Basics of Central Banking
Dr. D. Foster – ECO 473 – Money & Banking
Free Banking & Inflation
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No government control.
No government regulation.
Entry and exit is free.
Subject only to legal requirement to pay off debts.
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
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…”
Central Banking
• Government privilege or control.
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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 money
and lending it out, banks will keep fully loaned up
unless
prevail. (136)
Free Banking vs. Central Banking
With free banking what happens to the MS when
depositors cash out some of their DD for banknotes?
Assets
Reserves $3 million
Loans
$12 million
Assets
Reserves
Loans
$3 million
DD
Liabilities
$15 million
Liabilities
DD $14 million
Notes $1 million
$12 million
Nothing. Only the form of the MS changes;
from DD to banknotes.
Free Banking vs. Central Banking
With central banking what happens to the MS when
depositors cash out some of their DD for banknotes?
Assets
Reserves $3 million
Loans
$12 million
Assets
Reserves
Loans
$2 million
DD
Liabilities
$15 million
DD
Liabilities
$10
$14 million
$12
$8 million
The bank loses liabilities to the CB.
To restore reserve balance, loans, DD and MS must fall.
Central Banking & Reserves
• Reserves and desire for cash (public) move
in 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 has
been 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)
Central Banking & Inflation
• With many banks, an reserves
will MS by (1/rr)%
– If rr=20% and Fed buys $10 billion in bonds from one bank.
That bank can increase loans by only $8 billion.
– But this process continues with all other banks.
– Net increase in the MS will be $50 billion =(1/.2)*(+$10 b.)
• 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) & tax burden, benefiting of banks.
• Should Fed buy directly from the Treasury?
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.
Basics of Central Banking
Dr. D. Foster – ECO 473 – Money & Banking