plays a central role in
our lives, yet no one can be totally free of misconceptions about
This article deals with only a few basic ideas, but it should help to
overall understanding of what money is and how it works.
Two Kinds of Money
Money is a token that
is widely accepted as
a medium of exchange. The token can be tangible like a coin or
intangible like a bank deposit. If the token is convertible on
into a valuable commodity like gold, the token is known as commodity money.
The exchange value of commodity money varies, but is normally greater
value as a commodity. A precious metal
coin is simply a token potentially convertible into the bullion that
If the tokens are
and inconvertible, the government must endow them with a special status
them viable as money. Such tokens are known as fiat money.
for collector’s items, all government-issued tokens today are fiat
One must therefore avoid thinking in terms of commodity money to
In the era of
commodity money, the issuer
was constrained by the need to hold a sufficient supply of the
commodity. There is no such constraint in the case of fiat
The value of fiat money therefore depends on the policies and actions
issuer, normally the central bank of a country. The remainder of
applies to the monetary system of the U.S. and not necessarily to
Fiat Money as a
The general acceptance
of the government’s fiat
money derives from its status as legal tender and from the fact that it
required in payment of federal taxes. Those who have no tax
have reason to acquire fiat money because it is of value to those who
Thus fiat money can be viewed as a tax
credit, which will be used as a medium
of exchange as long as the government widely enforces tax collection.
Fiat money held by the
private sector is
known as the monetary
which we will refer to as base
money. The Fed issues base money when
it buys securities from the public for its own portfolio, mainly
debt. It pays by simply creating a deposit at the Federal Reserve
for the seller’s own bank. This is known as monetizing the debt.
Banks create deposits,
known as bank money,
when they issue loans by simply
crediting the borrower’s account with a new deposit.
The total amount of bank money increases when
a bank issues a loan. When a loan is
paid off, that amount of bank money vanishes.
The value of bank
money is based on the
promise that it can be converted on demand into base money at
rules require a bank to hold reserves
of base money equal to at least 10% of its transaction deposits.
can be held in any combination of vault cash and deposit at the
There is no required reserve for other bank liabilities, such as
accounts or certificates of deposit.
the Price of Reserves
Even if there were no
reserve requirement, a
bank would have to hold enough reserves at the Fed to cover its
checks, and enough vault cash to meet the demand for withdrawals by
depositors. The need for reserves thus creates an active
in which banks lend or borrow reserves among themselves. The
rate on these short-term transactions is called the Fed funds rate.
The Fed steers the Fed
funds rate toward its
target through its open
market operations. These
involve buying or selling securities in
the open market to add or drain system reserves as needed to balance
and demand at its target for the Fed funds rate.
Any bank in good
standing and with adequate
collateral can borrow on a short-term basis at the Fed’s discount window. The
interest rate the Fed charges is 100 basis points above its target rate
funds. With that large a spread, the discount window is used by
cover temporary liquidity problems rather than as a source of reserves
During the subprime mortgage crisis of 2007-2008, the Fed reduced
the discount rate to 25 basis points above the target Fed funds rate to
improve liquidity in the banking system. This is expected to be a temporary measure.
Fed's Reactive Role
Why does the Fed
control the price of
reserves rather than the quantity? The answer is that targeting
quantity risks endangering the liquidity of the banking system.
example, an increase in cash holdings by the public drains vault cash
banking system. Unless the Fed responded by injecting reserves,
more banks might be unable to meet either the reserve requirements or
withdrawal demands of its depositors.
Targeting the price of
reserves is also more
effective in controlling the volatility in the Fed funds rate, and thus
interest rate banks must charge on their loans. Firms cannot plan
efficiently when the price of credit is subject to large and
As a result of the
Fed’s focus on price, the supply of bank money will vary with demand. It expands or contracts
according to whatever factors influence private sector borrowing.
the Fed plays an essentially reactive role, adding or draining reserves
needed for bank liquidity and to hold the Fed funds rate on
Since the reserve
ratio requirement doesn’t
really impede bank lending, what prevents a bank from responding to any
loan demands? The answer is that every bank must also comply with
equity capital requirement. This is a complex formula that rates
assets by risk, and requires that its capital exceed a certain fraction
A bank can get into
trouble by creating too many
assets through lending. A bank with insufficient capital relative
assets will be placed under supervision by its regulator who may then
approve any new lending.
question is what limits
the supply of bank money from growing excessively? Banks are in the
of selling credit. If a creditworthy borrower is willing to pay
bank’s rate, the bank will normally make the loan even if it must
required reserves after the fact. The only defense against the
of an excessive supply of bank money is for the Fed to increase the
price of reserves
to the point that it slows net demand.
The Fed’s basic
monetary policy challenge is
to keep the supply of bank money in reasonable balance with the needs
producers and the availability of goods and services. That calls
great deal of knowledge about the economy as well as skill in
data. Mismanagement of the price of reserves can readily drive
economy off track towards inflation or recession. This is a
task, and the Fed has made its share of mistakes over the years that
usually obvious only in retrospect.