Link between the Fed Money, Debt & Taxes: Explained

Link between the Fed Money, Debt and Taxes: Explained

Introduction: 

  • The Federal Reserve System often referred to as the Federal Reserve or simply "the Fed," is the central bank of the United States. 
  • It was established on December 23, 1913 when the 28th US President Woodrow Wilson signed the Federal Reserve Act of 1913.
  • It was created “to provide the nation with a safer, more flexible, and more stable monetary and financial system”. Thus, there exists a direct link between the Fed and the Money. 

Fed and the Fiat Money: 

  • On August 15, 1971, the 37th US President Richard Nixon announced to the world that the “United States was closing the gold window.” Fiat Currency System was introduced in the USA. 
  • Fiat money is a currency established as money by government regulation or law. Fiat money has value and is good for exchange simply because the authorities say so. 

Creation of Money Supply: 

  • The money that the Fed uses to buy Treasury Securities and that the Fed receives and holds in trust as collateral is through the new money it has created and put into circulation. 
  • When the Fed buys Treasury securities, it does not print money to buy the Treasury Securities. The Fed issues a credit to the banking institutions and records the value of the Treasury Securities on its balance sheet. 
  • The banking institutions treat the credit just like money, even though no actual money has been printed. 

Fractional Reserve Banking and Increase in Money Supply: 

  • The Fed also increases the money supply in the country through the route of Fractional Reserve Banking. 
  • Fractional Reserve Banking is the practice whereby a bank accepts deposits, makes loans or investments, and holds reserves equal to a fraction of its deposit liabilities. 
  • This system facilitates the expansion of the money supply through Multiplier Effect. 
  • The multiplier effect is the expansion of a country's money supply that results from the ability of the banks to lend. 
  • The multiplier effect is implemented through the reserve requirement set forth by the Fed and this reserve requirement has been maintained at a rate of 10% since 2006. 
  • This mechanism of multiplier effect put in place by the Fed facilities the increase in money supply that could be theoretically increased by a factor of up to 10 times the amount of assets held. 

Velocity of Money and Money Supply: 

  • The Fed also takes into consideration the phenomenon of Velocity of Money.
  • The velocity of money is the rate at which money is exchanged from one transaction to another and how much a unit of currency is used in a given period of time. 
  • The Fed estimates the velocity of money in the country in order to meet a portion of the demand for money that is needed to be in circulation to fulfill the requirements of all the economic production that takes place in the U.S. economy. 

The Fed and the Debt Level in the United States: 

  • According to the Organisation for Economic Co-operation and Development (OECD), Government’s gross debt (federal, state, and local) in the United States is expected to be nearly $20.1 trillion, at the end of the Financial Year 2017. 
  • Apparently it seems to be very high. However, in the light of the US GDP at the end of 2016 of $18.562 trillion – it seems to be the appropriate level. 
  • The Fed takes decisions from time to time in order to assess and adjust the money supply level in the country as per the level of the economic production and the national debt level. 

The Fed and the Taxes in the United States: 

  • The Fed is playing a very crucial, important and significant role in the US Banking System and along with that as the central bank of the country it has to more or less maintain the balance among its own balance sheet, the money supply level in the country, the national debt level and the annual economic production of the country. 
  • Of all these, the Fed has to pay more attention towards maximization of the US economic production. With the greater percentage of increase in the US economic production, the path of the lower personal income tax rates and the lower corporate tax rates would be paved without compromising on the overall taxation revenue collected. 
  • And the lower taxation rates would mean that more of the money is left with the individual tax payers as well as corporate tax payers and in turn they would invest more in the rapidly developing technological efficiencies in order to boost further the US economic production and thereby increasing the volume of taxation ravenue even through the decrease in the taxation rates as the Taxation Rates are directly correlated with the nation’s economic production. 
  • The Fed also keeps a vigil on the aspect that the overall tax revenues are adequately generated in tune with the money supply needs of the growing economy. 

Conclusion: 

In a nutshell it can be said that there exists a crucial chain link among the various components of the US economy: the Fed through its balance sheet, the Money Supply in the US, the US Debt Level, the Rates of taxes in the US, total US economic production. It is the obligation of the Fed to supervise that all these are maintained at comparable levels for the future healthy growth of the US economy. More or less, the same formulas can be applied by the other nations also by learning a lesson from the Fed policies reflecting the vision of the US administration. After all, the US economy is the largest economy of the world and accounts for 24.5% of the Global GDP although it nearly grew at the rate of 2.4% in the year 2016. The actions of the Fed naturally deserve a big appreciation and admiration for this Himalayan achievement since its inception in 1913 – 104 years ago.

Special Note:
Seven largest economies of the world in terms of World GDP Ranking 2016 are: United States ($ 18562 Billion), China ($ 11392 Billion), Japan ($ 4730 Billion), Germany ($ 3495 Billion), UK ($ 2650 Billion), France ($ 2488 Billion) and India ($ 2251 Billion).

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