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David H Friedman I Bet You Thought


Academic year: 2021

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David B.

I Bet




Federal Reserye






Dec 17


fublic Info·

~tion Departlen~.




of lew fork





York, Nev


100115 Cfree)

BF01 Plus Postage. PC Hot Available fro. EDRS.




Concept Foraation:


(finance': Econa.1c Develop.ent: *Econoaic !ducation:

Eoono.ics: Pederal ReqQlation:



.pinancial SeryiC8$:





.8oney ftenaqeaent: *soney





Dnited States



Reserve syste.

The bocklet lists and di3pels 1ij economic myths

thl. "1h

a discussion of aoney. econoaic concepts, and






'rhe object


is to





adul ts




svstea as


to aone'







bankinq, qold and silver, credit.


role. financial concepts. and interest. For


topics historical


1nforaatioD is provided,



concepts are defined,

relationships between


and the banks are pointed out,



functiGDS and



outlined. and



of banks are co.pared.


mytha inclUde "Boney is si.ply

- coin

and paper currency." "Gold and


are the




"Tbe Governaent reduces aoney's ,alue






·Checks are aoney."

"Sanks are





-Ill banks are the


Niall Street banking



the federal Reserve and control


policy," "The Federal






currency in circulat.ion." and












and lend

the funds



hiqher rate





Cartoon drav!ncrs

illustrate the concept.s



•••••••••••••••••••••••••••••••••••••••• **••••••••••••••••••••


Reproductions sdpplied


EDRS are the best that can be made


fro. the
































-• 'PERMISSION TO ~t:PRLlllud !'~IS





Public Information Department

Federal R£!serve Bank of New York


Liberty Street

New York. New York 10045




- - - -









- - _....~








. _ - - - '



Mostof us acqUire two types of

knowledge-"~ "001 knowledge" and 'fall< knowledge .' Folk knowledge ISinformation and "wisdom" passed from generation to goner atIon or aCQuired on the streets For example, were often tOld that sItting In a d,.aft will gIve us acold SCIence tells uSthe common cole results frorn


V1fUS Yet. stili we

change our seat ;0avoid adraft We may acknowledge that drafts only contribute to lowering our resistance to Infection but we 51111 blame the tJreeza rathAr than the bug

So too most of us hold certain economic misconceptions folk knowledge cont8lnlng a germ of truth and a plague of misconcp.pliun economiC myths picked up by mlsreadlngs or t"e acceptance off'lCls from aIflend or relative Few of us are Immune to(~conomICmyths Of

misconceptions If yuu dunt ttllTlk so Ibet you thought



T...of Contents

Beforereading thIs booklet. indIcate whether

each statement belowIS true or false After,

check your answers and rate yourself

MoneyISSimply cOin amI paper currency

OnlvCalf!and currency dre real monIes

bec<:IlJse the Government says Iheyre legctl lender

GOld and stiver areIta! , pertecl morues

Gold' backfflg gIves It" dollarlIS V<3!lJe

The Governmentr('(lw;e-; moneys value by

pnntlng100much currency

Credll cards aredne.... form ofrnoFley

Checks are monl'y

Checkbook mOlleyI~ oeille,;'by

cunene y depOSll'i>

Banks are part of the Government

Banks are $0po.... erfulItley canfiX mleresl

rales on loans and dep0'311s and (10 Just about whatever else Ihey please

All bank!-i are Ihe same

WallStreetbanking InlE)re'jlS established the

FederalReserveanrJ control monetarypOliCY

The Federal Reservecontrol~the amount of

currency," CirculatIon

Banksborrow moncy fromthe Federal Reserve



dIscount rate and lend the funds at a

hIgher rale 10 make profll

Tru~ Fal!;t' Answer on page

[J U 5 [] [] 7 rJ


9 U U 11 tJ II 13 rJ U 15 rJ


17 LJ [J 19 [J [l 21


[J ?3 U [J 25 U LJ 27 0 0 31 0 [J 33


I' 3


l . _



--IIoMy .. 81mpl,


Ind . . . .


MontlyISany gsnerallyaccepr~jmedium of

exchange, not simply COin and paper currency.

