alternative means of safe investment at higher returns can divert public attention from investing in financial intermediaries.
History says cataclysmic instances of inflation are due to a shortage of goods and the inability to produce and distribute rather than an excess supply of money. A little bit of inflation is good as the postwar country by country analysis shows inflation is accompanied by high growth rather than with no inflation. Also the preservation of the dollar as an acceptable means of currency will entail less economic costs
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