5 marks
1.Arguments
The main functions of the central bank are to maintain low inflation and a low level of unemployment,
although these goals are sometimes in conflict (according to Phillips curve). A central bank may attempt
to do this by artificially influencing the demand for goods by increasing or decreasing the nation's money
supply (relative to trend), which lowers or raises interest rates, which stimulates or restrains spending on
goods and services.
An important debate among economists in the second half of the twentieth century concerned the central
bank's ability to predict how much money should be in circulation, given current employment rates and
inflation rates. Economists such as Milton Friedman believed that the central bank would always get it
wrong, leading to wider swings in the economy than if it were just left alone.[38] This is why they advocated
a non-interventionist approach—one of targeting a pre-specified path for the money supply independent
of current economic conditions— even though in practice this might involve regular intervention with open
market operations (or other monetary-policy tools) to keep the money supply on target.
The Chairman of the U.S. Federal Reserve, Ben Bernanke, has suggested that over the last 10 to 15
years, many modern central banks have become relatively adept at manipulation of the money supply,
leading to a smoother business cycle, with recessions tending to be smaller and less frequent than in
earlier decades, a phenomenon termed "The Great Moderation"[39] This theory encountered criticism
during the global financial crisis of 2008–2009[citation needed]. Furthermore, it may be that the functions of the
central bank may need to encompass more than the shifting up or down of interest rates or bank
reserves[citation needed]: these tools, although valuable, may not in fact moderate the volatility of money
supply (or its velocity)[citation needed].
2.Money supplies around the world
Components of US money supply (currency, M1, M2, and M3) since 1959. In January 2007, the amount of "central bank
money" was $750.5 billion while the amount of "commercial bank money" (in the M2 supply) was $6.33 trillion. M1 is
currency plus demand deposits; M2 is M1 plus time deposits, savings deposits, and some money-market funds; and M3 is
M2 plus large time deposits and other forms of money. The M3 data ends in 2006 because the federal reserve ceased
reporting it.
Components of the euro money supply 1998–2007
See also: Money supply
Fractional-reserve banking determines the relationship between the amount of "central bank money" in
the official money supply statistics and the total money supply. Most of the money in these systems is
"commercial bank money". Fractional-reserve banking allows the creation of commercial bank money,
which increases the money supply through the deposit creation multiplier. The issue of money through
the banking system is a mechanism of monetary transmission, which a central bank can influence
indirectly by raising or lowering interest rates (although banking regulations may also be adjusted to
influence the money supply, depending on the circumstances).
This table gives an outline of the makeup of money supplies worldwide. Most of the money in any given
money supply consists of commercial bank money.[16] The value of commercial bank money is based on
the fact that it can be exchanged freely at a bank for central bank money. [16][17]
The actual increase in the money supply through this process may be lower, as (at each step) banks may
choose to hold reserves in excess of the statutory minimum, borrowers may let some funds sit idle, and
some members of the public may choose to hold cash, and there also may be delays or frictions in the
lending process.[22] Government regulations may also be used to limit the money creation process by
preventing banks from giving out loans even though the reserve requirements have been fulfilled. [23]
3.Effects on money supply
The reserve requirement can be used as an instrument of monetary policy, because the higher the
reserve requirement is set, the less funds banks will have to loan out, leading to lower money creation
and perhaps ultimately to higher purchasing power of the money previously in use. The effect is
multiplied, because money obtained as loan proceeds can be re-deposited; a portion of those deposits
may again be loaned out, and so on. The effect on the money supply is governed by the following
formulas:
: definitional relationship between monetary base Mb (bank reserves
plus currency held by the non-bank public) and the narrowly defined money supply, M1,
: derived formula for the money multiplier mm, the factor by
which lending and re-lending leads M1 to be a multiple of the monetary base,
where notationally,
the currency ratio: the ratio of the public's holdings of currency (undeposited cash) to the
public's holdings of demand deposits; and
the total reserve ratio ( the ratio of legally required plus non-required reserve holdings of
banks to demand deposit liabilities of banks).
However, in the United States (and other countries except Brazil, China, India, Russia),
the reserve requirements are generally not frequently altered to implement monetary
policy because of the short-term disruptive effect on financial markets.
