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No Such Thing as a Free Lunch: Principles of Economics (Part 122)

Money is a mechanism for control.

David Korten

The Money Supply and the Federal Reserve System

(Part E)

by

Charles Lamson 

The Federal Reserve System

We have seen in the last few posts how the private banking system creates money by making loans. However, private banks are not free to create money at will. Their ability to create money is controlled by the volume of reserves in the system, which is controlled by the Federal Reserve (the Fed). The Fed, therefore, has the ultimate control over the money supply. We will now examine the structure and function of the Fed.

Founded in 1913 by an act of Congress (to which major reforms were added in the 1930s), the Fed is the Central Bank of the United States. The Fed is a complicated institution with many responsibilities, including the regulation and supervision of over 8,000 commercial banks. The organization of the Federal Reserve System is presented in Figure 4.

FIGURE 4 The Structure of the Federal Reserve System

The Board of Governors is the most important group within the Federal Reserve System. The board consists of seven members, each appointed for 14 years by the president of the United States. The chair of the Fed, who is appointed by the president and whose term runs for four years, usually dominates the entire Federal Reserve System and is sometimes said to be the second most powerful person in the United States. The Fed is an independent agency in that it does not take orders from the president or from Congress.

The United States is divided into 12 Federal Reserve Districts, each with its own Federal Reserve Bank. These districts are indicated on the map in Figure 4. The district banks are like branch offices of the Fed in that they carry out the rules, regulations, and functions of the central system in their districts and report to the Board of Governors on local economic conditions.

U.S. monetary policy---the behavior of the Fed concerning the money supply---is formally set by the Federal Open Market Committee (FOMC). The FOMC consists of the seven members of the Fed's Board of Governors, the president of the New York Federal Reserve Bank, and, on a rotating basis, four of the presidents of the 11 other district banks. The FOMC sets goals concerning the money supply and interest rates, and it directs the Open Market Desk in the New York Federal Reserve Bank to buy and/or sell government securities. (We discuss the specifics of open-market operations later.)

Functions of the Federal Reserve

The Fed is the central bank of the United States. Central banks are sometimes known as "bankers' banks" because only banks (and occasionally foreign governments) can have accounts in them. As a private citizen, you cannot go to the nearest branch of the Fed and open a checking account or apply to borrow money.

Although from a macroeconomics point of view the Fed's crucial role is to control the money supply, the Fed also performs several important functions for banks. These functions include clearing interbank payments, regulating the banking system, and assisting banks in a difficult financial position. The Fed is also responsible for managing exchange rates and the nation's foreign exchange reserves. In addition, it is often involved in intercountry negotiations on international economic issues.

Clearing Interbank Payments Suppose you write a $100 check, drawn on your bank, the First Bank of Fresno (FBF), to pay for tulip bulbs from Crockett Importers of Miami, Florida. Because Crockett Importers does not bank at FBF, but at Banco de Miami, how does your money get from your bank to the bank in Florida?

The answer: The FED does it. Both FBF and Banco de Miami have accounts at the Fed. When Crockett Importers receives your check and deposits it at the Banco de Miami, the bank submits the check to the Fed, asking it to collect the funds from FBF. The Fed presents the check to FBF and is instructed to debit FBF's account for the $100 and to credit the account of Banco de Miami. Accounts at the Fed count as reserves, so FBF loses $100 in reserves and Banco de Miami gains $100 in reserves. The two banks effectively have traded ownerships of their deposits at the Fed. The total volume of reserves has not changed, nor has the money supply.

This function of clearing interbank payments allows banks to shift money around virtually instantaneously. All they need to do is wire the Fed and request a transfer, and the funds move at the speed of electricity from one computer account to another.

Other duties of the Fed besides facilitating the transfer of funds between banks, the Fed performs several other important duties. It is responsible for many of the regulations governing banking practices and standards. For example, the Fed has the authority to control mergers between banks, and it is responsible for examining banks to ensure they are financially sound and they conform to a host of government accounting regulations. As we saw earlier, the Fed also sets reserve requirements for all financial institutions.