Money doesn't have tobeintrinsically valuable

(valuable," Itself), be issuedbya government or

beInany special form. In our past. Items

ranging from Iron nails and dried codfish to gun powder and tobacco have served as money Anything people generally accept in exchange for Items of value is money Money also IS a standard for measuring value and a means of storing purchasing power for future use Any Item that has these three traits is money Americans accept three types of money - COin iSsued by the Treasury, paper currency Issued by Federal Reserve Banks, and checkbook balances (demand deposits) at banks

In analyzlOg economiC activity, many economists take a much broader view of money and InClude other money-like Items immediately available to the public for spending, such as passbook savings and other funds depoSited for specific tll"\8 periods

Oemarad depoSits are the nation's most common form of money. compriSing about three-quarters

Of all money10clfculatlon. This checkbook

money is bOokkeeping money created malOly by tne nation's commercial banks. Americans prefer using checkbook money because It performs as a more efficient medium of exchange than COlO or currency for many transactions. Check WTlters have With one blank check the potential for spending small or large amounts. Since each cheCk must be Signed before funds are

transferred, checkbook money cannot eaSily be stolen. In addition, cancelled checks provide written proof of payments. Since we prize convenience, safety and recordkeeplng, it's no wonder that checkbook money is preferred

Checkbook money works because people are confident in the strength, safety and prudence of the American banking system. Their confidence has been bolstered by Government regUlation of commercial banks and Government deposit insurance. The check clearing and collection system of the Federal Reserve, the nation's central bank. has also made checkbook money highly acceptable by speeding checking account transfers nationwide.

We've been big check users for quite awhile. The move began in the post Civil War era, when bank deposits became the dominant form of money held. Today, If all payment transactions ""ere counted, including those for srock. bond and real estate purchases, the dollar volume of check spending to coin and paper currency spending would be enormous.

Only about 3 percent of oor money IS in coms, and for every 10 cents in small change we keep. we hold about a dollar in paper money. As a

nation, we hold only about$80billion of cash.

compared with $230 billion of checkbook money.


- - -



COin and currency .... rea' monl..


.... Government




Com anacurrency are "logal tender'" money the

Government says has to be accepted ,f offered to settle


det)' But Ihat approval doesnl make

cash any more rear than checkbook balances

Until the 18605, legal tender' appllerj onl~ito cotn ye' everl Ihen we uc;e~more prIVatebiil1k

notes and bank <1epos,'s d~money 'han cOin Logal render ucc,l()nat,on'NdSgIven



Goverrment-'s5uedpap~rcurrency dUflrlg Ihc C,Vil War 10 WinpuOllc confidence tn Ihe

paper mfmey Howevcr, Ihere haf> been no meaningful dlstlnctlun between 'lcgi11 lelluer

andotherU S money since 1933,whenCongres~

made all cOins and currenCIes legal tender for all public and private debIs

Regarc1Ie<;s01whitt any governmenI says money

must have cerra,n characteristics thaI make It acceptable Without rhose fra,ls, even legal tender" cannotbesuccessful asmoney Most early monies were not Issuefj by

governments They were commodities such


salt.cattle and rum. that were Widely known anr1

eaSIly sold or used


comrnodl!lOs proved less than perfect monies The tobaccoused by the early VIrgInIa settlers IS an example


rhe leaves weren'l easily dlvlslole cauSIng difficultyIn .'makIng change" The varyIng pnces

lor different grades01 tobacco made value difficult to determine It al50wa5 hardtocarry and slore Temperature and hUmlOlty changes caLlsed flaktng wtlll,;h eJeva/uet1· theleave~ In short tCJtlacco lacked many characteristiCS neer1ed to make II ~ork well



Forc1n ItCfTi10perfor:rI ~UCCC~Slullv


money ,t

rnu.,1 be eJurdble dIVI~lt)le portable and dIfficult to ClJUnterfc,t More Importdnt


the Vtrgmlans' e){pCrteflCe shows while any IIern




money It won, worl< well or Idst long unless It

C,J1l also !)crve wella~ d standi:Hd and store0' value,

People's wIllmgness to accept money Inany

lorm IS rooted no' In tr,elaw hut in money's ablltty to effectIvely measure anfJ hold value




11 .


r---.---.---.-- .. --- _. -.. - '. -..---....

Gold and

.,Iv., ....

tileonly perfect mon....

Gold and Silver monies have been used for thousands of years, bul they :He far trom perfect Gold and Silver alwavs have bet>n ueSlred The scarcity. lustor and almost mystical appeal of the metals made gold and Silver acceptable as Jewelry, armor am] religiOUS symbol:; Gold and

Silvers use~lScornmodllres and people's deSire

for them. estdl,jlshec1lhe acceplablllty of precIous rnelal money cenlunes ago

But preclou~melal lIke allcommodl'Y" mOfllf?S,

provec1 less It'liin perfecl COins were t1e,h'y and aCCUfr!UICltlon pOJel1 prnr)lerr,s :)f safe Iriinsporl

riflCJ Slor age COinS also could be remellec].

mixed With ~omrnon mOlals, ancl restruCk, which

reduced Ihfllr Intru'SIC value Gold anC1 sliver were scarce and demand for Ihem generally exceeded~upphes As a rosun lhe value of

prOCIOus rnf'!tal was gerwrnlly high relative to common meld Is

The history of Amencan cOinage deals largely With attempts to resolve problems of precIOUS melal money

