by Deepthi Sai
The health of any economy is largely dependent on 3 main players:
Let us start with the government. The government earns money (mainly through taxes) and spends money essentially on infrastructure, social security payments, defence and debt servicing. The government uses its revenue and expenditure to influence the economy. For instance, a decrease in taxes, leaves individuals in the economy with more money to spend and hence influences demand for goods. The government might also increase spending on infrastructure to increase economic activity. The use of such tools (taxes and government spending) to impact the economy is called ‘fiscal policy.’ In any financial year, the government plans its budget so that their total revenue equals their total expenditure. A mismatch can either lead to a surplus (when revenue exceeds expenditure) or a deficit (when expenditure exceeds revenue). A surplus on the budget is good news for the government but what is seen more frequently in the world is a deficit. Most economies finance their deficit through borrowings which is done by issuing bonds.
A bond is a promise to return the money borrowed at a later date with some interest on the initial amount. At this stage, financial institutions and commercial banks step in. When the government issues bonds, these institutions buy them. Thus, the amount they pay to the government for these bonds is what is used to finance the deficit on the budget. But these institutions, too, need money for making loans and to buy treasury bonds. This happens through the ‘fractional reserve system.’
Now to understand this, consider a simple example. Suppose individual X makes a deposit of $100 at Bank A. Now out of this $100, the central bank sets a ratio which must be kept aside, say 20 percent. This is called the ‘reserve requirement’ or the cash reserve ratio (CRR). Thus $20 becomes the reserve requirement. The central bank uses the reserve requirement to control the amount of money in circulation in the economy and to influence commercial banks’ ability to make loans. If there is a recession in the economy and people are not buying goods, the central bank might reduce CRR to increase people’s purchasing power and their demand for goods.
The remaining $80, kept in the bank vault is of no use to the bank. It makes more sense for the bank to loan it to someone else and earn interest on it. Thus, they loan it out to Y, who deposits it in his bank, say Bank B. Now Bank B must also keep aside the reserve requirement which is 20 percent of $80 (or $16) and loans out the remaining $64 to Z who deposits it in Bank C. A simplistic assumption in the example is that Y and Z deposit their loan in their bank. In reality, they use the money to purchase goods from someone else who will deposit it in their bank.
Thus in the economy, X has $100, Y has $80, Z has $64 and this process keeps continuing. It is evident how the initial $100 gets multiplied manyfold, increasing the purchasing power of many individuals (X, Y and Z in this example) in the economy.
The health of any economy is largely dependent on 3 main players:
- The central bank (e.g., the Federal Reserve System in the US, Reserve Bank of India);
- Financial institutions and commercial banks (e.g., Bank of America, Citibank); and
- The government.
Let us start with the government. The government earns money (mainly through taxes) and spends money essentially on infrastructure, social security payments, defence and debt servicing. The government uses its revenue and expenditure to influence the economy. For instance, a decrease in taxes, leaves individuals in the economy with more money to spend and hence influences demand for goods. The government might also increase spending on infrastructure to increase economic activity. The use of such tools (taxes and government spending) to impact the economy is called ‘fiscal policy.’ In any financial year, the government plans its budget so that their total revenue equals their total expenditure. A mismatch can either lead to a surplus (when revenue exceeds expenditure) or a deficit (when expenditure exceeds revenue). A surplus on the budget is good news for the government but what is seen more frequently in the world is a deficit. Most economies finance their deficit through borrowings which is done by issuing bonds.
A bond is a promise to return the money borrowed at a later date with some interest on the initial amount. At this stage, financial institutions and commercial banks step in. When the government issues bonds, these institutions buy them. Thus, the amount they pay to the government for these bonds is what is used to finance the deficit on the budget. But these institutions, too, need money for making loans and to buy treasury bonds. This happens through the ‘fractional reserve system.’
Now to understand this, consider a simple example. Suppose individual X makes a deposit of $100 at Bank A. Now out of this $100, the central bank sets a ratio which must be kept aside, say 20 percent. This is called the ‘reserve requirement’ or the cash reserve ratio (CRR). Thus $20 becomes the reserve requirement. The central bank uses the reserve requirement to control the amount of money in circulation in the economy and to influence commercial banks’ ability to make loans. If there is a recession in the economy and people are not buying goods, the central bank might reduce CRR to increase people’s purchasing power and their demand for goods.
The remaining $80, kept in the bank vault is of no use to the bank. It makes more sense for the bank to loan it to someone else and earn interest on it. Thus, they loan it out to Y, who deposits it in his bank, say Bank B. Now Bank B must also keep aside the reserve requirement which is 20 percent of $80 (or $16) and loans out the remaining $64 to Z who deposits it in Bank C. A simplistic assumption in the example is that Y and Z deposit their loan in their bank. In reality, they use the money to purchase goods from someone else who will deposit it in their bank.
Thus in the economy, X has $100, Y has $80, Z has $64 and this process keeps continuing. It is evident how the initial $100 gets multiplied manyfold, increasing the purchasing power of many individuals (X, Y and Z in this example) in the economy.
Another way for banks to get money is simply by issuing bonds, like the government does, to individuals. Individuals buy bonds belonging to financial institutions hoping for a reimbursement of their money with some interest. The health of financial institutions impacts financial markets and their ability to make loans. If the financial institutions do not have enough money to make loans, there will be a credit crunch in the economy, which is when a problem starts. If banks do not give out loans, people who wish to undertake business have no access to money. A credit crunch can impact businesses and therefore, employment and economic activity in general. This is exactly what is happening in a lot of economies today. As these institutions stand on shaky ground, they start depending on the central bank.
So, how does the central bank help them? These financial institutions have different bonds in their possession. Some belong to the home government, and some belong to governments of other countries. They deposit these bonds as collateral (for protection against default) with the central bank and receive printed money from the central bank. The process of printing new money is called ‘deficit financing.’ However, the central bank has to make an informed choice about printing money and increasing currency supply in the economy.
If there is too much money in circulation in the economy, it could lead to inflation, a situation in which there is too much money in the economy and few goods to spend it on. Thus the value of money falls, increasing the value of the goods. This function of the central bank where it controls money supply in the economy while ensuring stability in prices is called ‘monetary policy.’
Monetary and fiscal policy are very important tools through which governments and monetary authorities battle economic problems of unemployment and inflation. Understanding the dynamics at work between the central bank, governments and financial institutions can prove to be very useful in better comprehension of the 2008 economic crisis and the more recent European crisis.
So, how does the central bank help them? These financial institutions have different bonds in their possession. Some belong to the home government, and some belong to governments of other countries. They deposit these bonds as collateral (for protection against default) with the central bank and receive printed money from the central bank. The process of printing new money is called ‘deficit financing.’ However, the central bank has to make an informed choice about printing money and increasing currency supply in the economy.
If there is too much money in circulation in the economy, it could lead to inflation, a situation in which there is too much money in the economy and few goods to spend it on. Thus the value of money falls, increasing the value of the goods. This function of the central bank where it controls money supply in the economy while ensuring stability in prices is called ‘monetary policy.’
Monetary and fiscal policy are very important tools through which governments and monetary authorities battle economic problems of unemployment and inflation. Understanding the dynamics at work between the central bank, governments and financial institutions can prove to be very useful in better comprehension of the 2008 economic crisis and the more recent European crisis.
very well written :)
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