One of the most important responsibilities of the Fed is to act as the lender of last resort for the banking system. As our discussion of goldsmiths suggested, banks are subject to the possibility of runs on their deposits. In the United States, most deposits of less than $100,000 are insured by the Federal Deposit Insurance Corporation (FDIC). Deposit Insurance makes panics less likely. Because depositors know they can always get their money, even if the bank fails, they are less likely to withdraw their deposits. Not all deposits are insured, so the possibility of bank panics remains. However, the Fed stands ready to provide funds to a troubled bank that cannot find any other sources of funds.

The FED is the ideal lender-of-last-resort for two reasons. First, providing funds to a bank that is in dire straits is risky and not likely to be very profitable, and it is hard to find private banks or other private institutions willing to do this. The Fed is a non-profit institution whose function is to serve the overall welfare of the public. Thus, the Fed would certainly be interested in preventing catastrophic banking panics such as those that occurred in the late 1920s and the 1930s.

Second, the Fed has an essentially unlimited supply of funds with which to bail out banks facing the possibility of runs. The reason, as we shall see, is that the Fed can create reserves at will. A promise by the Fed that it will support a bank is very convincing. Unlike any other lender, the Fed can never run out of money. Therefore, the explicit or implicit support of the Fed should be enough to assure depositors they are in no danger of losing their funds. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS

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No Such Thing as a Free Lunch: Principles of Economics (Part 121)

Those who are of the opinion that money will do everything may reasonably be expected to do everything for money.

Edward Wood, 1st Earl of Halifax

The Money Supply and the Federal Reserve System

(Part D)

by

Charles Lamson

The Creation of Money

Bankers seek to earn income by lending money out at a higher interest rate than they pay depositors for use of their money.

In modern times, the chances of a run on a bank are fairly small; and, even if there is a run, the central bank protects the private banks in various ways. Therefore, banks usually make loans up to the point where they can no longer do so because of the reserve requirement restrictions.

A bank's required amount of reserves is equal to the required reserve ratio times the total deposit in the bank. If a bank has deposits of $100 and the required ratio is 20 percent, the required amount of reserves is $20. The difference between a bank's actual reserves and its required reserves is its excess reserves:

excess reserves ≡ actual reserves - required reserves

If banks make loans up to the point where they can no longer do so because of the reserve requirement restriction, this means that banks make loans up to the point where their excess reserves are zero.

To see why, note that when a bank has excess reserves, it has credit available, and it can make loans. Actually, a bank can make loans only if it has excess reserves. When a bank makes a loan, it creates a demand deposit for the borrower. This creation of a demand deposit causes the bank's excess reserves to fall because the extra deposits created by the loan use up some of the excess reserves the bank has on hand. An example will help demonstrate this.

Assume there is only one private bank in the country, the required reserve ratio is 20 percent, and the bank starts off with nothing, as shown in panel 1 of Figure 2. Now suppose dollar bills are in circulation and someone deposits 100 of them in the bank. The bank deposits the $100 with the central bank, so it now has $100 dollars in reserves, as shown in panel 2. The bank now has assets (reserves) of $100 and liabilities (deposits) of $100. If the required reserve ratio is 20 percent, the bank has excess reserves of $80.

How much can the bank lend and still meet the reserve requirement? For the moment, let us suppose anyone who gets a loan keeps the entire proceeds in the bank or pays them to someone else who does. Nothing is withdrawn as cash. In this case, the bank can lend $400 and still meet the reserve requirement. Panel 3 shows the balance sheet of the bank after completing the maximum amount of loans it is allowed with a 20 percent reserve ratio. With $80 of excess reserves, the bank can have up to $400 of additional deposits. The $100 in reserves plus $400 in loans (which are made as deposits) equal $500 in deposits. With $500 in deposits and a required reserve ratio of 20 percent, the bank must have reserves of $100 (20 percent of $500) and it does. The bank can lend no more than $400 because its reserve requirement must not exceed $100. When a bank has no excess reserves and can make no more loans, it is said to be loaned up.

Remember, the money supply (M1) equals cash in circulation plus deposits. Before the initial deposit, the money supply was $100 ($100 cash and no deposits). After the deposit and the loans, the money supply is $500 (no cash outside of bank vaults and $500 in deposits). It is clear, then, that when loans are converted into deposits, the supply of money can change.