For examplt> Congress Issu(!l1 paper money during the AmCrican Rp.volutlon bHcause It lacked gold and Silver coms and the metal to make them In the 18705, theU S allowed people to exchange Silver dollars for paper dollars because the weIght and size of the cOins made them unpopular and httle used In tho late 19605. (Ising mdustflal ,1emand forced Silver's ehminahon from U S COinage

Teday's U S COIns don't contain preCIous rpetal

Theface value of our COinS IS greater than

the value of the rnHlal rn the COinS We accept cems as "foken" or 'co,wenlence" money for the small fmanelal transacllons of dativ life, such as vending fll,Jchmepurchases phone cdlls

and lipS

The use of paper currency grew dlfecfly out of the problems of coms 1heInGonVE~nlenceof carrYing and safekeepmg large Quantities of corn caused people In different SOCieties 10exchange

paper recelpls for cOins or bullIon hele1,n a natIOnal treasury or prIvate bank More Important. paper money was often used to overcome the scarcity of~rec,ousmetal cOins

Paper money, however also provm1 less than perfect Thf? baSIC problem concerned ItS source When money was pre(1omlnantly gold and Silver COin govcrnments were prevented from ISSUIng more COin by the amount of melal InIhelr

treasuries. dug out ofthE~ground or obtained for goods 501(110 other nal,ons Wlthoul srnHlar

reslrlcllons on currency governments and banks coul(1over'ssuH ret1ucmg Ihe value of each note, and leoparfl1llng paper money's dccepliib,llly by making currency a poor slore of value

DlJflng the Amencan Rel/olut,on, Congress so over Issued conImenIal currency Its value almost (1,sappea red Indeed, the expression not worth a contInental" was WIdely used then to connote worthlessness The colonists were so angered that, after Independence. Congress dldn'l Issue paper money for over 70years, even Ihough It had the C"nstltutlonal power to'coln money' and 'regulate" Its value

Unlilthe Civil War, slate·chartered banks Issued Ihelf own currency In the early 1860s,

as many as 10,000different bank nole Issues

clfculated Banks were pledged to redeem their notes for COin or bullton. but beCalJSe many banks had only a fraction of the preCIous

COin or melal needed for repayment. and beca...se many were headquartered m remOle reglor1s Ihe value of thelf notes was suspect The result was a ChaotJc currency system In which people sometImes accepted bank notes at less

than face value

Unt,l after the eSlabllshment of the Federal Reserve SystemInDecember 1913, theU S

dIdn't have an'elastlc" currency, a currency whose supply could expand or contract as buslf1ess acllvlty and publiC demand changed


, '..s.'






~. ....

Gold "backing" Ilv... do.Ia,



Unt,l 1968, US currency had to be parllally backed by gold However. gold never gave the dollar Its value The dollar's value always has been determined by the amount of goods and services It can buy . Its purchasing power Gold backmg was requIred through most of U S history as a means of restraining Government overlSSudnce of paper money and ImprovlMg pubhc confidence. and, therefore, the acceptability of paper money

When the Federal Reserve was establIshed. Congress reqUIred the 12Reserve Banks to tjack thel: currencV. known thefl a'SFeder al Reserve

Bank notes and today as Federal Reserve notes, with 40percent gOld and 100percent 'eligible paper" (Short-term IOUsof busmesses and farmers) The eligible paper requirement was reduced to 60 pelcent In 1917 Gold WdSbought from the Treasury Eligible paper was obtained from commercial banks that pre5ented these cuSfomer IOUs as collateral for loans

Essenhally, only thoSe IDUs representtng commerCial banI( loans made to expand manufactuflng or farm output were deSIgnated "eligible" as collateral by the Federal Reserve

The backing reqUIrements on Federal Reserve notes were deSigned to regUlate currency

issuanceautomatically to the pace of the

ecrmomy's growth, smce only Increased bUSiness actiVity and bank lendmg could generate the collateral necessaryfOf


note Issuance

Backing requirements were Itber ahzed and

reduced over the years, as we gained better inSight Into how the aconomy works and how money should be regulated

By the 1930s. Congress allowed Reserve Banks to use assets other than eligible paper, such as

US Government secuntles, to back currency By

the 19409,Congress slashed the gold

requirement to 25 percent andIn 1968eliminated gold back1nt:, entirely

Federal Reserve notes ate stili "backed" dollar-far-dollar by the assets of the Reserve Banks About85percent of Ihese assets conSist of Government securities the FtJderal Reserve purchased over the years The rerr.aln:ng 15 , 'rcent conSists of gold cerltf,rates representing

~. I?dges against the Treasury's gold supply Ht:serve Banks no longer have to use thelf gold certifIcates thIS way, but many sllU do

Currency backing Isn! relevant In today's economy Currency can no! be . redeemed," or oxcrtanged for Treasury gOld or any other asset

USf~(Jas backing The questIon of Just what assets back' Federal Reserve notes has Iltlle but hookkeepmg significance

Money's value, however IShighly relevant Maintaining thedolla(~ lIue means maintaining Its purchaSing power 11.Stng pr,ces-lMflatlon--reduce purchaSing power, stable pflces keep purchaSing power strong,

Too mUC!1 money resultsInexcess spending

When consumers, bUSinesses and governments spend excessively, they compete for the available supply of goocs and services and force pflces

up When prices flse. the purchaSing power of money falls To keep purchaSing power strong, then, the supply of money must not Increase too rapidly



,-.'; ~ _....

