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40

whom is always the president from the New York Bank. The other four members serve one -year terms which rotate among the other 11 district banks.

The FOMC is responsible for establishing and implementing the monetary policy of the United States. While the Board has unilateral control over the discount rate and reserve requirements (within bounds prescribed by law), it attempts to set its policies according to objectives established by majority vote at FOMC meetings.

The meetings are currently held eight times per year. The committee decides its own schedule and ad hoc meetings may be called at any time. In addition, the FOMC decides upon a plan of open market operations to attempt to achieve its policy objectives, and the plan is carried out by the Federal Reserve Bank of New York.

Open market operations consist of buying and selling of govemment securities by the Fed on the open market. These transactions have an immediate and direct impact on the reserves held by the banking system and therefore on the availability of credit and the rate of growth of the money supply. It is through this process that the Fed expands or contracts credit availability and manipulates interest rates. Let me explain this process in detail.

HOW MONEY AND CREDIT AVAILABILITY IS CREATED AND CONTROLLED

In the last chapter, I described how in the early stages of banking history, lenders discovered that they could issue more gold- or silver-backed bank notes than their actual holdings of gold and silver. As long as the public had confidence in the institutions ability to redeem the bank notes in coin on demand, then the bank could create paper money, or fiduciary media, which was acceptable in the marketplace as a medium of exchange. I also showed, through the description of the Mississippi Scheme, the disastrous results which can come from pushing this process too farptice inflation and ultimate economic collapse.

The basic principles are the same in The Federal Reserve System, with one huge exception -there is nothing backing the dollar except a govemment law declaring it to be legal tender. This is called a fiat money system. The value of the dollar is totally dependent on the markets faith and confidence in its purchasing power, which is ultimately determined by the supply of a nd demand for currency in relation to other goods and services available in the market.

As a substitute for precious metals, which were used to serve as one of the checks of paper money expansion, the Fed establishes reserve requirements which, since the p assage of The Monetary Control Act of 1980, must be adhered to by all depository institutions in the United States."

Reserve requirements are a percentage of reserve liabilities that must be held by depository institutions in the form of reserve assets. Reserve liabilities consist of transaction deposits, time and savings deposits, and net liabilities to foreign banking offices (Eurodollar liabilities). Reserve assets consist of vault cash (actual dollars and coin) held by the depository institution and re serve deposits held at the Federal Reserve District Banks. In essence, reserve requirements act as the depository institutions only objective check on credit expansion, and therefore on the expansion of the money supply.

For example, if a commercial bank has transaction deposits (deposits with unlimited checking privileges such as checking and NOW accounts) of $100 million,

Table 10.1 Reserve Ratios, May 1990

Type of liability Reserve ratio (%)

Transaction accounts

$0-40.4 million 3

More than $40.4 million 12

Time and savings deposits



Personal

Nonpersonal, by maturity

Less than 1V2 years 3

IV2 years or more 0

Net liabilities to foreign banking offices. (Eurocurrency liabilities) 3

it must currently have at least $12 million in vault cash and/or deposits at the Federal Reserve Bank in its district. The $100 million is the reserve liability and the $12 million is the reserve requirement as calculated according to the current reserve ratios established by the Board of Govemors (see Table 10.1).

In terms of money creation, there is an inverse relationship between reserve ratios and the amount of money a depository institution can create. For example, a reserve ratio of 10% means that for every dollar of added reserve assets in the system, 10 dollars of new money can be created. In more realistic terms, if the Fed buys govemment securities of $250 million in a week, with a reserve ratio of 10% this creates a potential for $2.5 billion increase in the money supply. Conversely, the sale of $25 0 million in securities creates a potential contraction of $2.5 billion in credit availability.

This is difficult to see if you try to think in terms of all depository institutions, their transactions on the market, and their transactions with the Fed District Banks. But it is relatively easy to see if you look at a model of a hypothetical country; lets call it Newmoney, with a Central Bank and a fractional reserve system.

Im going to take you through the credit expansion process step by step, and show yo u how the Fed, or any Central Bank, can literally create or destroy money at the stroke of a pen. For simplicity, Im going to show only the affected portion of the balance sheets, so dont look for a balance between assets and liabilities. On a complete balance sheet, obviously, both sides would balance.

Assume for simplicity that the only kind of deposits in the Newmoney are demand deposits (checking accounts), that there is a total of $1 billion in those accounts-all as loans-and that the central bank has established a 10% reserve ratio. Also assume that the banking system in Newmoney stays loaned up to the maximum allowed by the central bank. Then, the relevant portions of the consoli dated balance sheet of the Newmoney Central Bank and the consolidated balance sheet of all depository institutions in Newmoney would look something like this:

Simplified segment of the consolidated balance sheet of the Newmoney Central Bank

Relevant Assets (thousands of dollars) Govemment securities 150,000

Relevant Liabilities Newmoney Central Bank Notes 100,000 Reserve Deposits 95,000

Simplified segment of the consolidated balance sheet of all Newmoney depository institutions

Key Assets (thousands of dollars) Loans 1,000,000

Vault cash 5,000

Reserve Deposits at Central Bank95,000 Govemment and other securities 150,000

Key Liabilities Demand Deposits 1,000,000



Notice that the combined reserve assets of commercial banks (vault cash plus reserve deposits at the central bank) of the depository institutions equal exactly 10% of their reserve liabilities (10% of demand deposits). At this point, the banks hands are tied. No new loans can be made because the loans would become demand deposits and put the banking system in violation of the 10% reserve requirem ent.

But lets assume that the Board of the Central Bank meets and decides that the unemployment rate is too high in Newmoney and that to stimulate new business and new jobs, they want to increase the availability of credit.

To do this, they engage in open market operations and purchase Newmoney govemment bonds from the banks to the tune of $50 million. When they buy these securities, they write checks against themselves (out of thin air) that the banks then deposit in their reserve accounts at the Central Bank. The transaction occurs with nothing but ink.

The banking system as a whole now has $50 million more reserve deposits. So now their balance sheets look like this:

Simplified segment of the consolidated balance sheet of the Newmoney Central Bank

Relevant Assets (thousands of dollars)

Govemment securities 200,000

Relevant Liabilities

Newmoney Central Bank Notes 100,000

Reserve Deposits 145,000

Simplified segment of the consolidated balance sheet of all Newmoney depository institutions

Key Assets (thousands of dollars)

Loans 1,000,000

Vault cash 5,000

Reserve Deposits at the Central Bankl45,000

Govemment and other securities 100,000 Key Liabilities

Demand Deposits 1,000,000

Now the banks have excess reserves of $50 million; that is, they have $50 million more on deposit with the Central Bank than they need to meet the 10% reserve requirement for existing demand deposits. That means they have enough excess reserves to support another $500 million in loans ($50 million divided by 10% equals $500 million). Being generous and patriotic men that want to see full employment and economic growth, the bankers promptly approve all sorts of new loans.

When the banks make the loans, they create an asset and a liability which automatically balances on their ledgers. In this case, when the $500 million in loans are made, the banks credit the borrowers demand deposit accounts by $500 million and credit their asset sides with loans so that the affected portion of the consolidated balance sheet now loo ks like this:

Simplified segment of the consolidated balance sheet of all Newmoney depository institutions

Key Assets (thousands of dollars)

Loans 1,500,000

Vault cash 5,000

Reserve Deposits at Fed District Banks 145,000

Govemment and other securities 100,000 Key Liabilities



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