20 marks
1.Money creation by the central bank
Main article: Monetary policy
Within almost all modern nations, special institutions exist (such as the Federal Reserve System in the
United States, the European Central Bank (ECB), and the People's Bank of China) which have the task of
executing the monetary policy and often acting independently of theexecutive. In general, these
institutions are called central banks and often have other responsibilities such as supervising the smooth
operation of the financial system. There are several monetary policy tools available to a central bank to
expand the money supply of a country: decreasing interest rates by fiat; increasing the monetary base;
and decreasing reserve requirements. All have the effect of expanding the money supply.
The primary tool of monetary policy is open market operations. This entails managing the quantity of
money in circulation through the buying and selling of various financial assets, such as treasury bills,
government bonds, or foreign currencies. Purchases of these assets result in currency entering market
circulation (while sales of these assets remove money from circulation).
Usually, the short term goal of open market operations is to achieve a specific short term interest rate
target. In other instances, monetary policy might instead entail the targeting of a specific exchange rate
relative to some foreign currency, the price of gold, or indices such as Consumer Price Index. For
example, in the case of the USA the Federal Reserve targets the federal funds rate, the rate at which
member banks lend to one another overnight. The other primary means of conducting monetary policy
include: (i) Discount window lending (as lender of last resort); (ii) Fractional deposit lending (changes in
the reserve requirement); (iii) Moral suasion (cajoling certain market players to achieve specified
outcomes); (iv) "Open mouth operations" (talking monetary policy with the market). The conduct and
effects of monetary policy and the regulation of the banking system are of central concern to monetary
economics.
Quantitative easing
Main article: Quantitative easing
Quantitative easing involves the creation of a significant amount of new base money by a central bank by
the buying of assets that it usually does not buy. Usually, a central bank will conduct open market
operations by buying short-term government bonds or foreign currency. However, during a financial crisis,
the central bank may buy other types of financial assets as well. The central bank may buy long-term
government bonds, company bonds, asset backed securities, stocks, or even extend commercial loans.
The intent is to stimulate the economy by increasing liquidity and promoting bank lending, even when
interest rates cannot be pushed any lower.
Quantitative easing increases reserves in the banking system (i.e. deposits of commercial banks at the
central bank), giving depository institutions the ability to make new loans. Quantitative easing is usually
used when lowering the discount rate is no longer effective because interest rates are already close to or
at zero. In such a case, normal monetary policy cannot further lower interest rates, and the economy is in
a liquidity trap.
Physical currency
In modern economies, relatively little of the supply of broad money is in physical currency. For example,
in December 2010 in the U.S., of the $8853.4 billion in broad money supply (M2), only $915.7 billion
(about 10%) consisted of physical coins and paper money. [2] The manufacturing of new physical money is
usually the responsibility of the central bank, or sometimes, the government's treasury.
Contrary to popular belief, money creation in a modern economy does not directly involve the
manufacturing of new physical money, such as paper currency or metal coins. Instead, when the central
bank expands the money supply through open market operations (e.g. by purchasing government bonds),
it credits the accounts that commercial banks hold at the central bank (termedhigh powered money).
Commercial banks may draw on these accounts to withdraw physical money from the central bank.
Commercial banks may also return soiled or spoiled currency to the central bank in exchange for new
currency.[3]
2.Money creation through the fractional reserve system
Main article: Fractional-reserve banking
Through fractional-reserve banking, the modern banking system expands the money supply of a country
beyond the amount initially created by the central bank.[4] There are two types of money in a fractionalreserve banking system, currency originally issued by the central bank, and bank deposits at commercial
banks:[5][6]
1. central bank money (all money created by the central bank regardless of its form, e.g.
banknotes, coins, electronic money)
2. commercial bank money (money created in the banking system through borrowing and lending)
- sometimes referred to as checkbook money[7]
When a commercial bank loan is extended, new commercial bank money is created. As a loan is paid
back, more commercial bank money disappears from existence. Since loans are continually being issued
in a normally functioning economy, the amount of broad money in the economy remains relatively stable.
Because of this money creation process by the commercial banks, the money supply of a country is
usually a multiple larger than the money issued by the central bank; that multiple is determined by
the reserve ratio or other financial ratios (primarily the capital adequacy ratio that limits the overall credit
creation of a bank) set by the relevant banking regulators in the jurisdiction.
Re-lending
An early table, featuring reinvestment from one period to the next and a geometric series, is found in
the tableau économique of the Physiocrats, which is credited as the "first precise formulation" of such
interdependent systems and the origin of multiplier theory.[8]
Money multiplier
Main article: Money multiplier
The expansion of $100 through fractional-reserve lending under the re-lending model of money creation, at varying rates.