_-..A .._,.-._.l"~ . '--'-'








...'.:, .




. . . .: .






Govwnment reducn man.,'.





muctl currency.

TheBureau of Engraving and Prinllng In

Washinglon,O C,


unit of the Treasury.

I!.responsible for printing the nahon's currency

But its orders10print come from the '2

Federal Reserve Banks, not the President or Congress. The Reserve Banks, not Ihe

Treasury, delermlne how much currencyIS

printed. based mainly on estimates of commercial bank and public cash demands Under this arrangement. the Government can't punt more Federal Reserve notes to pay its bIlls or debts.

Since most U.S moneyIScheckbook money, the

printing presses have liltle10do with the

buying power of money. Maintaining money's value involves Ihe Federal Reserve's control over commerCial banks that create most checkbook balances.

The Federal Reservedoesthisinthree ways

Flfst, the Federal Reserve Act requires commercial banks that are members of the System to keep "reserves" as COin and currency in their vaults or balances at their district

Reserve Bank.


ralsmg the percentage of

reserves thaI must be held, Ihe Federal Reserve reduces banks' ability to create more money Lowering reserve requirements increases banks'

money creating


-.' - .-1

Second. the Federal Reserve lends money. generllfly for only a day or two, to banks that belong to the Federal Reserve System It charges Ihem inlerest, called the "dIscount rate ..

Changes in the Jtscounl rate have the effect of making Federal Reserve loans more or less attractive to member banks.

The most important control ISopen market

operatlons-ouylnQ and sellingU S Government

securtties through anetwork ofalmost three

dvzen privale dealer fIrms. When Ihe Federal

Reserve sells securities from lIs$100billion

pl'Jr!follo. dealers pay with checkbook money that

ISlaken out of circulation when the checkbof)k

funds are transferred from the dealer's bank to

the Federal Res~rve.When the Federal Reserve

buyt securifies. itpays with checKbook money,

increasmQ moneyInCirculation


j. •










-CndItcard8 ... ,...form of money.

CredIt cards aren't a form of money, bu' a "deferred payment" device, am~ans



gOOds and services by promlsmg 10 pa)' laler CredIt card transactIons are similar to loans When you use a credIt card, Ihe C<Jru company, sometImes an affiliate of a large bank, pays what you owe to the merchant directly and ImmedIately In tIme. you receIve a bIll from the credIt card company which you can eIther pay fully, or partially. with cash or checkbook money Until you pay. the credIt card companyIS

e>\tendmg you credit for whIch you Will pay Interest after a short period Many people, however, pay theIr credit card bIlls within the month billed and aVOId Interest charges Many credit cards carry a "credlt Ime," a maXimum amount the Issuer WIll lend you. A $1,000 credIt line allows you to accumulate $1.000InunpaId purchases or cash advances.

CredIt lmes are prearranged loans that become effective when used. an arrangement commonly used by large companies.

All bank lending depends on the availabIlIty of reserves whIch are determined bythe Federal Reserve When the supply of reserves

.s small and cred.t card users draw on their credit ltnes, banks have to reduce loans to other customers Commercial banks alone lent about $12 bIllIon through credIt cards and simIlar plans

In 1976, about 10 percent of thelf loans to

IndlYlduals that year

Even though credIt cards aren't money. !hey affect 'he way we spend money and. in that sense, arf3 Important to understanding people's purchasing behavior

For thiS reason, some economists beheve lines of credIt gIven on credit cards should be counted as part of the nation's "money supply"-a techn,cal measure of the funds the public has avariabl3 for Immediate spending. They argue that many Important spendmg deciSions are based not lust on the amount of cash and checkbook muneypeo~lehave on hand, but on indiViduals' holdIngs of financial assets, such as savmgs depOSits, stocks and bonds, as well as the availabIlity of credIt


ca.au ••


Checks aren't money in themselves. Theyare stmply


forms instructingbank& tomovecheckbook

deposits, whicharemoney, from one account to another. Thosecheckbook depoSits are

~inOentrie$, numbers onbanks' ledgers

and In their computers.

