Fractional Reserve Banking - Essay Sample

Introduction

The fractional reserve banking is a system where the financial institutions like banks hold a particular fraction of money that has been deposited by the customers in the reserves. This action allows the banks to use the money left in making loans thus creating extra money. Through these acts, the financial institutions can control the supply of money in the country since most of the money currently is generated by the commercial banks through this system. For example, through the fractional banking system, the federal central banks and the government monetary authorities can regulate the supply of currency and conduct a follow up on the financial system. The Fractional Reserve banking led to the power and the centralization of the central banks which existed in the world financial system. In the United States, the Federal Reserve is among the banking systems, and their objectives are to stabilize prices, maximization of employment and the moderation of the long term interest rates. The Federal Reserve has the responsibility of regulating and overseeing private commercial banks. Therefore, this paper will focus on addressing particular concepts which are used in the Federal Reserve's thus enabling banking.

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Open Market Operations

Purpose of the Open Market Operation

An open market operation is a tool which is used by the central banks in trading the governments securities while in the free market for the expansion or contraction of money present in the banking systems. The security purchases usually put money in the banking system and promote stimulation of growth while the sales of the securities do the vice versa thus helping in the contraction of the economy. The Federal Reserve utilizes this process and technique for the adjustment and manipulation of the rates of federal funds that allow banks in borrowing reserves from others and themselves (Allen et al. 639). Whenever the central bank buys the securities on the open markets, it leads to the increment of the reserves present in the commercial banks, increases the cost of the government securities and lowers the interest rates thus promoting investment of the business if there will be the sale of the securities by the central bank.

How the Buying and Selling of the United States Securities by the Fed Influence the Federal Funds Market

The reserves which are held by a bank changes the deposits and transactions daily. Whenever a bank requires extra reserves on a short term, it might borrow from different banks which tend to have an additional amount of reserves. The federal fund rate is the interest rate which occurs due to overnight borrowing of the reserves presents in that market. The federal fund either decrease or increase due to the total amount of the reserves which are in the fed market. When the demand for the reserves in the market is higher than its supply, there has to be an increase in the federal funds rate. Whenever the amount is higher than the demand of the reserves, there happens to be a decrement in the funds' rate in the market. Due to this, the federal funds rate happen to be a catalyst which pushes the central fund to an equilibrium; hence ensuring demand is satisfied by supply at any time. In the United States, the federal funds rate is used by the Fed in the conduction of the monetary policy where it changes the cost associated with borrowing in the market. This action affects the price of purchasing of the goods and services present in the market. Therefore, whenever the Fed predicts a movement of the economy towards a recession, it ends up boosting the economic activity since it makes borrowing less expensive (Cecchetti 51-75). The banks in the United States, utilize the reserves which they had obtained at reduced rates in providing loans at lower interests to the consumers and businesses. Fed also leads to an increment of the credit as it helps in curbing the demand hence reducing the inflationary pressures in the economy.

Discount and Federal Funds Target Rates

Difference between the Discount and Federal Funds Target Rates and if the Federal Reserve controls both Rates

The interest rate which is charged to a bank which has borrowed money from another bank is known as the federal funds rate. In a scenario where money is deposited in a particular bank, the banks lend the funds out to others. Fed needs the bank to have a given percentage of the money which was deposited due to the depositors who might require to withdraw those funds. Banks which possess additional reserves are called the federal funds since they are deposited in the regional Federal Reserve's banks. The discount rates are the interest rates which are charged by the Fed to the member banks who need to borrow. A discount rate is a tool which was used before the open market operations in expansion or contraction of the money supply (Nautz and Sandra 1274-1284). Therefore, the discount rates and the federal funds rate are not controlled by the Federal Reserve since if a bank does not meet the requirements of the reserve, it can still borrow money from the Federal Reserve which is different from the discount rates.

Fractional Reserve Banking System

The Economic Importance of the Fractional Reserve Banking System

The fractional reserve banking is a system where the fraction of the bank deposits are followed by the exact cash on the hands of those who are depositing so that they can be ready to be withdrawn. This action is carried out so that it can lead to an expansion of the economy through freeing up of the capital which might be loaned to different parties. When people try to withdraw all the assets in banks at a specific time, it can lead to depression in the country's economy. The analyst usually references the multiplier equation whenever they are doing estimations on the effect of the reserve requirements on an economy. The multiplication of the initial deposit calculates the fractional banking estimates by the one which is divided by the reserve requirements. Therefore, the fractional reserve banking pools the smaller savings together thus can lend them to a variety of market. Money tends to be generated through the fractional banking systems where it is acquired from the outside sources and inside sources which are referred to as the deposit money (Rockoff 118). Through deposit and lending, banks create various types of money which exist over the base money. Therefore, this helps the banks to generate extra income from the interests earned from the loan provided to others and also have a continuous flow of money as deposits and loans.

Conclusion

The Federal Reserve utilizes different concepts which facilitate in monitoring and concentration of funds in the markets. The fractional reserve banking helps in the expansion of the country's economy through freeing up the capital that is loaned to the other financial institutions. The central bank uses the open market operations in buying and selling of the governments securities while in the free market for the expansion or contraction of money present in the banking systems. During the buying and selling of government securities, whenever the supply is high, and demand is low it leads to lowering the prices of these securities while when the amount is low, and the demand is high there is the expansion of market since there are improved costs. The Fed usually controls the discount rates which are in the banking system to the member banks who need to borrow funds. Therefore, the fed reserves play a vital role in determining prices, monitoring and concentration the costs of goods and services presents in the economy.

Works Cited

Allen, Franklin, Elena Carletti, and Douglas Gale. "Interbank market liquidity and central bank intervention." Journal of Monetary Economics 56.5 (2009): 639-652. Retrieved from https://ideas.repec.org/a/eee/moneco/v56y2009i5p639-652.html

Cecchetti, Stephen G. "Crisis and responses: The Federal Reserve in the early stages of the financial crisis." Journal of Economic Perspectives 23.1 (2009): 51-75. Retrieved from https://www.researchgate.net/publication/227349731_Crisis_and_Responses_The_Federal_Reserve_in_the_Early_Stages_of_the_Financial_Crisis

Nautz, Dieter, and Sandra Schmidt. "Monetary policy implementation and the federal funds rate." Journal of Banking & Finance 33.7 (2009): 1274-1284. Retrieved from file:///C:/Users/Downloads/ImplementingMonetaryPolicyInAFragme_preview.pdf

Rockoff, Hugh. "Milton Friedman and Anna J. Schwartz on the Inherent Instability of Fractional Reserve Banking." Coping with Financial Crises. Springer, Singapore, 2018. 107-129. Retrieved from https://www.springer.com/gp/book/9789811061950