Each curve approaches a limit. This limit is the value that the money multipliercalculates. Note that the top amount
resulting in $1000 is not 20% but 10% as 100/0.1=1000.
The most common mechanism used to measure this increase in the money supply is typically called
the money multiplier. It calculates the maximum amount of money that an initial deposit can be
expanded to with a given reserve ratio – such a factor is called a multiplier. As a formula, if the reserve
ratio is R, then the money multiplier m is the reciprocal,
and is the maximum amount of
money commercial banks can legally create for a given quantity of reserves.
In the re-lending model, this is alternatively calculated as a geometric series under repeated lending of a
geometrically decreasing quantity of money: reserves lead loans. In endogenous money models, loans
lead reserves, and it is not interpreted as a geometric series. In practice, because banks often have
access to lines of credit, and the money market, and can use day time loans from central banks, there is
often no requirement for a pre-existing deposit for the bank to create a loan and have it paid to another
bank.[9][10]
The money multiplier is of fundamental importance in monetary policy: if banks lend out close to the
maximum allowed, then the broad money supply is approximately central bank money times the
multiplier, and central banks may finely control broad money supply by controlling central bank money,
the money multiplier linking these quantities; this was the case in the United States from 1959 through
September 2008.
If, conversely, banks accumulate excess reserves, as occurred in such financial crises as the Great
Depression and theFinancial crisis of 2007–2010 – in the United States since October 2008, then this
equality breaks down, and central bank money creation may not result in commercial bank money
creation, instead remaining as unlent (excess) reserves.[11] However, the central bank may shrink
commercial bank money by shrinking central bank money, since reserves are required – thus fractionalreserve money creation is likened to a string, since the central bank can always pull money out by
restricting central bank money, hence reserves, but cannot always push money out by expanding central
bank money, since this may result in excess reserves, a situation referred to as "pushing on a string".
3.Emergency Economic Stabilization Act of 2008
On October 3, 2008, Section 128 of the Emergency Economic Stabilization Act of 2008 allowed the Fed
to begin paying interest on excess reserve balances as well as required reserves. They began doing so
three days later.[3] Banks had already begun increasing the amount of their money on deposit with the
Fed at the beginning of September, up from about $10 billion total at the end of August, 2008, to $880
billion by the end of the second week of January, 2009.[4][5] In comparison, the increase in reserve
balances reached only $65 billion after September 11, 2001 before falling back to normal levels within a
month. Former U.S. Treasury Secretary Henry Paulson's original bailout proposal under which the
government would acquire up to $700 billion worth of mortgage-backed securities contained no provision
to begin paying interest on reserve balances.[6]
The day before the change was announced, on October 7, Fed Chairman Ben Bernanke expressed some
confusion about it, saying, "We're not quite sure what we have to pay in order to get the market rate,
which includes some credit risk, up to the target. We're going to experiment with this and try to find what
the right spread is."[7] The Fed adjusted the rate on October 22, after the initial rate they set October 6
failed to keep the benchmark U.S. overnight interest rate close to their policy target, [7][8] and again on
November 5 for the same reason.[9]
The Congressional Budget Office estimated that payment of interest on reserve balances would cost the
American taxpayers about one tenth of the present 0.25% interest rate on $800 billion in deposits:
Estimated Budgetary Effects[10]
Year
Millions of dollars
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
0
-192 -192 -202 -212 -221 -242 -253 -266 -293 -308
(Negative numbers represent expenditures; losses in revenue not included.)
0.25% simple interest on $800 billion is $2 billion, not $202 million as shown for 2009. But those
expenditures pale in comparison to the lost tax revenues worldwide resulting from decreased economic
activity from damage to the short-term commercial paper and associated credit markets.
