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Chapter 13 Money, Banking and the Creation of Money
I. Functions of money
Hyperinflation in the Weimar Republic
A 50,000,000 (50 million) mark banknote from 1923 Germany
The Demand for Money
1. Transaction D, Dt, results because people hold money, often in a money market
account, to use as a medium of exchange.
2. Asset Demand, Da, results because people accumulate money, often held in an
investment account, to buy assets.
3. The demand for money Dm= D t + Da
4. Interest rates are set in the money market.
5. For more information visit
Demand for money - Wiki
VI. The Federal Reserve System
|1. Board of Governors oversee the Federal Reserve System
a. Seven governors
b. Governors are appointed by the President and confirmed by the Senate.
c. The chair is appointed by the President for a four-year term.
1) To foster independence, the term does not coincide with the President's
2) Other board members are appointed to 14-year terms on a staggered
basis to insure an experienced board.
2. Federal Open Market Committee
a. Membership consists of the Board of Governors and 5 of the 12 Federal
Reserve bank presidents with the N.Y. president always a member
because N.Y. City is the financial center for U.S. international trade.
b. The Committee tries to affect interest rates by affecting the supply of
money by buying and selling U.S. government bonds (See Chapter 15).
3. Federal Advisory Council 12 prominent commercial bankers, one from
each district, who advise the Board of Governors
4. Twelve Federal Reserve Banks
a. The United States is divided into 12 homogenous districts and each
has its own bank
b. Bank for the federal government
c. Bank for member banks
d. Graphic is complements of the Board of Governors of the Federal
5. Member commercial banks
6. Nonmember commercial banks and thrifts are regulated by other
|Federal Open Market
Note: During the later part of the Great Depression, the Fed tightened too soon(at the eight year mark) and the recession returned. Then WWII came along and government spending finally ended the Great Depression.
Functions of the Federal Reserve
1. Regulate the money supply
3. Oversea the financial system
4. Check collection and clearing
5. Fiscal agent for the government
6. Supervise (audit) member banks
7. Hold reserves (deposits) for member banks
8. Compile economic statistics such as the 2010 BeigeBook, which is
a quarterly summary of each districts' recent economic activity.
9. Many Federal Reserve publications are free.
C. The Federal Reserve System Purposes and Functions
1. ANDREW JACKSON took on the eastern bankers, vetoed
the charter extension of the Second Bank of the United States
because he felt it had excessive power over farmers.
2. THEODORE ROOSEVELT took on the corporate monopoly
Trusts that control railroad rates and routes and thus destroyed
small towns and farms.
E. Current Events Readings
1. Philadelphia Reflections: Whither, Federal Reserve? is a wel
l done, concise history of banking in the United States.
2. The Real Threat to Fed Independence Henry Kaufman, Wall
Street Journal. The financial giant cuts the industry no slack.
3. The Current Events Internet Library has many up-to-date economic
Profit isn't usually listed as a function but $200 from 2009 -11 and 80 billion in 2012 isn't chicken feed.
Origins of the Federal Reserve
Recessions originating from a financial event were common in the late 19th and early 20th centuries. Many stemmed from banking panics. Figure 1 provides a global historical perspective. We calculate by decade the number of countries that experienced financial crises among a sample of 17 industrialized economies representing more than half of global GDP during the past 140 years (for details, see Jordą, Schularick, and Taylor 2012). from econintersect comparing-the-panic-of-1907-to-fed-s-actions-in-2008 5/7/13
VII. Recent Developments
A. Banks and thrifts are the only institutions whose checking accounts are not
restricted as to check size and number
1. The Financial Institutions Reform, Recovery and Enforcement Act of 1989,
liberalized banking laws, caused a declined in their importance although
reforms resulting from the Great Recession of 2008 cold change this.
2. Consolidation has caused their numbers to decline and their size to increase.
3. Many bank/thrift services are now performed by insurance companies,
pension, and securities companies.
