G-khan
04-16-2003, 12:31 PM
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 credit in a bank deposit. If the token is convertible on demand into a commodity like an ounce of gold or a bushel of wheat, the token is known as commodity money. The exchange value of commodity money can vary, 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 value as a commodity.
Money that is inconvertible is known as fiat money. Lacking intrinsic value, it must depend on some other mechanism to maintain a positive exchange value. All modern money systems employ fiat money. One must therefore avoid thinking of money in terms of a commodity 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.
An Overview
All fiat money is issued by the Federal Reserve, the central bank of the U.S. Its value derives from the fact that it is the only kind of money acceptable in payment of taxes and for settling private debts in court. 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 to fiat money at par. Banks must hold sufficient reserves of fiat money to accommodate such conversion on demand.
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
The reserve ratio requirement limits a bank’s lending to some fraction of its demand deposits. The current rule allows a bank to issue loans, i.e. create credit money, in an amount equal to 90% of such deposits, holding 10% in reserve. 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, 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 where there is zero 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 credit money rather than its quantity? The answer is that it cannot directly control bank lending, the main component of the money supply. Past attempts to control the money supply have resulted in unacceptably wide fluctuations in its price. Businesses 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. The Fed must provide the reserves the banking system needs in its response to the borrowing demand. If it failed to do so, it would lose control of the Fed funds rate, the bench mark for all short term rates. Ultimately that would imperil the liquidity of banking system itself. Thus the Fed plays an essentially reactive role, providing the 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 an asset base through excessive lending. A bank with insufficient equity 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. But this is like a small rudder on a massive ship. It can take a long time before there is much response to the corrective action. The time lag in the credit market is usually a matter of many months.
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.
http://wfhummel.cnchost.com/index.html
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 credit in a bank deposit. If the token is convertible on demand into a commodity like an ounce of gold or a bushel of wheat, the token is known as commodity money. The exchange value of commodity money can vary, 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 value as a commodity.
Money that is inconvertible is known as fiat money. Lacking intrinsic value, it must depend on some other mechanism to maintain a positive exchange value. All modern money systems employ fiat money. One must therefore avoid thinking of money in terms of a commodity 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.
An Overview
All fiat money is issued by the Federal Reserve, the central bank of the U.S. Its value derives from the fact that it is the only kind of money acceptable in payment of taxes and for settling private debts in court. 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 to fiat money at par. Banks must hold sufficient reserves of fiat money to accommodate such conversion on demand.
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
The reserve ratio requirement limits a bank’s lending to some fraction of its demand deposits. The current rule allows a bank to issue loans, i.e. create credit money, in an amount equal to 90% of such deposits, holding 10% in reserve. 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, 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 where there is zero 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 credit money rather than its quantity? The answer is that it cannot directly control bank lending, the main component of the money supply. Past attempts to control the money supply have resulted in unacceptably wide fluctuations in its price. Businesses 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. The Fed must provide the reserves the banking system needs in its response to the borrowing demand. If it failed to do so, it would lose control of the Fed funds rate, the bench mark for all short term rates. Ultimately that would imperil the liquidity of banking system itself. Thus the Fed plays an essentially reactive role, providing the 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 an asset base through excessive lending. A bank with insufficient equity 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. But this is like a small rudder on a massive ship. It can take a long time before there is much response to the corrective action. The time lag in the credit market is usually a matter of many months.
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.
http://wfhummel.cnchost.com/index.html