Re: Another View on Money and Credit

["William F. Hummel" <wfhummel@xxxxxxxxxxxx>]

>>In a message dated 27/01/2000 02:54:21 GMT Standard Time,
>>wfhummel@xxxxxxxxxxxx writes:
>>
>>> Banks are not ordinary intermediaries.  When a bank creates a
>>>  credit to fund a loan, it draws on its line of credit from the
>>>  Fed.  Ultimately that credit line is limited by a bank's capital.
>>>  As the banking system increases its aggregate issue of credit,
>>>  the minimum reserve ratio requirement forces the Fed to add
>>>  reserves.  If the Fed failed to do so, it would lose control of
>>>  the interbank lending rate, i.e. the Fed funds rate, its primary
>>>  monetary policy instrument.  Thus net lending by the U.S. banking
>>>  system automatically brings forth new credit from the Fed.

To clarify the point made in the above paragraph, here is a more
detailed version:

Banks are not ordinary intermediaries.  When a bank issues
credit, i.e. creates a new deposit to fund a loan, it draws on a
line of credit from the Fed, limited to a multiple of its own
capital.  Of course a bank must hold sufficient reserves to cover
net daily withdrawals by its depositors.  Those reserves come
from its own capital plus borrowed capital.  In the US, banks are
required to hold a 10% reserve against demand deposits, averaged
over a two-week period.  That means a bank has a working margin
against withdrawals that allows it to run below its required
reserves on a given day.

Interbank lending suffices to redistribute reserves to those
banks that lose deposits due to ordinary checking activities.
However banks with sufficient capital sometimes create new
deposits in excess of their required reserves, and count on
acquiring them in the interbank lending market.  That leaves the
banking system as a whole short of reserves, which applies upward
pressure on the interest rate charged in the interbank lending
market.  In order to defend its target rate on Fed funds, the Fed
is obliged to supply the required reserves itself.  Thus a net
increase in credit issued by the banking system automatically
brings forth new base money from the Fed.
----------------------
There is an important difference between the U.S. system and a
system with zero required reserves.  Ignoring frictional effects,
banks in a zero reserve system can redistribute clearing balances
perfectly.  In such a system, a bank with adequate capital can
increase its lending without forcing any action upon the CB.  In
the U.S. system, the 10% reserve requirement applies in the
aggregate just as it does to individual banks.  Thus Fed is
forced to respond with added reserves equal to about 10% of the
net new credit issued in order to defend its Fed funds rate.

The reserves in the U.S. banking system currently total about 42
billion.  Demand deposits (M1 - currency - travelers checks)
total about 500 billion.  That's not quite the 10% required, but
close enough.

William F Hummel