The Federal Reserve Board (FRB) of the United States provides the nation with a safe, stable, yet flexible monetary and financial system. Therefore, the actions of the FRB should allow for changes to broad monetary policies for the implementation of the government’s fiscal policy (Pride, Hughes, & Kapoor, 2013a, p. 525). These actions include oversights and management of currency production and distribution, public sharing of statistical information, and promotion of employment and overall economic growth. All these measures affect the discount rate whose shifts change the building blocks of macroeconomics, such as consumer borrowing and spending.
For financial institutions like banks, the discount rate is the interest rate for short-term loans acquired from the Federal Reserve (Pride, Hughes, & Kapoor, 2013b). The discount rate is merely the cost of borrowing money from the Federal Reserve. Therefore, if the FRB increases the discount rate, banks get discouraged from lending and they, in turn, decrease consumer borrowing by increasing consumer interest rates for a house mortgage, car loans, credit cards, and cash deposit rates. A lowering of the discount rate causes an opposite effect.
The Federal Deposit Insurance (FDI) is a system established by the federal government to ensure accounts in financial institutions, especially banks, against losses up to a specified amount (Miller, 2014, p. 525). The FDI is the insurance of the deposits that are kept in banks: insured by the Federal Deposit Insurance Corporation (FDIC) in the event of bank failure. FDIC is an independent federal agency of the US government that protects depository institutions.
The FDI is a good incentive for borrowers since it bears the two significant undesirable consequences. First, is the ‘moral hazard’ whereby banks enjoy the profits of risk-taking without incurring the consequences of that risk-taking because the federal government covers any shortfalls between the assets and liabilities of the banks. Second, is the problem that arises during the insolvency procedure and the cost thereof in the scenario of a bank failure. The FDI scheme guarantees bank bailout or bank closure during an insolvency procedure. However, bank closure is far too expensive, and governments can only afford to repay the customers due to deposit insurance or bailout the bank through a capital injection. Therefore, a bank may take higher risks knowing that the government cannot afford not to rescue it if it should fail (Miller, 2014)
The Quantity Theory of Money is a macroeconomic model used to explain the relationship between money supply in an economy and the price level of goods and services. The theory asserts that changes in general price levels are influenced primarily by the changes in the quantity of money in circulation (Rochon & Rossi, 2015, p. 354). Ultimately, the amount of money in circulation determines the general price levels of goods and services.
Policy Implications: The prime objective of the Quantity Theory of Money is to determine monetary policies that maintain low inflation. As such, the theory affects the design and conduct of monetary policy (Alimi, 2012, p. 286). In design, the central bank should adopt inflation as the fundamental variable of its monetary policy to achieve the objective of price stability. In conduct, the central bank should not alter the supply of money in response to economic changes. Accordingly, monetary policy during a recession should not focus on increasing money supply but on changing the price levels.
Reserve ratio is the percentage amount of all customer deposits that commercial banks must have as cash at hand (“The Fed – Reserve Requirements,” 2017.). In the United States, the reserve ratio is determined by the Federal Reserve Board. For example, if the reserve ratio is set at 10% and a bank’s customer deposits are at $1 billion, the required reserve is $100 million.
The reserve ratio affects money supply in an economy at any given time. A ratio is an essential tool of monetary policy used in regulating the amount of money. For example, when the Federal Reserve Board wants to lower the amount of money in supply, it increases the reserve ratio (“The Fed – Reserve Requirements,” 2017.).
According to Karimzadi (2013, p. 118), money has four primary functions as highlighted below:
- Money is a medium of exchange. Money is used as a means of change for buying and selling of goods and services. As an ideal medium of exchange money must be acceptable, divisible, portable, durable, and homogeneous, among others.
- Money is a unit of account. Money is used as a standard measure of the worth of goods and services. The use of money removes the difficulty of many exchange rates associated with barter trade.
- Money is a store of value. Money provides a convenient way of storing wealth since it is the most liquid asset. Therefore, money provides a perfect means of saving.
- Money is a standard for deferred payments. It enables current transactions to be discharged in the future. As such, money facilitates borrowing and lending.
Alimi, S. R. (2012). The quantity theory of money and its long-run implications: empirical evidence from Nigeria. European Scientific Journal, ESJ, 8(12).
Karimzadi, S. (2013). Money and Its Origins. Routledge.
Miller, R. L. (2014). Business Law Today, Comprehensive: Text and Cases: Diverse, Ethical, Online, and Global Environment. Cengage Learning.
Pride, W. M., Hughes, R. J., & Kapoor, J. R. (2013a). Business. Cengage Learning.
Pride, W. M., Hughes, R. J., & Kapoor, J. R. (2013b). Business. Cengage Learning.
Rochon, L.-P., & Rossi, S. (2015). The Encyclopedia of Central Banking. Edward Elgar Publishing.
The Fed – Reserve Requirements. (2017). Retrieved January 8, 2018, from https://www.federalreserve.gov/monetarypolicy/reservereq.htm