Chapter 35 _ Money Creation _ ECON 2020.pdf - \u201cWe have seen that the M1 money supply consists of currency(coins and Federal Reserve Notes and

Chapter 35 _ Money Creation _ ECON 2020.pdf - “We have...

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“We have seen that the M1 money supply consists of currency (coins and Federal Reserve Notes) and checkable deposits and that M1 is a base component of M2, a broader measure of the money supply that also includes savings deposits, small-denominated time deposits, and balances in money market mutual funds. The U.S. Mint produces the coins and the U.S. Bureau of Engraving and Printing creates the Federal Reserve Notes. So who creates the checkable deposits? Surprisingly, it is loan officers! Although that may sound like something a congressional committee should investigate, the monetary authorities are well aware that banks and thrifts create checkable deposits. In fact, the Federal Reserve relies on these institutions to create this vital component of the nation’s money supply.” 35.1 [The Fractional Reserve System]: Discuss why the U.S. banking system is called a “fractional reserve” system. The United States, like most other countries today, has a fractional reserve banking system in which only a portion (fraction) of checkable deposits are backed up by reserves of currency in bank vaults or deposits at the central bank. Then some clever goldsmith hit on the idea that paper “receipts” could be issued in excess of the amount of gold held. Goldsmiths would put these receipts, which were redeemable in gold, into circulation by making interest-earning loans to merchants, producers, and consumers. A borrower might, for instance, borrow $10,000 worth of gold receipts today with the promise to repay $10,500 worth of gold receipts in one year (a 5 percent interest rate). Borrowers were willing to accept loans in the form of gold receipts because the receipts were accepted as a medium of exchange in the marketplace. This was the beginning of the fractional reserve system of banking, in which reserves in bank vaults are a fraction of the total money supply. If, for example, the goldsmith issued $1 million in receipts for actual gold in storage and another $1 million in receipts as loans, then the total value of paper money in circulation would be $2 million—twice the value of the gold. Gold reserves would be a fraction (one-half) of outstanding paper money. The goldsmith story highlights two significant characteristics of fractional reserve banking. First, banks can create money through lending. In fact, goldsmiths created money when they made loans by giving borrowers paper money that was not fully backed by gold reserves. The quantity of such money goldsmiths could create depended on the amount of reserves they deemed prudent to have available. The smaller the amount of reserves thought necessary, the larger the amount of paper money the goldsmiths could create. A second reality is that banks operating on the basis of fractional reserves are vulnerable to “panics” or “ runs. ” A goldsmith who issued paper money equal to twice the value of his gold reserves would be unable to convert all that paper money into gold in the event that all the holders of that money appeared at his door at the same time demanding their gold.
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