The bank whose T-accounts are presented in Figure 2 is allowed to make loans of $400 based on the assumption that loans that are made stay in the bank in the form of deposits. Now suppose I borrow from the bank to buy a personal computer, and I write a check to the computer store. If the store also deposits its money in the bank, my check merely results in a reduction in my account balance and an increase to the store's account balance within the bank. No cash has left the bank. As long as the system is closed in this way remember that we have so far assumed that there is only one bank---the bank knows that it will never be called on to release any of its $100 in reserves. It can expand its loans up to the point where its total deposits are $500.

Of course, there are many banks in the country, a situation that is depicted in Figure 3. As long as the banking system as a whole is closed, it is still possible for an initial deposit of $100 to result in an expansion of the money supply to $500, but more steps are involved when there is more than one bank.

To see why, assume Mary makes an initial deposit of $100 in bank 1, and the bank deposits the entire $100 with the Fed (panel 1 of Figure 3). All loans that a bank makes are withdrawn from the bank as the individual borrowers write checks to pay for merchandise. After Mary's deposit, bank 1 can make a loan of up to $80 to build, because it needs to keep only $20 of its $100 deposit as reserves. (We are assuming a 20 percent required reserve ratio.) In other words, bank 1 has $80 in excess reserves.

Bank 1's balance sheet at the moment of the loan to Bill appears in panel 2 of Figure 3. Bank 1 now has loans of $80. It has credited Bill's account with the $80. So its total deposits are $180 ($80 in loans plus $100 in reserves). Bill then writes a check for $80 for a set of shock absorbers for his car. Bill wrote his check to Sam's Car Shop, and Sam deposits Bill's check in bank 2. When the check clears, bank 1 transfers $80 in reserves to bank 2. Bank 1's balance sheet now looks like the top of panel 3. Its assets include reserves of $20 and loans of $80; its liabilities are $100 in deposits. Both sides of the T-account balance: The bank's reserves are 20 percent of its deposit, as required by law, and it is fully loaned up.

Now look at bank 2. Because bank 1 has transferred $80 in reserves to bank 2, it now has $80 in deposits and $80 in reserves (panel 1, bank 2). Its reserve requirement is also 20 percent, so it has excess reserves of $64 on which it can make loans.

Now assume bank 2 loans the $64 to Kate to pay for a textbook and Kate writes a check for $64 payable to the Manhattan College Bookstore. The final position of bank 2, after it honors Kate's $64 check by transferring $64 in reserves to the bookstore's bank, is reserves of $16, loans of $64, and deposits of $80 (panel 3, bank 2).

The Manhattan College Bookstore deposits Kate's check in its account with bank 3. Bank 3 now has excess reserves, because it has added $64 to its reserves. With a reserve ratio of 20 percent, bank 3 can loan out $50.20 (80 percent of $64, leaving 20 percent in required reserves to back the $64 deposit).

As the process is repeated over and over, the total amount of deposits created is $500, the sum of the deposits in each of the banks. Because the banking system can be looked on as one big bank, the outcome here for many banks is the same as the outcome in Figure 2 for one bank.

The Money Multiplier

In practice, the banking system is not completely closed---there is some leakage out of the system. Still, the point here is:

Do not confuse the money multiplier with the spending multiplier as we discussed in the last several posts. They are not the same thing.

In the example we just examined, reserves increase by $100 when the $100 in cash was deposited in a bank, and the amount of deposits increased by $500 ($100 from the initial deposit, $400 from the loans made by the various banks from their excess reserves). The money multiplier in this case is $500/$100 = 5. Mathematically, the money multiplier can be defined as:

money multiplier ≡ 1/ required reserve ratio

*CASE & FAIR, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 483-485*

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No Such Thing as a Free Lunch, Principles of Economics (Part 120)

Do what you love and the money will follow.

Marsha Sinetar

The Money Supply and the Federal Reserve

(Part D)

by

Charles Lamson

The Modern Banking System

To understand how the modern banking system works, you need to be familiar with some basic principles of accounting. Once you are comfortable with the way banks keeps their books, the whole process of money creation will seem logical.

