A bank's ability to provide loans

 A bank's ability to provide loans is limited by only 2 things:

• the amount of its deposits and
• its reserve requirements. 

The reserve requirements are determined by the central bank or monetary authority.

Most banks are required to put a minimum percentage of their funds - 10% of deposits, for example - on reserve and are prohibited from lending these funds back to customers.

If a central bank increases the reserve requirement, it effectively reduces the money supply, since banks then have less to lend to businesses and consumers.

On the other hand, by reducing the reserve requirements - as several central banks around the world did during the Great Recession of 2008 - they allow the country's banks to lend more, stimulating the economy and releasing even more money for lending.

The main tool for fighting uncontrolled inflation: reduce the money supply

The main tool for fighting uncontrolled inflation is for the government and local monetary authorities to reduce the money supply.

Since most easily accessed money is in the form of bank deposits, the most efficient way for a central bank to control the money supply is by regulating 

• bank lending and 
• reserve requirements.

Essentially, when banks have more money to lend to customers, the economy grows  And when banks reduce their lending the economy slows.

The reason central bank monetary policy works so well is because of the multiplier effect.

Measuring and Monitoring Overheating economy and Slowing economy

Interest rates and Money supply

Interest rates and money supply are the major tools the Fed and other central banks have traditionally used to control economic growth; the key is in how the tools are applied.

A country's economy is regulated by its money supply, which determines interest rates.  And each country's money supply is controlled by its central bank.  These quasi-public institutions are set up by governments but are then given the independence to keep an economy under control without undue interference from dabbling politicians.

How to measure and monitor growth and inflation in an economy?

Despite the tendency of the media to concentrate on the latest major economic statistic, such as GDP growth or unemployment, there is no one single indicator that tells us 

• how fast an economy is growing or 
• if that growth will lead to inflation down the road.

In addition, there is no way to know how quickly an economy will respond to changes in monetary policy.  

• If a country's central bank allows the economy to expand too rapidly - by keeping too much money in circulation, for example - it may cause bubbles and rampant inflation.  
• But if it slows down the economy too much, an economic recession can result, bringing financial turmoil and severe unemployment.  
• When economic stagnation coincides with high inflation, sometimes referred to as stagflation, a worst-case scenario is created.

Central bankers, therefore, need to be prescient and extremely careful - keeping 

• one eye on inflation, which is usually a product of an overheating economy, and 
• one eye on unemployment, which is almost always the product of a slowing economy.

In the twenty first century, with the amount of capital flowing around the world dwarfing many countries' money supplies, it is almost impossible to know with certainty what the effect of any one monetary decision will have on a local economy, let alone on the world.

Fiscal policy or Massive deficit spending

Given the extremely low inflation rates in the 2010s, some have called for alternative methods for controlling economic growth.  Instead of using the central banks' authority to raise tor lower interest rates, referred to as "monetary policy," another solution would be to use "fiscal policy" to alter the money supply - essentially allowing governments to circumvent central banks by printing massive amounts of money to increase the money supply, for example.  

The use of a government's ability to issue new currency to influence economic growth, commonly referred to as Modern Monetary Theory (MMT), is not unproblematic in that inflation can come roaring back at a moment's notice.  

Many governments may misuse the power of MMT to pay for massive deficit spending in ways that lack the prudent guidance provided by the world's central banks.

Unforeseen and unpredictable events

Sometimes financial crises are caused by - and sometimes solved by forces -  entirely unconnected to the original problem.  

Most of the recent financial meltdowns, 

• from the stock market crash of 1987, 
• to the bursting of the dot-com bubble in 2000, 
• to the market collapse following the terrorist attacks of September 11, 2001, 

were exacerbated by economic and sociopolitical forces well outside the control of any one country and greatly affected markets around the world.

How Banks Create Money out of Thin Air

Inflation and the Dollar's crash

Money as debt

http://financialindependent.blogspot.com/2010/01/understand-money-as-debt-concept.html


http://video.google.com/videoplay?docid=-2550156453790090544&hl=en#
Money as debt (47 minute video)

Our Monetary System is NOT Sustainable?

In previous example, you will notice that majority of the money that we have today in this economy is created by loan or debt. Therefore in other words, the money supply to this economy is equal to the total amount of loan principal. However, when you pay back to bank, you're paying not only the principal but the interest of the loan.

Money Supply = Loan Principal
Money Owed = Loan Principal + Loan Interest

The total of money circulate in this economy is approximately equal to the total of loan principal. So now you need to pay the extra loan interest to the bank, where do you get the money from? There are only 2 possibilities:

Not everyone will not able to pay back the loan together with interest

To avoid that from happening, bank will supply more money to the economy by creating more loans

In order to sustain this monetary system, more debts needs to be created to make sure the system have enough money supply to pay back the loan interest. The funny thing is when more debts are created, more debt interests are created too. Thus, more money you owe. This is the exponential thing and are fixing the things or making it worse? Will this continue forever or will it collapse one day?

The Economic Climate (11): Fed and Money Supply

The agency in charge of climate control is the Federal Reserve System, also known as the Fed. 

It has a special way of heating things up and cooling things down - not by blowing on them, but by adding and subtracting money.  Given its huge importance, it's amazing how few people know what the Fed is all about.

