Basics of Central Banking

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Basics of Central Banking

• Dr. D. Foster ECO 473 Money Banking

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Free Banking Inflation

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

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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

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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 Freedom in the issuance of banknotes
  will narrow down the use of banknotes

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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)

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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 changesfrom
DD to banknotes.
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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.
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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).

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

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Central Banking Inflation

• With many banks, an ?reserveswill ?MS by (1-rr)
• If rr20 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 doesnt act, govt. 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?

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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) 151162.
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Basics of Central Banking

• Dr. D. Foster ECO 473 Money Banking