Beginning December 18, the Fed directly established interest rates paid on required reserve balances
and excess balances instead of specifying them with a formula based on the target federal funds
rate.[11][12][13] On January 13, Ben Bernanke said, "In principle, the interest rate the Fed pays on bank
reserves should set a floor on the overnight interest rate, as banks should be unwilling to lend reserves at
a rate lower than they can receive from the Fed. In practice, the federal funds rate has fallen somewhat
below the interest rate on reserves in recent months, reflecting the very high volume of excess reserves,
the inexperience of banks with the new regime, and other factors. However, as excess reserves decline,
financial conditions normalize, and banks adapt to the new regime, we expect the interest rate paid on
reserves to become an effective instrument for controlling the federal funds rate."[14]
Also on January 13, Financial Week said Mr. Bernanke admitted that a huge increase in banks' excess
reserves is stifling the Fed's monetary policy moves and its efforts to revive private sector lending.[15] On
January 7, 2009, the Federal Open Market Committee had decided that, "the size of the balance sheet
and level of excess reserves would need to be reduced."[16] On January 15,Chicago Fed president and
Federal Open Market Committee member Charles Evans said, "once the economy recovers and financial
conditions stabilize, the Fed will return to its traditional focus on the federal funds rate. It also will have to
scale back the use of emergency lending programs and reduce the size of the balance sheet and level of
excess reserves. Some of this scaling back will occur naturally as market conditions improve on account
of how these programs have been designed. Still, financial market participants need to be prepared for
the eventual dismantling of the facilities that have been put in place during the financial turmoil" [17]
At the end of January, 2009, excess reserve balances at the Fed stood at $793 billion [18] but less than two
weeks later on February 11, total reserve balances had fallen to $603 billion. On April 1, reserve balances
had again increased to $806 billion, and on February 10, 2010, they stood at $1.154 trillion. By August
2011, they reached $1.6 trillion.[19]
4.History
In 1924, Senator James Couzens (Michigan) introduced a resolution in the Senate for the creation of a
Select Committee to investigate the Bureau of Internal Revenue. At the time, there were reports of
inefficiency and waste in the Bureau and allegations that the method of making refunds created the
opportunity for fraud. One of the issues investigated by the Select Committee was the valuation of oil
properties. The Committee found that there appeared to be no system, no adherence to principle, and a
total absence of competent supervision in the determination of oil property values.
In 1925, after making public charges that millions of tax dollars were being lost through the favorable
treatment of large corporations by the Bureau, Senator Couzens was notified by the Bureau that he owed
more than $10 million in back taxes. Then Treasury Secretary Andrew Mellon was believed to be
personally responsible for the retaliation against Senator Couzens. At the time, Secretary Mellon was the
principal owner of Gulf Oil, which had benefited from rulings specifically criticized by Senator Couzens.
The investigations by the Senate Select Committee led, in the Revenue Act of 1926, to the creation of
the Joint Committee on Internal Revenue Taxation. The select committee emphasized
the need for the institution of a procedure by which the Congress could be better advised as to
the systems and methods employed in the administration of the internal revenue laws with a view
to the needs for legislation in the future, simplification and clarification of administration, and
generally a closer understanding of the detailed problems with which both the taxpayer and the
Bureau of Internal Revenue are confronted. It is more properly the function of the Senate Finance
Committee and the House Ways and Means Committee, jointly, to engage in such an activity.(2)
As originally conceived by the House, a temporary "Joint Commission on Taxation" was to be created
to "investigate and report upon the operation, effects, and administration of the Federal system of
income and other internal revenue taxes and upon any proposals or measures which in the judgment
of the Commission may be employed to simplify or improve the operation or administration of such
systems of taxes.....".(1)
The Senate expanded significantly the functions contemplated by the House and transformed the
proposed Joint Commission to a Joint Committee with a permanent staff. The Senate version was
incorporated into the Revenue Act of 1926 and the Joint Committee was created.(3)
The first Chief of Staff of the Joint Committee on Internal Revenue Taxation was L.H. Parker, who
had been the chief investigator on Senator Couzens' Select Senate Committee. The Revenue Act of
1926 required the Joint Committee on Internal Revenue Taxation to publish from time to time for
public examination and analysis proposed measures and methods for the simplification of internal
revenue taxes and required the Joint Committee to provide a written report to the House and Senate
by December 31, 1927, with such recommendations as it deemed advisable. The Joint Committee
published its initial report on November 15, 1927, and made various recommendations to simplify the
federal tax system, including a recommendation for the restructuring of the federal income tax title.
In the Revenue Act of 1928, the Joint Committee's authority was extended to the review of all refunds
or credits of any income, war-profits, excess-profits, or estate or gift tax in excess of $75,000. In
addition, the Act required the Joint Committee to make an annual report to the Congress with respect
to such refunds and credits, including the names of all persons and corporations to whom amounts
are credited or payments are made, together with the amounts credit or paid to each.
Since 1928, the threshold for review of large tax refunds has been increased from $75,000 to $2
million in various steps and the taxes to which such review applies has been expanded. Other than
that, the Joint Committee's responsibilities under the Internal Revenue Code have remained
essentially unchanged since 1928.
While the statutory mandate of the Joint Committee has not changed significantly, the tax legislative
process, however, has.