Thursday, September 18, 2008

US Financial Crisis

The US $85 billion dollars bailout of AIG by the Federal Reserve on Tuesday helped ward off a major financial crisis engulfing the United States for the time being.

US $85 billion ! That is a huge sum of money! So invariably some people would start questioning where does the Federal Reserve get its source of income from?

According to the Federal Reserve Website:

The Federal Reserve's income is derived primarily from the interest on U.S. government securities that it has acquired through open market operations. Other sources of income are the interest on foreign currency investments held by the System; fees received for services provided to depository institutions, such as check clearing, funds transfers, and automated clearinghouse operations; and interest on loans to depository institutions (the rate on which is the so-called discount rate). After paying its expenses, the Federal Reserve turns the rest of its earnings over to the U.S. Treasury

At this time of a likely looming economic crisis, where dollars and cents are the buzzwords, I believe many may still do not understand the fundamental term of the word, ‘money’, thus it is a good time to recall the fundamentals of ‘moneytalk’.

Many layman associate money with the dollars and cents one carry and keep in his saving accounts. To economists, they are partially correct.
Strictly speaking, the definition of money supply or total amount of money within an economy is as follows:

Money supply = M1+M2+M3

M1 includes all physical denominations of coins and currency, demand deposits and travelers' checks (money used to make payments).
M2 adds all the money found in M1 to all time-related deposits, savings deposits, and non-institutional money-market funds (money that can be readily transferred into cash). M3 combines all money found in the M2 definition and adds to it all large time deposits, institutional money-market funds, short-term repurchase agreements, along with other larger liquid assets.

Before we used currencies and banking as of today, man carried out Barter trade.

So what is money? For some definitions, you may look at this website. As you can see from the website, money itself is an abstract concept.

Money is not just the dollars and cents you carry or have in your banks.
The government doesn't create money, private banks do and they do so by making loans.

Making loans is creating money, how? Let me explain:

An example, I put $500 in my account and my bank assumes I would not be drawing it out that fast and lends $385 of my $500 to Tom which he decides to use on a holiday. Now Tom has $385 and I've got $500 in my account which theoretically I can draw out at any time. The local money supply has thus bloomed from $500 to $885 !!!

It doesn't stop there. If Tom puts the $385 in his account, his bank will lend out most of it, increasing the money supply even more!

However if everybody decided to take what they had in their accounts and bury it in their gardens, the financial system may collapse.

In the US, the total amount of money that banks can create is regulated by the Federal Reserve, the Central bank of U.S. Too much money would certainly lead to an inflation.

The central bank can increase the money supply by buying government fixed-income bonds (that is how the US government gets some of its income) in the market and hence putting money in the hands of the public. How does a central bank such as the Federal Reserve pay for this? As strange as it sounds, they simply create the money out of thin air and transfer it to those people selling the securities!

To reduce the money supply, the central bank sells government securities.
The money with which the buyer pays the central bank is essentially taken out of circulation.

Now we talk about currency…..

In the U.S, the US Treasury Department prints it, but the amount actually distributed to the public is purely a function of consumer demand. If people want more currencies, they draw out from their accounts. So how much currency is produced daily by the US Treasury Department? Please see this website for answer.

Too much currency produced and released into the market would definitely and utimately lead to inflation when there's way too much money and not enough to buy.

When I check out this website, and this other website, I was shocked to note the US debt as of today is around US $ 9.6 trillion! The U.S. government's national debt is growing by almost $1 million per minute, or $1.4 billion per day! One website even report the debt as US $53 trillion! and US $59 trillion in this website!

Should the financial crisis continues to aggravate, the whole world may be heading to a recession or a depression. According to this website,

A depression is any economic downturn where real GDP declines by more than 10 percent. A recession is an economic downturn that is less severe.

And that’s enough economical terms for now!

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