A brief review of accounting Central to accounting practices is the statement that "the books always balance." In practice, this means that if we take a snapshot of a firm---any firm, including a bank---at a particular moment In time, then by definition:

Assets - Liabilities ≡ Net Worth, or

Assets ≡ Liabilities + Net Worth

Assets are things a firm owns that are worth something. For a bank, these assets include the bank building, its furniture, its holdings of government securities, cash in its vault, bonds, stocks, and so forth. Most important among the bank's assets, for our purposes at least, are its loans. A barrower gives the bank an IOU, a promise to repay a certain sum of money on or by a certain date This promise is an asset to the bank because it is worth something. The bank could (and sometimes does) sell the IOU to another bank for cash.

Other bank assets include cash on hand (sometimes called vault cash) and deposits with the United States' central bank the Federal Reserve Bank (the Fed). Federal banking regulations require that banks keep a certain portion of their deposits on hand as vault cash or on deposit with the Fed.

A firm's liabilities are its debts---what it owes. A bank's liabilities are the promises to pay, or IOUs, that it has issued. A bank's most important liabilities are its deposits. Deposits are debts owed to the depositors, because when you deposit money in your account, you are in essence making a loan to the bank.

The basic rule of accounting says that if we add up a firm's assets and then subtract the total amount it owes to all those who have lent it funds, the difference is the firm's net worth. Net worth represents the value of the firm to its stockholders or owners. How much would you pay for a firm that owns $200,000 of diamonds and had borrowed $150,000 from a bank to pay for them? The firm is worth $50,000---the difference between what it owns and what it owes. If the price of diamonds were to fall, bringing their value down to only $150,000, the firm would be worth nothing.

We can keep track of a bank's financial position using a simplified balance sheet called a T-account. By convention, the bank's assets are listed on the left side of the T-account and its liabilities and net worth, on the right side. By definition, the balance sheet always balances, so that the sum of the items on the left side of the T-account is exactly equal to the sum of the items on the right side.

The T-account in Figure 1 shows a bank having $110 million in assets, of which $20 million dollars are reserves, the deposits that the bank has made at the Fed and its cash on hand (coins and currency). Reserves are an asset to the bank because it can go to the Fed and get cash for them, just the way you can go to the bank and get cash for the amount in your savings account. Our bank's other asset is its loans, worth $90 million.

FIGURE 1

Why do banks hold reserves/deposits at the Fed? There are many reasons, but perhaps the most important is the legal requirement that they hold a certain percentage of their deposit liabilities as reserves. The percentage of its deposits that a bank must keep as reserves is known as the required reserve ratio. If the reserve ratio is 20 percent, Then a bank with deposits of $100 million must hold $20 million as reserves, either as cash or as deposits at the Fed. To simplify, we will assume that banks hold all of their reserves in the form of deposits at the Fed.

On the liability side of the T-account, the bank has taken deposits of $100 million, so it owes this amount to its depositors. This means that the bank has a net worth of $10 million to its owners ($110 million in assets - $100 million in liabilities = 10 million dollars net worth). The net worth of the bank is what "balances" the balance sheet. Remember:

If a bank's reserves increase by $1 then one of the following must also be true: (1) its other assets (e.g., loans) decrease by $1; (2) its liabilities (deposits) increase by $1; or (3) its net worth increases by $1. Various fractional combinations of these are also possible. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 481-482*

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No Such Thing as a Free Lunch: Principles of Economics (Part 119)

A bank is a place that will lend you money if you can prove that you don't need it.

Bob Hope

The Money Supply and the Federal Reserve System

(Part C)

by

Charles Lamson

How Banks Create Money

So far we have described the general way that money works and the way the supply of money is measured in the United States, but how much money is there available at any given time? Who supplies it, and how does it get applied? We are now ready to analyze these questions in detail. In particular, we want to explore a process that many find mysterious: the way banks create money.

A Historical Perspective: Goldsmiths

To begin to see how banks create money, consider the origins of the modern banking system. In the fifteenth and sixteenth centuries, citizens of many lands used gold as money, particularly for large transactions. Because gold is both inconvenient to carry around and susceptible to theft, people began to place their gold with goldsmiths for safekeeping. On receiving the gold, a goldsmith would issue a receipt to the depositor, charging him a small fee for looking after his gold. After a time, these receipts themselves, rather than the gold that they represented, began to be traded for good. The receipts became a form of paper money making it unnecessary to go to the goldsmith to withdraw gold for a transaction. 