In a survey from several years ago, some people said the Federal Reserve was a national park, while others thougth it was a brand of whiskey.

In fact, it's the central banking system that controls the money supply. (Monetary policy)



Whenever the economy is cooling off too much, the Fed does 2 things. 

(1)  It lowers the interest rates that banks must pay when they borrow money from the government. 

• This causes the banks to lower the interest rates they charge to their customers, so people can afford to take out more loans and buy more cars and more houses. 
• The economy begins to heat up.

(2)  The Fed also pumps money directly into the banks, so they have more to lend. 

• This pumping of money also causes interest rates to go down. 

And in certain situations, the government can spend more money and stimulate the economy the same way you do every time you spend money at a store. (Fiscal policy)



If the economy is too hot, the Fed can take the opposite approach:  raising interest rates and draining money from the banks. 

This causes the supply of money to shrink , and interest rates go higher. 

• When this happens, bank loans become too expensive for many consumers, who stop buying cars and houses. 
• The economy starts to cool off. 
• Business lose business, workers lose jobs, and store owners get lonely and slash prices to attract customers.

Then at some point, when the economy is thoroughly chilled, the Fed steps in and heats it up again.  The process goes on endlessly, and Wall Street is always worried about it.

The Economic Climate (1): Companies live in this economic climate

Companies live in a climate - the economic climate.

They depend on the outside world for survival, just as plants and humans do. 

• They need a steady supply of capital, also known as the money supply.
• They need buyers for whatever it is they make, and
• Suppliers for whatever materials they make it from. 
• They need a government that lets them do their job without taxing them to death or pestering them to death with regulations.

When investors talk about the economic climate, they don't mean sunny or cloudy, winter or summer.  They mean the outside forces that companies must contend with, which help determine whether

• they make money or
• lose money,

and ultimately, whether they

• thrive or
• wither away. 

How do central banks inject money into the economy?

Investment Question
How do central banks inject money into the economy?

Central banks use several different methods to increase (or decrease) the amount of money in the banking system. These actions are referred to as monetary policy. While the Federal Reserve Board (the Fed) could print paper currency at its discretion in an effort to increase the amount of money in the economy, this is not the measure used.

Here are three methods the Fed uses in order to inject (or withdraw) money from the economy:

1. The Fed can influence the money supply by modifying reserve requirements, which is the amount of funds banks must hold against deposits in bank accounts. By lowering the reserve requirements, banks are able loan more money, which increases the overall supply of money in the economy. Conversely, by raising the banks' reserve requirements, the Fed is able to decrease the size of the money supply.
2. The Fed can also alter the money supply by changing short-term interest rates. By lowering (or raising) the discount rate that banks pay on short-term loans from the Federal Reserve Bank, the Fed is able to effectively increase (or decrease) the liquidity of money. Lower rates increase the money supply and boost economic activity; however, decreases in interest rates fuel inflation, so the Fed must be careful not to lower interest rates too much for too long.
3. Finally, the Fed can affect the money supply by conducting open market operations, which affects the federal funds rate. In open operations, the Fed buys and sells government securities in the open market. If the Fed wants to increase the money supply, it buys government bonds. This supplies the securities dealers who sell the bonds with cash, increasing the overall money supply. Conversely, if the Fed wants to decrease the money supply, it sells bonds from its account, thus taking in cash and removing money from the economic system.

To learn more about central banks and their role in monetary policy, check out Formulating Monetary Policy.

http://www.investopedia.com/ask/answers/07/central-banks.asp?ad=feat_fincrisis

How do I gauge the trend of interest rate?

Question: How do I gauge the trend of interest rate?

Generally, the central bank of a country uses interest rates to control inflation. Therefore, an understanding of interest rate trend is important since it invariably affects the stock market.

Basically, the trend of interest rates tend to depend on several factors.

One of the more important factors concerns the growth of money supply, that is, by comparing M3 with the economic growth which is that of Gross Domestic Product (GDP).


Illustration.

Country "A" (Broad Money Supply M3) Year 1993

*Broad money supply (M3) = A + B + C = $38.3bn
Annual % change in M3 = 24%

GDP (Rate of expansion) = 12.6%

Base Lending Rate (BLR) Current = 7.1% - 7.25%

Conclusion: The economy is facing high risks of inflation as the M3 growth rate of 24% is twice as fast as the rate of expansion which is 12.6% in nominal GDP.

Possible Action: As there is likely to be a surge in inflation in the immediate future, an increase in the BLR to 8.5% is a possible move in order to bring M3 growth rate back to about 15%.

Effect: Interest rate in Country "A" could be on the rise.


_____________

*Broad Money Supply (M3) = A+B+C
The Determinants are:......................... 1993......... % change

A. Net Lending to Government..........1.6bn........-1.0%

B. Private Sector Credit Demand........18.1bn......11.3%
Manufacturing...................2bn....+1.2%
Construction....................1.3bn....0.8%
Commerce.......................1.8bn....1.0%
Transport........................2.2bn....1.4%
Other Business...............1.0bn....0.7%
Personal...........................9.8bn...6.2%

C. External Liquidity.........................21bn......13.7%
Traders & Income
Repatriation........-5.4bn....-6.0%
Investments..................11.7bn....8.4%
Short Term Funds........15.5bn...11.3%


Ref: Making Mistakes in the Stock Market by Wong Yee