Friday, September 21, 2007

The Two Tools of Money

This post is focused on how money works in the economy. It directly relates to the policies that are used to control money directly influence the behavior of the real estate market, including the increase or decrease in home values. Having a basic knowledge of how money is supplied to the economy can help homeowners understand how economic-related hardships become more probably at certain times, and how best to take care of their personal finances in any economic cycle.

The mechanisms of money are controlled by two parties: the federal government and the Federal Reserve System. The government controls the supply of money through a process called "fiscal policy." The Federal Reserve Bank controls the supply of money through a process called "monetary policy." We will briefly discuss each of these policies, how they are enacted, and the eventual repercussions within the economy.

Fiscal policy is controlled by the federal government through the tax policy and government spending.

Through the use of taxes, the government can indirectly increase or decrease the supply of money that consumers and businesses have access to. When the government lowers taxes, everyone has more money to spend on other items, such as new homes, personal goods, or business equipment. If taxes are raised, the government collects more money from everyone, thereby decreasing the amount of money in the economy. This causes a general increase in prices due to the higher demand for fewer dollars.

In reality, this can be related to quite easily. If you receive a large tax refund every year, then you have more money to spend on items like TVs, computers, vacations, and food. If millions of people have extra money to spend on these items, then prices will increase to meet the rising demand. A small tax refund, or having to send the government a check due to higher taxes will cause you to spend less money on bills or consumer items. Prices will fall due to fewer people being able to afford items such as iPods or home additions.

In terms of the other method of influencing the economy, the amount of money the government spends can increase or decrease the supply of money in the economy. If the government increases federal spending to programs, then more money enters the economy. Alternately, if the government decreases its spending on federal programs, then less government money enters the economy.

In practice, this means that if the government spends extra on the federal forest fighting program, for instance, then more employees are hired and more firefighting equipment is purchased, which puts extra money into the economy. And if programs are cut or scaled back, employees are laid off and contracts are canceled for equipment, thereby decreasing the amount of money in the economy.

These are general explanations of the two main ways the government can influence prices of goods in the economy: through taxes and government spending. The effects of this fiscal policy techniques are felt indirectly by the economy as a whole and do not have the same level of impact as the monetary policy practiced by the Federal Reserve Bank.

The Federal Reserve Bank is the central bank of the US and sets the interest rates at which banks can borrow money from the federal government. The Fed, as it is commonly called, can control the supply of money in the economy directly by a number of different tactics.

The first way involves the Fed purchasing or selling government securities, such as Treasury Bills. If the Fed buys large numbers of these, then they exchange money for the securities, and more money is put into the economy when investors exchange their Treasury Bills for money. When the Fed sells these securities, then they are exchanging money from investors for the promise of money in the future, and this decreases the amount of money in the economy. Investors trade their dollars for Treasury Bills, and the Fed holds onto the dollars, preventing them from going back into the economy to be used for other purposes.

The Fed also controls the amount of money that banks have to deposit with the Federal Reserve Bank. When banks have to deposit a large amount with the Fed, then this money can not be used for additional loans for consumers or businesses. This can raise interest rates, because more parties are competing for less money. If the Fed lowers the deposit requirement (known as the reserve requirement), then banks can use more of their money to extend credit to customers, and this money finds its way into the economy. Interest rates for loans and mortgages will go down, as there is more supply of money to be loaned out.

A final way that the Federal Reserve can control money is by directly raising or lowering the interest rate at which banks borrow money from the Fed. When banks have short-term problems paying extending credit or paying on demand deposits (such as checking accounts), they can borrow money from the Federal Reserve directly to meet their needs. If the Fed raises interest rates, then banks are less willing to borrow money and do not lend as much money, or lend money at higher rates. As the Fed lowers its rates, then banks can also lower their rates or extend extra credit, as their cost of borrowing decreases.

The Fed directly influences the economy by controlling the total supply of money by creating or destroying money and determining the rate at which consumers can borrow money.

Homeowners are the group most directly affected by these changes in the money supply. If home values decrease as a result of higher interest rates, or a recession in the economy, then homeowners in foreclosure may find that they owe more on their homes than the current value. They will have a hard time selling their homes to stop foreclosure, and may not be able to refinance at all.

Thankfully, the economy operates in cycles of increasing and decreasing values, with a general optimistic trend. This means that prices, even if they decrease, can generally be expected to increase to their original price in the near future and will almost always increase beyond their original price in the long term. Of course, this is only small consolation for foreclosure victims who would benefit from higher home values in the short term.

Hopefully, this post explains clearly how the supply and cost of money in the economy, with a focus on home values, is affected by changes in governmental policy and operational policy of the Federal Reserve System. It is meant to give homeowners a bit of information regarding the broader economic context of their fight to stop foreclosure. It is not meant to provide an exhaustive explanation of how our economy works, but merely to be a meaningful introduction.

Knowing that the economy operates in cycles that are affected by these two entities can help homeowners realize that a foreclosure season in the economy is just like any other season: it comes periodically, may have extreme conditions, but will eventually pass into a different phase leaving only memories.

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