BankSdon't keep cash in "hecking accounts and


transfer currency or coin when acting on a

check's instructions. Checkbook deposits are transferred between accounts and banks as bookkeeplng entries only.



the nation's 14,600 commercIal banks

held about


billion of checkbook deposits for

individuals, businesses and governments.



_ . __ -,_-_~_... _ I










. .

Commercial banks create checl<book money whenever they grant a loan. SImply by adding new deposit dollars 10 accounts on their books In exchange for


borrower's IOU

Mtlney creatIon bookkeeping Isn't gimmickry Far from It Banks are creating money based ona

borrower's promIse to repay (the IOU), WhiCh, ,'1 turn, is often secured or backed by valuable Items the borrower owns (collateral)

Someone obtaining an auto loan, for example, mIght use Ihe new car as col'aleral A home Improvement loan mighI be secured by rne value of the house being Improved BUSIness loans may be secured byphYSIcal assets. such as machines. factorIes and mventortes. or may be "unsecured," backed only by the companys

earnings record and expectations or general credit WOfl"mess

Banks create money by "monetIZing" the private debls of bUSinesses and IndiVIduals That 15, they create amounts of money agamst the \talue of those IQUs

To create money. however, hanks must have "excess" reserves. funds exceeding those they

are legally requlfed to hold Banks belong109to the Federal Reserve System must abideby the System's requirements. Banks that aren't

members are sublect to the reserve requirements of the state thaI chartered them.


without legal rules. prudent bank


dictates thatsome "requIred" reserves be held Bankers know that. on any given day, they will have to payout com and currency to people cashmg personal checks They also know that

they WIll have to transfer reserve balances


checks drawn agamst accounts they hold are presentedfOfpaymentby other banks_ Meeting theseroutine transactions requires thac


holdsome reserve funds

It a bank has excess reserves It can create an amount of money equal to that excess: It can grant a loan Borrowers wflle checks against their new depOSIts When these checks are deposited at other banks. tnose banks collect payment from the borrowers bank Bankers know that when other banks present borrowers' checks for payment, they WIll have to transfer reserves on a dollar-far-dollar baSIS

If a bank creates an amount greater than Its excess reserves, It also wouldlose some reqUITed reserves and face temporary ViolatIon of

requirement rules Prolonged ViolatIon of

reqUIrement rules subjects banks 10 penaltIes So they tend to match lending to excess reserves A

bank short of reqUired reserves usually Will borrow from another bank Member banks can also borrow from the Federal Reserve

As newly cre?led checkbook dollars move from bank to bank. banks g81OlOg excess reserves can make additIonal loans As a group. banks are capable of creating money


a multIple way, Currently. our banktng system theoretically can ganerate a sevenfold Increase10total money creatIon With


given amount of excess reserves, Money multlphcaflOn, rather than currency depoSIts, accounts for most of our$230 billon of checkbook money Banks hold only about $34 billionInreserves. Only$8billIon of that total is cash, the remaining rest;lrves are depOsit balances at Federal Reserve Banks Reserves are the base on whIch the banking system has generated the bulk of the nation's cheCkbook money.


811ftu ....




Manv banks carry very othclal-soundlng names, like "Bank of America" and 'State Bank of Albany," but they aren't run by, owned, or part of goverl"ment

CommercIal bankS are prtv8lCly owned b'JSlneSSes ,rYlng to earn profits prlmanlV by lending money 10 other bUSinesses and 10 ,"d,vlduals Don't get the wrong ImpreSSion from the government· type sp.als on their Windows Banks musl be Ircensed to operate The license,

called a 'charter,"ISgIven either by the Federal

Government (Comptroller of Ihe Currency) or the

government of lhe stateInwhich the bank wants

to operate Banks ChOOSing Federal charlers, about ona-thlrd of all commerCial banks, must have Ihe word "National" In their nr -"e or the leners'N A "(NatIonal ASSoclatlo:" after

thelf title Slate· chartered banks don·t have10

use the word" State" In their names. bul many do Banks must meet government rules and

regulallons Banks With Federal charters, for example, must lOIn Ihe Federal Reserve System. the Independenl agency Congress created to

regulate the nallon's flow


money and credit

Stste-chartered banks may lOin the Federal Reserve, an optIon cl"osen by only 10 percent of the nation's 9,800 state-chartered banks

Sanksbetongmg to the Federal Reserve may

display aseal onthe1frY'lQIfl wmdow md,catmQ

theyare a "memberofthe Federal Reserve

System" Member banks are subject to many Fedsral Reserve regulatIons and can borrow

moneyfrom Reserve SankS for short peflods to meet unelCp.'9cted custonler Withdrawals or other claims exceedmg funds on hand Federal Reserve membershIp doesn't make a bank a "member" ot the Federal Government


