Basics of Central Banking

Dr. D. Foster – ECO 473 – Money & Banking

Free Banking & InflationFree Banking & Inflation

• No government control.No government control.• No government regulation.No government regulation.• Entry and exit is free.Entry and exit is free.• Subject only to legal requirement to pay off debts.Subject only to legal requirement to pay off debts.

What limits excess bank note issue?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-inflationaryFree banking non-inflationary

Other Free Banking IssuesOther 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 “[F]reedom in the issuance of banknotes [will narrow] down the use of banknotes…”narrow] down the use of banknotes…”

Central BankingCentral 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)

Free Banking vs. Central BankingFree 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;Nothing. Only the form of the MS changes;from DD to banknotes.from DD to banknotes.

Assets LiabilitiesReserves $3 million DD $15 millionLoans $12 million

Assets LiabilitiesReserves $3 million DD $14 million

Notes $1 millionLoans $12 million

Free Banking vs. Central BankingFree 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. The bank loses liabilities to the CB. To restore reserve balance, loans, DD and MS must fall.To restore reserve balance, loans, DD and MS must fall.

Assets LiabilitiesReserves $3 million DD $15 millionLoans $12 million

Assets LiabilitiesReserves $2 million DD $14 million

Loans $12 million

Assets LiabilitiesReserves $2 million DD $10 million

Loans $8 million

Central Banking & ReservesCentral Banking & Reserves

• Reserves and desire for cash (public) moveReserves and desire for cash (public) movein opposite directions.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.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).The Fed mostly ∆s reserves by buying stuff (T-bonds).

[U]ntil now virtually the only asset the Fed has systematically [U]ntil now virtually the only asset the Fed has systematically bought and sold has been U.S. government securities. (157)bought and sold has been U.S. government securities. (157)

Central Banking & InflationCentral Banking & Inflation

• With many banks, an With many banks, an reservesreserveswill will MS by (1/rr)%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.”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 bankWOAPW: Fed buys bonds from bank

– We get inflation (MS) & tax burden, benefiting of banks.• Should Fed buy directly from the Treasury?Should Fed buy directly from the Treasury?

Central Bank Independence, Average Inflation, and Central Bank Independence, Average Inflation, and Inflation Variability in Major Developed NationsInflation 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