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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,

Fundamentals of a Fractional Reserve Banking System

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.


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.


The "Tools" of Monetary Policy.

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
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.
b) Control of the amount of


ehiofly by means

amount of T r e a s u r y securities
ofdeterminingtheamountofTreasurysecurities,e . g . , about51billion.

(Holdings of Treasury obligations can be changed




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,


The money supply i s
the volume of money


The Relationship Between the Supply of Money and Total Spending.

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

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


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.


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

1 9 8 billion (4£ billion currency I
380 billion ( 196 billion deposits)


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


commercial banka-or thrift institutions;
d) On balance, there is still lack of uniformity regarding the definition of money.

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 •


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


(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 .


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
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.



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).


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 -


tary policy as setting and seeking measurable monetary

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.


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.