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datalog, Banker
Category: Finance
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Experience:  FINRA/NASD 6 & 63, Health, Life & Annuities License, Bank Vice President
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how banks create” money. a. Explain in your own

Resolved Question:

how banks “create” money.

a. Explain in your own words the process by which banks “create” money.

b. Discuss the impact of that ability to create money on the economy during an inflationary gap, as well as during a recessionary gap.

c. Considering the higher rates of unemployment and the likelihood of lower prices during a recessionary gap, do banks with their lending policies, contribute to a recovery back to potential output, or hinder that recovery? Why do you believe your answer to be correct? What about during an inflationary gap?
Submitted: 6 years ago.
Category: Finance
Expert:  datalog replied 6 years ago.

datalog :

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The impact of the central bank, which in the United States is the Federal Reserve of creating cheap money, is vital to the financial system. It can be argued that only the central bank has this ability, which is sometimes referred to as the printing of money. Considering that we no longer use the gold standard/bars to back our currency, the FED’s ability to produce just the right amount of cash in the system is a delicate dance. Since if it prints too much, we run the risk of inflation “higher than the Fed’s target” level. We all know the risk that inflation has on the economy which can cause the runaway in the prices, a devaluation of our currency which in turns causes imported items to be more expensive. However, such money printing can cause locally produced items to be less expensive, which in turn can have a positive impact on a country’s trade deficit. Case in point. Is our current Fed policy of cheap money with lowered interest rates? The dollar can be argued is at risked of being undervalued, however, the positive impact is that Americans are more likely to purchase more goods and services produced locally versus imports, which again has a positive impact on our trade deficits, balance of payments and the rate of employment. Thus, if we consume more made in American products, more jobs will be created and this in terms will have a positive impact on the unemployment rate. The trick to this delicate dance is to control inflation and currency value.

Banks do serve a positive function in the above explanation, as cheap funds from the FEDs allow commercial banks to lend money at lowered interest rates. Banks are more likely to lend to businesses for the development of the economy versus keeping the money on deposit/or stored away at the FED earning a low rate of return. It can be argued that history has showed show that economies with easier lending are more likely to jump start their economies and thus lower their high unemployment rates, because businesses are more likely to “take risk” and invent and the banks are similarly incentived to invest in the economy as a partner with the business owner. With the goal of producing a higher return on deposited funds versus investing in government papers.

I believe the above is correct, with very few exceptions for example Japan. Although the Japanese had practically a zero interest rate economy for government papers, the easy of doing business arguable not the same as in the USA. When I say the easy, I am referring to obtaining business licenses/permits etc., To conclude, a cheap monetary policy will be effective only with effective government policies in terms of the easy of doing business, etc., However, during an inflationary gap, I will refer back to the “delicate dance” as cheap money defeats the goal of lowered interest rates, etc., if high inflation becomes a issue. Albeit our current economy situation. All things being equal, the prices of locally produced goods and services will arguably stay constant; however, in terms of factors external to the control of the FED such as the importation of oil and foreign good & services. These we cannot control and if this procedure is not monitored weekly, monthly, quarterly, etc, will defeat the goal of easy/cheap money in the markets.

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