Re: Let's understand how money is created ... and how the Fed works
- From: RogerDodger <none@xxxxxxxxxxxx>
- Date: Thu, 18 Dec 2008 11:27:08 -0500
On Thu, 18 Dec 2008 06:55:48 -0800 (PST), Saggy <gurfinkle@xxxxxxxxx>
wrote:
I've read a few books recently, but am still not crystal clear on this
mechanism .... my goal is not to explain every variation possible, but
to understand the main methods ....
We start with no money in existence.
No, we start today, and describe how the Fed creates money today.
There has never been a period in US history when there was "no money
in existence". There was plenty of money when the Fed was created.
The US government prints a bond, sells it to the Federal Reserve.
No. The US goverment sells bonds to the public. It then spends the
money it gets from the public pretty much immediately.
This cycles exiisting money, creating none, changing the money supply
not at all
The
Fed buys the bond, incrementing the governments checking account. Now
the government has new money it can dispense as it chooses.
No, again the Fed does not buy bonds from the Treasury. That is called
"monetizing the debt" and it is entirely illegal.
The Fed buys and sells assets in dealings with the public.
Historically, in normal times, these have almost always been T-Bills
bought froim selected "dealer" banks.
(Today it's on course to getting to be pretty much anything).
When the Fed *buys* assets it pays money for them, thus the money
supply goes *up* as the result is that the public holds more money and
less assets.
When the Fed *sells* assets it receives money from the public for
them, thus the money supply goes *down* as the result is that the
public holds more assets and less money.
That's the basic mechanism.
The Fed can make loans to banks. The Fed increments the banks
checking account with the Fed, and the bank has new money it can
dispense as it likes.
What types of loans to banks does the Fed make?
Changing by the minute!
Does it require security? Does it expect to be repaid?
Until now and so far, yes and yes.
Once the bank has money, it can deposit ten percent in its Fed reserve
account and lend an amount equal to what remains. The bank increments
the checking account of the borrower, and the borrower has new money
to dispense with as he chooses.
A bank receives cash, it then makes a loan to a customer who deposits
it in another bank. Process repeats.
The basic money supply conisists of cash and *deposits* (not loans)
since people think and act as if their deposited "money in the bank"
is as good as cash. E.g: M1 consists of currency, travelers' checks,
demand deposits, and checkable deposits.
The lending creates a chain of deposits. So the initial dollar
supports a total money supply of a multiple of its amount, via the
"money multiplier".
Other definitions of money including more items:
http://en.wikipedia.org/wiki/Money_supply
This is how I understand it so far. Is it correct? Is there more?
Now, if a loan defaults, the money is still in circulation. I've read
that this money is somehow effectively removed from the money supply
because the bank has to decrease it's asset base by the amount of the
default, but I don't understand the reasoning for this.
Loans are not money.
If deposits are reduced the money supply falls. If this happens a lot
then the money multiplier goes into reverse and total money supply
falls.
This happens when banks don't want to make loans, people/businesses
that have cash don't want to lend it, everybody "deleverages" by
liquidating loans. New deposits aren't made, existing deposits are
eliminated when used to pay off loans.
This is what has happened in the current crisis: the money multiplier
has crashed, to compensate the Fed is pumping out base money as fast
as it can to keep the total money supply stable.
You can see this in pictures:
Money multiplier:
http://research.stlouisfed.org/fred2/fredgraph?chart_type=line&s[1][id]=MULT&s[1][range]=10yrs
Base money:
http://research.stlouisfed.org/fred2/fredgraph?chart_type=line&s[1][id]=BOGAMBNS&s[1][range]=10yrs
Can you explain?
If I'm right so far, then I want to continue to see how the Fed's bond
and loan balances relate to the total supply of money.
All the data you'll want for starters is at:
http://research.stlouisfed.org/fred2/
.
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