Regardless of charter, banks can IGItlanother

"Federal" organ,za!:c:" the Federal DepOSIt Insurance CorporatIon (FDIC) Congress

establtshed the FDIC In 1933 to Insure depositors

againstlosSwhen a bank lalls VIrtuallyall US

commerCial banks are FDIC members Most have a seal on their main door or near tellers'

WIndows mOleatlng that depOSits are Insured up

to a ma)umum. which Congress sets, of


~er account But aga,n. thai "membershIp"

doesn't mean the bank ISpart of, runby,or

owned by the Government

Most commercial banks ,n Ihls country are small, locally owned bUSinesses, wl1h no branches, lust a few employees, and only a few million dollars of depOSits Relatively few commerCial banks are bIg busmesses With many branch offices and rhousands of employees These bIg banks. however, hold a relatively larger share 01 the banking system's depOSits than the small banks,

Concentraled mainlyIn maier Cities, these bIg

banks, like Chase Manhatlan and Chemical Bank m New York City, and Bank of America," San FranCISco. are owned by S10ckhold1!ts Their ownership shares are bought and sold publicly on the stock exchanges

CommerCIal bankstry to earn profrts for

stockholders by lending money and by ,"vesting

InFedersl, state and local government secufltles.

Most commercial bank loans are to businesses which need funds tor such purposes as buying raw mateflals and moderniZing faclones

Although many of the largest banks aim most of

their advertising at consumers. only about


of eve,y $10 lenl bycommercial banks are

"consumer"'oans About $3,50of every $10 lent

are "commercial and Itldustrial" loans, Real estate loans take about $3, and loans to financial firms. farmers, or others about $1 of every $10 lent,


-,~~ ;,-';'" <~"- '





BanIll ....




can flx


rllt. . on loan. Ind


and do Jual Iboul

whaleVtll ....

die, ,...

Banks cannot do whatevor they please Their marketplace 'power" and their ability to "f'~"

mterest rales are hIghly restricted by overlapping layers of laws and government rules and

regulattons, and byaC~lvecompetition among

banks and other Imanctal institutions

There are lour Federal agenClos that have bank regulatory responSibilities Federally chartered

banks are regulated by the C'Jmptrolierof the

Currency, part of the Treasury Department that

serves as the Federal Government's bank

chartering agency Since all federally chartered

banks must belong to the Federal Reserve System, they are also sublect to the central bank's rules

Nonmember banks are regulated by both the charterm9 stale government and the Federal DepoSit Insurance Corporallon In addllton, all banks are sub/t"ctlO the authOrity of the Justice

Department. 11the,r act,vIlles appear to Violate

antitrust laws

The hroad goalvI governmenl regulatIon of

banks IS10safeguard the public's money by

making sure banks are operahng prUdently Federal and state laws. for example, prohibit banks from Investing In common stocks, and IImll the maximum loan they can make to one borrower Furthermore, banks cannot open new branches.

mergeWIthother banks. affiliateWith other

bUSinesses, such as credit card companies. or change bUSiness hours unless Ihe regUlatory agencies say okay


. .

In recent years. regulators have focused on bank

lend109and adverllslng practices Recent

leglslallon, for example


aimed at ehminatlng

raCial and seKual dlscflmmatlon In lending and requIres that borrowers be mformed of the precise conditions and terms of loans

CommerCial banks must conform to Federal and state laws on Interest charged on some loans and Interest paId on depOSits State 'usury" laws set the legc.l Intere:;t rale IIlTHt on loans to

IndIVIduals State governments also determIne

ma)(IfTllH~rates on reSidential mortgage loans and maXimum rales Slate-chartered banks can pay on Interest-earning (time) depOSits

In 1933,Congress prOhibited ccrnmerclal banks from ~aYlng Intereston checKmg account funds

(demand depOSits) Atthe same lime, Congress

gave rhe Federal Reserve power to sel ceIlings

on whdt member commerCial banks could payIn

mterest on time depoSits Member banks. however, are limited to the maximum rates

established by the stales Since Ihe 19305.the

FDIC's Interest rate ceilings have matched those

Imposed by the Federal Reserve and s,"ee 1912.

so haveall slate ceilings AllcommerCial banks.

then, have the same Interest rate limits CommerCIal banks. however. do not charge

the same rates for stmllar loans or paythe same

rates for Similar depOSits. CommerCial banks actively compete against each other and against 'thflft InslltutiOns" - savings banks. savings and

loan aSSOCiations and credit unions-for depOSits and many types of loans.

illS not uncommon for banks In the same area

to have different automObile, home Improvement or mortgage loan rates, diNerent rates on savings and time depOSits and different charges for f,nanClal servlces.lSuch as money orders, personalized checks. and cheCking accounts





-AU ...,..



