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| William F Hummel |
 Posted: Wed Dec 28, 2005 6:46 pm |
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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 sheet
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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| Lantern |
| Posted: Sun Jan 01, 2006 5:11 pm |
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Hummel wrote:
[quote:5d0a63a86c]This is money the Fed issues when it buys
securities from the public for its own portfolio, mainly Treasury[/quote:5d0a63a86c]
debt. It pays by simply creating a deposit at the Federal Reserve
Bank for the seller's own commercial bank.>
Surely this can't be. The FED buys securities ( US Treasuries) for its
own portfolio with no cash, no check, no electronic transfer - the FED
just makes a book entry deposit to whoever they buy the security from?
But this means unlimited money. The FED can make book entries any time
they want. There must be some constraint on this. (Happy New Year) |
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| The Trucker |
| Posted: Sun Jan 01, 2006 8:29 pm |
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"Lantern" <lantern@nethere.com> wrote in message
news:1136153516.928125.19180@g14g2000cwa.googlegroups.com...
[quote:be0e5560b2]Hummel wrote:
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.
Surely this can't be. The FED buys securities ( US Treasuries) for its
own portfolio with no cash, no check, no electronic transfer - the FED
just makes a book entry deposit to whoever they buy the security from?
But this means unlimited money. The FED can make book entries any time
they want. There must be some constraint on this. (Happy New Year)
[/quote:be0e5560b2]
The constraint on the amount of money that can be injected into
the economy through the Fed purchase of US Treasuries is
the amount of taxation that takes that money back out of the
money system. Deficit spending increases the amount of money
in the system and taxation erases that money.
NOTE! If you do not count T-Bills and US Government bonds
as "money" then the amount of money in the system can also be
reduced with bond and T-Bill sales. Such sales move highly
liquid clearing balances (both savings and checking) from the
"money" pool to the less liquid "bond" pool.
And it certainly "can be". As a matter of fact the Fed buys
T-Bills directly from the Treasury on a very short term and
the government then spends this dough into circulation.
The Treasury THEN collects taxes and offers T-Bills to the
public sector so as to recapture this government spent money.
The recaptured money is then used to buy back from the Fed
those original T-Bills that secured the Fed loan to the Treasury.
The dollars so returned to the Fed and the T-Bills returned by
the Fed to the Treasury are both burned in the furnace.
Therefore the amount of money in the system plus the
amount of government securities in the system will increase or
decrease depending on the amount of taxation. Tax proceeds
not used to buy back T-Bills from the Fed and/or the public
sector are simply burned in a furnace. That has not happened
since Pinocchio took over.
While the SOURCE of all base money is technically the Fed,
it is government spending that calls the money into existence.
The increase in the national debt and the increase in T-Bills
and government bonds occurs when taxation is less than
expenditures.
--
"I know no safe depository of the ultimate powers
of society but the people themselves; and
if we think them not enlightened enough to
exercise their control with a wholesome
discretion, the remedy is not to take it from
them, but to inform their discretion by
education." - Thomas Jefferson
http://GreaterVoice.org |
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| william_b_ryan@hotmail.co |
| Posted: Mon Jan 02, 2006 11:36 am |
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"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."
------------------------------------------------------
It is not "known" as commodity money for the simple reason it cannot be
both a token and a commodity. The token is itself a contract.
-
"The exchange value of commodity money varies, but is never less than
its value as a commodity."
------------------------------------------------------
To the extent the token is made of a commodity that some people in the
community might want and are willing to give something in return, it
has intrinsic value directly related to the quantity of the commodity
which it contains. It is tantamount to a disbursed fractional reserve
that psychologically augments the token's acceptability in trade.
-
"Money that is inconvertible is known as fiat money."
------------------------------------------------------
Inconvertibility is not the defining characteristic of fiat money.
Convertibility is merely a contractual promise augmenting its
acceptability. It is not the only way that acceptability might be
augmented.
The defining characteristic of fiat money is how it gets into
circulation.
-
"The government necessarily holds a monopoly on the issue of fiat
money, and no longer issues convertible money."
------------------------------------------------------
It also no longer issues 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 central bank issues central bank credit, held by member banks as
reserves.
-
"All fiat money is issued by the Federal Reserve, the central bank of
the U.S."
------------------------------------------------------
The Federal Reserve issues no fiat money whatsoever.
-
"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."
------------------------------------------------------
No, the United States Government accepts checks written on any bank.
All bank credit within the integrated banking system is fungible,
whether emanating from the Federal Reserve or member banks.