B. Globalization of financial markets.
C. Some politicians think the Federal Reserve system is too independent.
1. Congress Is Politicizing the Fed Jan 25, 2010
2. Central bank independence versus inflation.
This often cited  research published by Alesina and Summers (1993)
is used to show why it is important for a nation's central bank (i.e.-monetary
authority) to have a high level of independence. This chart shows a clear
trend towards a lower inflation rate as the independence of the central bank
increases. The generally agreed upon reason independence leads to lower
inflation is that politicians have a tendency to create too much money if given
the opportunity to do it. The Federal Reserve System in the United States
is generally regarded as one of the more independent central banks.
|VIII. The fractional reserve system and the creation of money
A. Commercial banks are required to keep a reserve (cash) of about 12% of their
demand deposits (checking accounts) at their bank or on deposit with the
Federal Reserve (required reserves). The remainder, (Excess Reserves)
may be loaned out even though they support deposits.
B. Money is created by these loans as long as the demand deposits (DD) created
by them stay within the banking system, that is, the money loaned is redeposit
as a DD into a bank within the system. The banks owe the demand deposits
created by the loans to each other. These inter-brain debts are canceled with
a bookkeeping entry. It should be pointed out that the demand deposits
created by such loans are spent, and goods transferred, just as if the
transaction involved currency.
C. Example: Bank A has $50,000 in demand deposits. A reserve requirement of
10% would yield required reserves of .10 x $50,000 = $5,000. If Bank A
had $7,000 in reserve, it could loan up to $2,000 in the form of demand
deposits. Suppose Bank B does exactly the same with both banks' customers
depositing their DD in the other bank. Banks would owe cashed checks to
each other, would cancel interbank debts, and money has been created.
D. The system works in reverse with money destroyed if reserves leave the system.
E. Required reserves, reserves not loaned, and loans of cash (reserves) represent
a leakage which eventually stops money supply growth.
IX. The monetary multiplier
A. An infusion of reserves into the system by the Treasury as directed by the
Federal Reserve can be loaned a number of times by the commercial
banking system. For example, the Federal Reserve may buy a $100
Treasury bond from Ms. A who deposits the Federal Reserve check
(reserves) into Bank A.
B. Bank A's new DD of $100 requires them to keep $10 (10%) in reserve
leaving $90 excess to loan to Mr. B who deposits it in Bank B.
C. Bank B needs to keep only $9 ($90 x .1) in reserve and may loan out $81.
D. This process continues and as long as the demand deposits being created
by the loans stay within the commercial
banking system, interbank debts are canceled and money has been created
E. Monetary multiplier (M) sets the upper limit of the expansion
1. R = reserve requirement = 10% = .1
2. M = 1/R = 1/.1 = 10
F. In the above example the total amount of DD created beginning with Bank
A's $90 in excess reserves would equal
Excess Reserves x M = $90 x 10 = $900. If the $100 infusion by the
Federal Reserve is included, the increase is 10 x 100 = $1,000.
G. Visit The Banking System and the Money Multiplier from Jay Kaplan
of the University of Colorado at Boulder for more information.
X. Additional reading
1. Money creation - Wikipedia
2. Recollections of Pine Gulch reffeconomics reviews money.
3. Banks Create Money
4. The (2nd) Deleveraging: What Economists Need to Know About the Money Creation Process
5. A Brief History of U S Banking Problems
6. A 9-page summer read for historical context in understanding the history
of monetary policy: the famous Wizard of Oz book is economic allegory/satire
on who will create US money: federal government as "money" or a central bank
as "debt." This issue was the foundation for the "Greenback Party,"
"Populist Party," "free silver," and William Jennings Bryan's three
presidential campaigns (and "Cross of Gold" speech): or a film version
of this allegory, The Secret of Oz can be
viewed online (winner of two 2010 international Best Documentary awards).
7. The Nixon Shock from Business Week 8/14/11
How Nixon stopped backing the dollar with gold and changed global finance,
a 40-year-old decision that still echoes in Greece, Ireland, and the U.S.
8. Buttonwood, Forty yeas on from 8/11 of Economist Magazine
9. Visual Guide To The Federal Reserve Barry Ritholtz (furzy mouse) begins with why we have a Fed!
10. A brief history of U S dollar debasement?
11. Phony Currency Wars
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Some Central Banks Are Easing to Create Growth,
Some Are Not
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