"SavIngs" and "commercIal" banks dIffer In many respects First, they have dIfferent corporate forms Savings banks are "mutually" owned by depositors, not stockholders They are runby

nonsalaned boards of trustees, not corporate dtrectors EarnIngs aren't paId to private owners as diVIdends but dlstnbuted to depositors as mterest on savmgs

Savings banks collecllndlvlduals' savIngs and channel those funds mainly Into home mortgd(]eS CommercIal banks lake demand deposlls and make profIts by lendIng and investing

The ability of Ih"'t InstitutIOns to lend money for mortgagesIS!Inked te depoSItors' savmgs behavior Many people depoCilt moneyInthnft

InSlltutlons because they o11er a nood Inlerest relurn on savings However, whe.l mterest rates flse10the natIon's credIt markets. better returns

oflen can be obtained by puttIng savings elsewhere Fewer depOSIts mean fewer

mortgages, and fewer morlgages generally lead to less home bUIlding and more unemploymenl in


construction Irades In addItIOn, many tnduSlfles that depend on a strong housmg market, such as furnIture and appliance makers, also suffer from reduced sales,

tn the 19605,Congress established~further distinction between savings banks and

comm"rClal banks by allowtng thrift mslltulions to

paysavings depositors a rate above the cellmg ffTlposed on commercial banks, ThiS small rate differential was designed to keep thrift depOSit inflows strong enough to buttress the mortgage and housmg markets.


One entlcal difference between savings and commerCial banks traditIonally has been in the way they lend money Commercial banks lendby

creating new checkbook deposits Savings banks and Similar thrift institutIons Simply payout eXlstmg funds lefl by depOSitors.

In recent years, many states, particularly in the Nor!heast, have changed thelf laws to lift reslrlctlons confining thrift ,"st,tutlon operations mainly 10 acceptIng savtngs depOSits and grantmg mortgages Thnfts In more than 20 stales can now prOVide some form of checkbook-type account

Mosl of these accounts, however, don't hold newly created checkbook money. but rather the savings that depOSitors have transferred into them to pay bIlls. These accounts comprise only a fracflon of the nation's total checkbook deposits. If thrift ·lnstitutions obtain broadj;1r powers to make loans other than long-term mortgages, they undoubtedly would begin creating money in much the same way as their commercial bank counterparts, by adding new deposit dollars to checking accounts. For now, most thrift

institutions payout loans with special checks against funds on hand. or funds deposited at a commercial bank, not bycreating new demand deposits.









. . . benId"l ...



, . . . Mel


poUoy. In 1913, the most vocal opposition to the Federal Reserve came from the Wan Street banking community. In part. that opposition stemmed trom the intent of Congress to establish the Federal Reserve with built in "checks and balances" specIfically to insure that monetary policy-making would be decentraltzed and made in the

broad national interest The System's structure. organization and relationship to Congress make it impossible for any interest group to domInate monetary policy.

The Federal Reserve System~onsisrs of rhree

interlockingparts - a seven-member.

Washington-based Board of Governors. 12

regional Reserve Banks. and 5.600member

commercial banks.

The Board of Governors ISa Government

agency- Each Governor.$ appointed


a 14-year

termbythe Presidenr of theU.S. with the advice

and consent of the Senate. Terms are staggered for an appointment every two years. By law. Governors must come from dIfferent regions of the country. and "fair representation" must be given to financial. agricultural. industrial and commercial Interests in their selection. Only two of the present Governors have Substantive banking experience. Four are economists and one was a corporation presiden,.

The 12 regional Reserve Banks aren't Government institutions but corporations nominally "owned" by member commercial banks. who must buy special. nonmarketable stock in their district Federal Reserve Bank. Each Reserve Bank has nine directors, each of

whom serves three-year staggered terms. As stockholders, member banks elect the majority of the directors (six) but only three bankers can

serve on



The Federal Reserve Act requires that three

directors of each Reserve Bankbpappointed by

the Board of Governors. Theymay not be

bankers. Of the six elected directors, three must,

bylaw. be actively engaged In some

commercial. agricultural or industrial lob. The Federal Reserve Act also prohibits the six "nonbanking" directors from being affiliated

with a bank in any way. Thus. the nominal "owners" of the Reserve Banks, the

private member commercial banks. have only

threeof the nine directors' seats at each

Reserve Bank.

Moreover. the three banking directors must be representative of the entire banking industry. not just the big banks. Member commercial banks vote for their directors according to size.

with small, medium and farge banks each electing one banking director. Thus, the most powerful banks cannot dominate the banking directors. In the 1970&. the New York Reserve Bank's directors have included chairmen and presidents of corporations and banks throughout the New York Federal Reserve District SUt educators. a civil rights activist. law firm partners. and the president of a philanthropic organization also have been recent New York Reserve Bank directors.