Hummel, you are proof positive you can't teach an old dog new tricks.
Bank credit derives its value from its general acceptability for the
products of industry, not just taxes to government.
-
"Each dollar of base money held by banks can support several times that
amount of credit money."
------------------------------------------------------
What you call "base money" is central bank credit, and is entirely
fungible with member bank credit in terms of its function as money by
the general public.
-
"In truth the amount of reserves depends on the amount of bank credit
issued, not the other way around, as will be explained."
------------------------------------------------------
This theory is that the central bank merely responds to demand for
reserves and is a otherwise a passive player in the process.
Poor, poor Federal Reserve, taking all the blame!
-
"The Fed steers the Fed funds rate to its target quite effectively
through its open market operations."
------------------------------------------------------
Wait a minute! This theory of the "target" contradicts the theory
above.
-
"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."
------------------------------------------------------
For the past several decades these transactions have predominantly not
involved federal securities but derivative securities the banks have
created themselves, called repos.
-
Hummel: Propagandist for the banking fraternity and its theoretician in
chief, Warren Mosler. |
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| Andy F. |
| Posted: Thu Jan 05, 2006 9:51 am |
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"Lantern" <lantern@nethere.com> wrote in message
news:1136153516.928125.19180@g14g2000cwa.googlegroups.com...
[quote:bfb0182fbc]Hummel wrote:
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.
Surely this can't be. The FED buys securities ( US Treasuries) for its
own portfolio with no cash, no check, no electronic transfer - the FED
just makes a book entry deposit to whoever they buy the security from?
But this means unlimited money. The FED can make book entries any time
they want. There must be some constraint on this. (Happy New Year)
[/quote:bfb0182fbc]
In principle the FED can create as much money as it wants.The only restraint
is the need to control inflation. |
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| Chas |
| Posted: Fri Jan 06, 2006 2:02 am |
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"The Trucker" <mikcob@verizon.net> wrote in message news:dp9vm702ea1@> > >
[quote:2ea7770c15]The constraint on the amount of money that can be injected into
the economy through the Fed purchase of US Treasuries is
the amount of taxation that takes that money back out of the
money system. Deficit spending increases the amount of money
in the system and taxation erases that money.
[/quote:2ea7770c15]
Technically speaking, there is not constraint on the amount of money that
the Fed could, in theory, create.
Deficit spending does not necessarily increase the amount of money in
circulation. Taxes do not necessary erase money from the system, even when
running a budget surplus. |
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| Lantern |
| Posted: Fri Jan 06, 2006 1:12 pm |
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Andy F. wrote:
"In principle the FED can create as much money as it wants.The only
restraint
is the need to control inflation."....If this is correct, the
constraint on how much money the FED can create is pretty flakey.
Inflation is not a definite quantity, how much inflation ( or how
little), is desireable... is flakey. I guess someone understands our
money system. It's been working since 1913 when the FED was started. I
guess the members of the FED Bd. of Governors undersatnd it and maybe a
bunch of bankers and academics, but I think light must be shown on our
money system because afterall it's the people's money. |
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| The Trucker |
| Posted: Fri Jan 06, 2006 10:18 pm |
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"Chas" <chasna2@earthlink.net> wrote in message
news:tCovf.2883$ZA2.463@newsread1.news.atl.earthlink.net...
[quote:437401318e]
"The Trucker" <mikcob@verizon.net> wrote in message news:dp9vm702ea1@
The constraint on the amount of money that can be injected into
the economy through the Fed purchase of US Treasuries is
the amount of taxation that takes that money back out of the
money system. Deficit spending increases the amount of money
in the system and taxation erases that money.
Technically speaking, there is not constraint on the amount of money that
the Fed could, in theory, create.
[/quote:437401318e]
Technically speaking the Congress can shut the Fed down if it
sees fit. The notion of an "independent Fed" is rubbish.
[quote:437401318e]Deficit spending does not necessarily increase the amount of money in
circulation.
[/quote:437401318e]
But it DOES increase the total amount of money in that bonds and
T-bills are merely non circulating money.
[quote:437401318e]Taxes do not necessary erase money from the system, even when
running a budget surplus.
[/quote:437401318e]
BZZZZZZZZZZZZZZZZT. Taxes erase money. Over and out.
--
"I know no safe depository of the ultimate powers
of society but the people themselves; and
if we think them not enlightened enough to
exercise their control with a wholesome
discretion, the remedy is not to take it from
them, but to inform their discretion by
education." - Thomas Jefferson
http://GreaterVoice.org |
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