At this point, all the receipts issued by goldsmiths were backed 100 percent by gold. If a goldsmith had 100 ounces of gold in a safe, he would issue receipts for 100 ounces of gold, and no more. Goldsmiths functioned as warehouses where people stored gold for safekeeping. The Goldsmiths found, however, that people did not come often to withdraw gold. Why should they, when paper receipts that could easily be converted to gold were "as good as gold"? (In fact, receipts were better than gold---more portable, safer from theft, and so on.) As a result, goldsmiths had a large stock of gold continuously on hand.

Because they had what amounted to "extra" gold sitting around, goldsmiths gradually realized that they could lend out some of this gold without running out of gold. Why should they do this? Because instead of just keeping their gold idly in their vault, they earned interest on loans. Something subtle, but dramatic, happened at this point. The goldsmiths changed from mere depositories for gold into banklike institutions that had the power to create money. This transformation occurred as soon as goldsmiths began making loans. Without adding any more real gold to the system, the goldsmiths increased the amount of money in circulation by creating additional claims to gold---that is, receipts, which entitled the bearer to receive a certain number of ounces of gold on demand. Thus there were more claims than there were ounces of gold.

A detailed example may help to clarify this. Suppose you go to a goldsmith who is functioning only as a depository, or warehouse, and ask for a loan to buy a plot of land that costs 20 ounces of gold. Also suppose that the goldsmith has 100 ounces of gold on deposit in his safe and receipts for exactly 100 ounces of gold out to the various people who deposited the gold. If the goldsmith decides he is tired of being a mere goldsmith and wants to become a real bank, he will loan you some gold. You don't want the gold itself, of course; rather, you want a slip of paper that represents 20 ounces of gold. The goldsmith in essence "creates" money for you by giving you a receipt for 20 ounces of gold (even though his entire supply of gold already belongs to various other people). When he does, there will be receipts for 120 ounces of gold in circulation instead of the 100 ounces worth of receipts before your loan, and the supply of money will have increased.

People think the creation of money is mysterious. Far from it! The creation of money is simply an accounting procedure, among the most mundane of human endeavors. You may suspect the whole process is fundamentally unsound, or somehow dubious. After all, the banking system began when someone issued claims for gold that already belongs to someone else. Here you may be on slightly firmer ground.

Goldsmiths-turned-bankers did face certain problems. Once they started making loans, their receipts outstanding (claims on gold) were greater than the amount of gold they had in their vaults at any given moment. If the owners of the 120 ounces worth of gold receipts all presented their receipts and demanded their gold at the same time, the goldsmith would be in trouble. With only 100 ounces of gold on hand, people could not get their gold at once.

In normal times, people would be happy to hold receipts instead of real gold, and this problem would never arise. If, however, people began to worry about the goldsmiths financial safety, they might begin to have doubts about whether their receipts really were as good as gold. Knowing there were more receipts outstanding then there were ounces of gold in the goldsmith's vault, people might start to demand gold for receipts.

This situation leads to a paradox. It makes perfect sense to hold paper receipts (instead of gold) if you know you can always get gold for your paper. In normal times, goldsmiths could feel perfectly safe in loaning out more gold than they actually had in their possession. But once you (and everyone else) start to doubt the safety of the goldsmith, then you (and everyone else) would be foolish not to demand your gold back from the vault.

A run on a goldsmith (or in our day, a run on a bank) occurs when many people present their claims at the same time. These runs tend to feed on themselves. If I see you going to the goldsmith to withdraw your gold, I may become nervous and decide to withdraw my gold as well. It is the fear of a run that usually causes the run. Runs on a bank can be triggered by a variety of causes: rumors that an institution may have made loans to borrowers who cannot repay, wars, failures of other institutions that have borrowed money from the bank, and so on. As you will see in a later post, today's bankers differ from goldsmiths---today's banks are subject to a "required reserve ratio." Goldsmiths had no legal reserve requirements, although the amount that they loaned out was subject to the restriction imposed on them by their fear of running out of gold. 

*CASE & FAIR, 2004, PRINCIPALS OF ECONOMICS, 7TH ED., PP. 479-481*

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