Basics of Central Banking

1. Basics of Central Banking Dr. D. Foster – ECO 473 – Money & Banking

2. Free Banking & Inflation • No government control. • No government regulation. • Entry and exit is free. • Subject only to legal requirement to pay off debts.

3. What limits excess bank note issue? • Trust. • Extent to which we use bank notes. • Fear of a bank run. • If loans are sound, then bank should be able to liquidate without loss to depositors. • Once started it is impossible to stop. • Limited clientele as a day-to-day restraint. • Conclusion: Free banking non-inflationary

4. Other Free Banking Issues • Forces at work to consolidate; weakens restraint. • But, forming cartels is quite unlikely. • International gold flows would still limit a monopoly bank. • Hume/Ricardo “specie flow price mechanism.” • Fractional reserve banking as causing boom/bust cycle. • Mises: “[F]reedom in the issuance of banknotes [will narrow] down the use of banknotes…”

5. Central Banking • Government privilege or control. • Monopoly on note issue. • Tend to centralize holding of gold. • Can prevent individual bank collapse. • Will expand (contract) the MS by expanding (contracting) bank reserve deposits. • Assuming banks are “fully loaned up” the MS is: Notes in circulation + (1/rr)*(Bank reserves) Since banks earn their profits by creating new moneyand lending it out, banks will keep fully loaned upunless highly unusual circumstances prevail. (136)

6. Free Banking vs. Central Banking With free banking what happens to the MS whendepositors cash out some of their DD for banknotes? Nothing. Only the form of the MS changes;from DD to banknotes.

7. Free Banking vs. Central Banking With central banking what happens to the MS whendepositors cash out some of their DD for banknotes? The bank loses liabilities to the CB. To restore reserve balance, loans, DD and MS must fall.

8. Central Banking & Reserves • Reserves and desire for cash (public) movein opposite directions. • Some factors cash demand: seasonal spending and underground/illegal transactions. • Some factors cash demand: credit & debit cards and improvements in the clearing system. • The Fed can/does make loans to banks. • Although of minor importance, discount rate hasbeen used in way to bias towards inflation. • The Fed mostly ∆s reserves by buying stuff (T-bonds). [U]ntil now virtually the only asset the Fed has systematically bought and sold has been U.S. government securities. (157)

9. Central Banking & Inflation • With many banks, an reserveswill MS by (1-rr)% • If rr=20% and Fed buys $10 billion in bonds, which get deposited; a bank can increase loans by only $8 billion. • But this process continues with same effect as if one bank. • Government budget deficit/surplus is “unrelated.” • When Fed buys bonds, debt is “monetized” and MS rises. • When Fed doesn’t act, gov’t. bonds “crowd out” private sector investment and raise interest rates. • WOAPW: Fed buys bonds from bank • We get inflation (MS) and tax burden, to the benefit of banks. • Should Fed buy directly from the Treasury?

10. Central Bank Independence, Average Inflation, and Inflation Variability in Major Developed Nations SOURCE: Alberto Alesina and Lawrence Summers, “Central Bank Independence and Macroeconomic Performance,” Journal of Money, Credit, and Banking (May 1993): 151–162.

11. Basics of Central Banking Dr. D. Foster – ECO 473 – Money & Banking