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Madison, Wisconsin - August 30, 1968 Mr. F r a n c i s ' 15-minute presentation Fractional R e s e r v e s , Monetary Policy Tools and the Role of Money, A. Fundamentals of a Fractional Reserve Banking System 1. In the United States, c o m m e r c i a l banks operate on a fractional r e s e r v e s y s t e m . National and other Federal are required by law to Reserve member banks/hold a certain percentage of their deposits as vault cash or deposits at the Fed. 2. Under this s y s t e m , the volume of loans and investments that commercial banks can extend is determined by the availability of c a s h r e s o u r c e s to provide the required r e s e r v e s against the deposits that result from such loans and investments. B. The "Tools" of Monetary Policy. 1. The Federal Reserve System has three principal "tools' at its disposal to influence both the r e s e r v e base of the banking structure and the volume of bank credit and deposits: a) The establishment of a relation between amount of deposits and legal r e s e r v e s , e. g. , now from 7 to 22 per cent demand 3 to 10 per cent time. time. b) Control of the amount of reserves ehiofly by means ... "7 amount of T r e a s u r y securities ofdeterminingtheamountofTreasurysecurities,e . g . , about51billion. B) (Holdings of Treasury obligations can be changed HJ/ak 8/8/68 v- from day-to-day and provide great flexibility. When the Federal Reserve wants toexpandthe cont'd. Money Supply, it provides additional r e s e r v e s to the banking s y s t e m by buying U. S. Government securities in the open market. When this o c c u r s , the Federal Reserve pays for the securities with a check drawn on itself that is given to the s e l l e r of the s e c u r i t i e s . The check finds its way to a c o m m e r c i a l bank and then comes to the Reserve Bank as a credit to the r e s e r v e account of a m e m ber bank. Since no other member bank's r e s e r v e account is reduced with the p r o c e s s , there is an i n c r e a s e in both total bank r e s e r v e s and the capacity of the banking s y s t e m to expand loans and i n v e s t ments and thereby deposits. increased and, presumably, The money supply i s the volume of money influ The Relationship Between the Supply of Money and Total Spending. 1. In general, m o s t bankers and b u s i n e s s m e n would readily agree that monetary policy does have an effect on total spending. Overall, i n c r e a s e s in the amount of money and credit are associated with increased total spending. v e r s e l y , restrictions on money operating with a lag Con- C. 1. (cont'd) are generally thought to be restraining influences on consumption, and investment. 2. We should be somewhat moreanalytical in our appraisal of the relationship between money and spending. There are three questions that seem appropriate in making our appraisal: a) What is money ? b) How should the supply of money or changes in the money supply influence economic activity? c) What evidence do we have to support these claims of such a relationship? 3. Money is a common word in everyday usage. Yet there is some controversy over which assets a r e , and, which are not, money. a) Ordinarily, money is defined as those financial assets that serve as a medium of exchange; - M1 vs. M2 - Credit v s . Money - Interest rates b) In the U. S. the money supply is normally taken to in- clude demand deposits at commercial banks and c u r rency and coin; - Amount - M 2 1 9 8 billion (4£ billion currency I 380 billion ( 196 billion deposits) cont'd. c) There are s o m e economistswho would include all very liquid a s s e t s - those that are convertible on an immediate basis into demand deposits or cash - such as savings - deposit type balances at com- commercial banka-or thrift institutions; d) On balance, there is still lack of uniformity regarding the definition of money. 4. One of the central unresolved questions in monetary economics centers on the t r a n s m i s s i o n path over which the growth of money has its effect on the ultimate economic policy goals of full employment, maximum production, stable p r i c e s , sustainable growth and equilibrium in international t r a n s actions • 5. To put the d i s c u s s i o n in perspective, we recall that: a) Federal Reserve monetary actions have their primary effect on the r e s e r v e s of the c o m m e r c i a l banks ±1 (26 billion). b) That the volume of c o m m e r c i a l bank credit (loans and investments) and the principle component of the money supply - demand deposits - are largely determined by the volume of c o m m e r c i a l bank r e s e r v e s . 5 C. cont'd. 6. As a first approximation, therefore, it seems reasonable to assume that the initial impact of monetary policy changes are felt by the member commercial banks; first in the amount of their r e s e r v e s and then on their loans, investments and deposits. 7. Many economists assume that aggregate income is the preferred ultimate target on which monetary policy has its effect since income influences consumption and business investment to a considerable degree and these in turn have an impact on employment, production, prices and so on. 8. A most debated question is whether total spending is most influenced through bank credit or through the quantity of money. a) Some economists argue that there is a direct relationship between bank r e s e r v e s , money holdings, spending and income; b) Others argue that the principal path i s : Changes in the quantity of money lead to changes in interest rates or the "cost of capital," which is one determinant of business investment - the unstable component of income. c) Still others argue that changes in quantity of money lead to changes in interest rates and asset prices and all other prices, which have an impact on both consumption and investment and, ultimately, on income. 6 The lack of a uniform view extends inside of the Federal Reserve System a l s o . Some of us hold strongly to the view that the System's role is to bring about changes in the money supply and that free market forces will lead to the proper change in total spending (income). Others argue that monetary policy formulation should encompass changes in a range of interest rates and a s s e t prices to influence spending (income). Most of the empirical r e s e a r c h bearing upon the problem indicates that there i s a consistent relationship between changes in the money supply and changes in spending (income but that i n c r e a s e s and d e c r e a s e s in money are not, in a statistical s e n s e , the strongest factor influencing similar movements in spending (income). Further, many economists and financial analysts claim to have proof of a six month average) lag between changes in policy and the effect on spending (income). There are many who argue that lack of really substantive evidence related to the theoretical concepts of the m o n e tary policy mechanism and empirical support for the idea of a fixed lagged relationship between monetary policy actions and changes in (income) means that the judgment of policy m a k e r s i s still superior to the concept of m o n e - 7 cont'd. tary policy as setting and seeking measurable monetary objectives. This analysis s e e m s to conclude that the System's primary focus should be on attempting to create appropriate conditions in money and capital m a r kets as each developing situation unfolds. We certainly learned during 1966 that, in a restrictive situation, monetary policy can cause a "Credit crunch" in the money and capital markets and have a restraining impact on spending in a number of s e c t o r s of the economy. Of course, the reaction time of each sector varies in time and magnitude - but this i s due, in some m e a s u r e , to structural arrangements in the economy.
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