Money Basics

MONEY BASICS

Money plays a central role in our lives, yet no one can be totally
free of misconceptions about it. This article deals with only a few
basic ideas, but it should help those who want to gain a better
insight into what money is and how it works.

Two Kinds of Money

Money is a token that is widely accepted as a medium of exchange. The
token can be tangible like a coin or a note, or intangible like a bank
deposit. If the token is convertible on demand into a commodity like
an ounce of gold, the token is known as commodity money. The exchange
value of commodity money varies, but is never less than its value as a
commodity. A precious metal coin is a token convertible into the
bullion that comprises it, meaning the intrinsic value of the token
coincides with its market value as a commodity.

Money that is inconvertible is known as fiat money. The government
necessarily holds a monopoly on the issue of fiat money, and no longer
issues convertible money. One must therefore avoid thinking in terms
of commodity money to understand modern money.

In the era of commodity money, the issuer was constrained by the need
to hold a sufficient supply of the underlying commodity. There is no
such constraint in the case of fiat money. The viability of a fiat
money system depends on the policy and actions of the issuer, normally
the central bank of a country. The remainder of this article applies
to the monetary system of the U.S. and not necessarily to other
countries.

Source of Money

All fiat money is issued by the Federal Reserve, the central bank of
the U.S. The general acceptance of fiat money as the ultimate form of
money derives from the fact that it is required in payment of federal
taxes. Those who have no tax liability have reason to acquire fiat
money because it is of value to those who do. Thus fiat money can be
viewed as a tax credit that is widely accepted as a medium of
exchange.

Banks greatly expand the scope of fiat money by issuing credit through
the act of lending. The value of bank credit money is based on the
promise that it can be converted on demand to fiat money at par.
Banks must hold sufficient reserves of fiat money to accommodate such
conversion.

The Monetary Base

The story of money properly begins with the origin of fiat money, also
known as the monetary base. This is money the Fed issues when it buys
securities from the public for its own portfolio, mainly Treasury
debt. It pays by simply creating a deposit at the Federal Reserve
Bank for the seller?s own commercial bank. This is sometimes referred
to as monetizing the debt. Each dollar of base money held by banks
can support several times that amount of credit money.

Reserve Ratio Requirements

Banks create transaction deposits whenever they issue loans. Current
rules require a bank to hold reserves of fiat money equal to at least
10% of its transaction deposits. The reserves can be held in any
combination of vault cash and deposit at the Fed. There is no
required reserve for other bank liabilities, such as savings accounts
or certificates of deposit.

The money multiplier in its basic form is the reciprocal of the
required reserve ratio. It is commonly thought to be a measure of how
large the credit money supply will grow due to bank lending, given the
amount of reserves created by the Fed. In truth the amount of
reserves depends on the amount of bank credit issued, not the other
way around, as will be explained. The money multiplier is little more
than an after-the-fact observation of the multiple. Indeed the money
multiplier can have no meaning in the many countries that impose no
reserve requirement on banks.

Controlling the Price of Credit

Even if there were no reserve requirement, a bank would have to hold
enough reserves at the Fed to cover its depositors' checks, and enough
vault cash to meet the demand for withdrawals by depositors. The need
for reserves thus creates an active interbank market in which banks
lend or borrow reserves among themselves. The interest rate on these
short term transactions is called the Fed funds rate.

The Fed steers the Fed funds rate to its target quite effectively
through its open market operations. These involve short-term
transactions for its own account, purchasing or selling securities to
add or drain system reserves as needed to balance the supply and
demand at its target price.

Any bank in good standing and with adequate collateral can borrow on a
short term basis at the Fed?s discount window. The interest rate the
Fed charges is 100 basis points above its target for the Fed funds
rate. With that large a spread, the discount window serves as a
backup rather than a regular source of funding.

The Fed's Reactive Role

Why does the Fed control the price of reserves rather than the
quantity? The answer is that targeting the quantity risks endangering
the liquidity of the banking system. An increase in cash holdings by
the public drains vault cash from the banking system. Unless the Fed
responded by injecting reserves, one or more banks might be unable to
meet the reserve requirements or the withdrawal demands of its
depositors.

Targeting the quantity would also result in excessive volatility in
the interest rate banks must charge on their loans. If the demand and
supply of reserves were not adequately balanced to maintain the Fed
funds rate, bank lending rates would vary accordingly. Firms cannot
plan efficiently when the price of credit is subject to large and
unpredictable variations.

As a result of the Fed?s focus on price, the money supply will vary
with demand. It expands or contracts according to whatever factors
influence private sector borrowing. Thus the Fed plays an essentially
reactive role, adding or draining reserves as needed to hold the Fed
funds rate on target.

Limiting Bank Lending

Since the reserve ratio requirement doesn?t really impede bank
lending, what prevents a bank from responding to any and all loan
demands? The answer is that every bank must also comply with an
equity capital requirement. This is a complex formula that rates a
bank?s assets by risk and requires that its own capital exceed a
certain fraction of its risk-weighted assets.

A bank can get into trouble by creating too large a balance ***
through excessive lending. A bank with insufficient capital relative
to its assets will be placed under supervision by its regulator who
may then demand to approve any new lending.

Limiting Money Supply Growth

Another important question is what limits the money supply from
growing excessively? Banks are in the business of selling credit. If
a creditworthy borrower is willing to pay the bank?s rate, the bank
will normally make the loan even if it must seek the required reserves
after the fact. Thus the only defense against the creation of
excessive credit money is for the Fed to increase the price of credit
to the point that it slows net demand.

Mismanagement of the price of credit can readily drive the economy off
track towards inflation or recession. The Fed must act to keep the
supply of credit money in reasonable balance with the production of
real goods and services -- its basic monetary policy challenge. That
calls for a great deal of knowledge about the economy as well as skill
in interpreting the data. The Fed has made its share of mistakes over
the years that are usually not obvious until much later.

W. F. Hummel
http://wfhummel.net/
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