Reserve Bank directors appoint Reserve Bank presldcrll5. who serveWlt~l the Board of Governors on the Syslern's key policy-making body. the Federal Open Markel Commillee (FOMC) Directors' appointments of presidents. however. must be approvecj by the Board of Governors

Tt10FOMC, which meels monthlyIn Washington,

DC 10decide the course of monetary polley, consists of all seven Governors and live Reserve Bank presidents, four of whom serve one-year terms on a rotalmg basIs The president of lhe New York Reserve Bank, who traditionally serves as FOMC vice chairman. IS!he only Reserve Bank president who serves as a permanent Committee member

FOMC decisions aren't secret. A summary of the deliberations and record of policy actions are made public about 30 days after each meeting. A record of the vote of each member of the . . Commillee appears after the formal policy

decision, called the "directive." Dissenting votes are recorded with the reasons for the dissent. The 30-day delay is designed to avoid creating excessive reactions to policy moves that might hinder the functioning of markets and the orderly implementation of policy decisions.

What's more. the chairman of the Federal Reserve Board of Governors formally reports to Congress every three months on the course of monetary policy and the Federal Reserve's long-term objectives. In addition, System Governors routinely testify on key economic and banking issues before House and Senate commillees.

The Federal Reserve is unique among I

government-type institutions in that it is "independent" within the Federal Government.

Congress specifically structured the Federal Reserve so that monetary policy judgments and actions would be made non politically. The

14-year term .ur System Governors is an example of that intent.




...__....,..._...•"'J.,...;.,...,.,..-- ..."..,..-_--...-...- ~... • _


·.'·.Neither the System'S monetary policies nor its . '1;>anking activities are designed to guarantee

~'·profitsfor anyone.

-Almost all Federal Reserve earnings come from the interest paid by the U.S. Government on the . $100 billion or so of Government securities the

System acquired over the years for monetary

policy purposes. "

,So farI in the 1970s the System earned more

than $5 billion a year. Almost all of the Federal Reserve's earnings are returned to the U.S. Treasury. Funds retained by the System are used to pay the budgeted expenses of the Reserve Banks and the Board, maintain a small surplus, and pay the 6 percent atatutory dividend on the ReservE:. Bank stock held by member banks. Member commercial banks don't share in the System's earnings.






TIle ... "...


the I8ICMIftt

of .





Federal Reserve doesn't control the amoYnt


"cuffency" in circulation. Thepu~ic does. The

Federel Reserve.

however. determines the total amount of "money" in Circulation.

Whenpeople want mors currency, they cash

checks at their banks. When banks want more currency, they purchase it from their Reserve


with the checkbook money they have on

depositas partoftheirrequired reseNes. Since

currency in circulation increases only when

check~deposits dedine, the total amount of

moneyremains unchanged. Only the composition

ofthe money supply changes when thepU~ic

atters the form in which it holds money balances.


pub!ic has shown, O\l&r the years. a very

strong preference tor checkbook money over cash. At particular times of the year, however,

such asinDecember, thjslong-term preference


CS8Ctdedfy toward


and more than $2

bitlion in currency andCOlOleave



system. In January, demand shifts back to checkbook money. and cash returns to the bankingsystem.


Federal Reserve doesn', try to alter public

preferences. but accommodates them by selling currency to banks to meet public demands and accepting currency deposits to reserve accounts

. . demands




-. ".-. ----.-. ~





. . . . 1Ionow



Federal R•••, .

.. 1M


nile and


functe It •

... ,... to



Bantes can't borrow money 'rom the Federal Reserve to lend ata higher rate, evenifthey want to.


Federal Reserve. not commerCial banks determines the rules for borrowing at the discount rate. These rules restrict borrowing to snort·run, temporary. seasonal or emergency needs, Banks that borrow too mUCh, too often, fortoolong, or for the wrong reasons, will soon

hear fromtheFederal Reserve. Because banks knowtherules and understand the Federal Reserve's fundamental central bank '9'e as


"lender of last resort," they rarely try to abuse

theborrowing privilege.

Commercial banks get the reserves that support

their loans

and investments by attracting individual and corporatefundswith interest payments


time deposIts, by borrowing reserves from other banks. orbyselling assets,

such as

Government securities.

When the Federal Reserve was established, the worldngs of the economy weren't as well

understood as today. In those days. banks could readily replenishthefunds they lent to farmers and to


engaged in buying raw materials and manufacturing finished goods


borrowing from the Federal


Economic theory indicated that. since "commerCiallcans"


lncrea58 production

and create more

jObs,accom"'Odating banks would help feed


expansion. To encourage


additional tending







wouldbe reduced .

... To dlseourage








no longer fOltow8 the "commercial loan theory" of discount lending.

lending at the discount rate is now used as a


valve" that provides funds to individual





:.- ..:.'-;~.,.-..-.._,-'-..,-'.



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