ED 175 743

AUTHORTITLEINSTITUTIONPUB DATENOTEAVAILABLE FRON

DOCOHENT RESONE

SO 011 750

Friedman, David H.I Bet You Thought...Federal Reserve Bank of New fork. N.Y.Dec 7736p.Public Infoy -tion Department, Federal Reserve Bankof New fork 3 Liberty Street. New York, New York10045 (free)

EDRs PRICE HF01 Plus Postage. PC Not Available from RIM.DESCRIPTORS Adult Education: *Banking; Concept Formation: Credit

(Finance): Economic Developaent: *Economic Education:.

Economics: Federal Regulation: Financial Policy:*Financial Services: Government Role: InstructionalMaterials: Honey Management: *Honey Systems:Purchasing: Secondary Education: United StatesHistory

IDENTIFIERS *Federal Reserve System

ABSTRACTThe booklet lists and dispels 14 economic myths

th: .lh a discussion of money, economic concepts, and the Federal'e System. The oblective is to help secondary students or adults

undelJtand tbe economic system as relates to money and banking.Topics focus on money, banking, gold and silver, credit, governmentrole, financial concepts, and interest. For these topics historicalbackground information is provided, terms and concepts are defined,relationships between government and the banks are pointed out,Federal Reserve functions and operations sre outlined, and varioustypes of banks are compared. Sample myths include "Honey is simplycoin and paper currency," "Gold and silver are the only perfectmonies," "The Government reduces money's value by printing too muchcurrency," "Checks are money," "Banks are part of the Government,""111 banks are the salmis," "Wall Street banking interests establishedthe Federal Reserve and control monetary policy," "The FederalReserve controls the amount of currency in circulation," and "Banksborrow money from the Federal Reserve at the discount rate and lendthe funds at a higher rate to sake profit." Cartoon drawingsillustrate the concepts discussed. (CK)

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141 u s CISPARTMIENT OF WEALTH.EDUCATION AV/WARE

NATIONAL INSTITUT', Of'EDUCATION

TNIS DOCuMENT NAS BEEN REPRO.DuCED ExAcTLY AS RECEiVED FROMTNE PERSON OR ORGANIZATION ORIGIN-ATIII4G IT POINTS OF v IE* Ow OPINIONSSTATED DO NOT NECESsARILY QEPRE-

ii SENT OFF1C.AL NATIONAL INSTITUTE OFEDUCATION POSITION OR POLICY

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pPERMISSION TO FitPROLiok,t iiSMATERIAL IN MICROFICHE ONLYHA BEEN (RANTEtT) LY

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TO THE EDLICATiONAL RESOLJFILES!NEORMAT(ON CENTER Effl

Pubhc Information DepartmentFederal Reserve Bank of New York33 Liberty StreetNew York. New York 10045

PrefaceMost of us acquire two types of knowledge

"t ',MI knowledge" and "folk knowledge Folkknowledge is information and "wisdom" passed fromgeneration to generation or acquired on the streetsFor example, we're often told that sitting in athafl will give us a cold Science tells us theCommon cold results frorn a virus Yet, still wechange our seat to avoid a draft We mayacknowledge that drafts only contribute tolowering our resistance to infection, but we stiliblame the breeze rather than the bugSo too most of us hold certain economicmisconceptions folk knowledge containinggerm of truth and a plague of misconceptiOneconomic myths picked up by misreadings or theacceptance of 'facts' tram a friend or relativeFew of us are immune to economic myths Ormisconceptions If you dori t think SO I bet youthought

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Table of ContentsBefore reading this booklet, indicate whethereach statement below is true or false After,check your answers and rate yourself

Money is simply coin and paper currencyOnly coin and currency are real moniesbecaNse the Government says they re legaltender

True Faise Answer on page

ti 0 5

El El 7

Gold and silver are the i perfect monies Li (1 9Gold backing gives tr dollar its value Li LI 1 1

The Government reduces money s value byprinting too much currency

LJ r] 13

Credit cards are a new form ot money C) 1..:J 15Checks are money H fl 1 7

Checkbook money is created 'bycurrency deposits

[3 Li 19

Banks are part of Me Government D [1 21Banks are so powerful they can fix interestrates on loans and deposits and do lust aboutwhatever else they please

11 E] 23

All banks are the same D LI 25Wall Street banking interests established the L] 1.1 27Federal Reserve and control monetary policyThe Federal Reserve controls the amount otcurrency in circulation

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Banks borrow money from the Federal Reserveat lhe discount rate and lend Me funds at ahigher rate to make profit

0 L-] 33

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Money is simply coin and paper currency.Money is any generally acceptezi medium ofexchange. not simply coin and paper currency.Money doesn't have to be intrinsically valuable(valuable in itself), be issued by a government orbe in any special form. In our past, itemsranging from iron nails and dried codfish to gunpowder and tobacco have served as money

Anything people generally accept in exchangefor items of value is money. Money also is astandard for measuring value and a means ofstoring purchasing power for future use. Anyitem that has these three traits is money.

Americans accept three types of moneycoinissued by the Treasury, paper currency issuedby Federal Reserve Banks, and checkbookbalances (demand deposits) at banksIn analyzing economic activity, many economiststake a much broader view of money and includeother money-like Items immediately available tothe public for spending, such as passbooksavings and other funds deposited for specifictime periods.

Demarad deposits are the nation's most commonform of money, comprising about three-quartersof all money in circulation, This checkbookmoney is bookkeeping money created mainly bytne nation's commercial banks. Americans preferusing checkbook money because it performs asa more efficient medium of exchange than coinor currency for many transactions. Check writershave with one blank check the potential forspending small or large amounts. Since eachcheck must be signed before funds aretransferred, checkbook money cannot easily bestolen. in addition, cancelled checks providewritten proof of payments. Since we prizeconvenience, safety and recordkeeping, it's nowonder that checkbook money is preferred.

Checkbook money works because people areconfident in the strength, safety and prudence ofthe American banking system. Their confidencehas been bolstered by Government regulation ofcommercial banks and Government depositinsurance. The check clearing and collectionsystem of the Federal Reserve, the nation'scentral bank, has also made checkbook moneyhighly acceptable by speeding checking accounttransfers nationwide.

We've been big check users for quite awhile.The move began in the post Civil War era, whenbank deposits became the dominant form ofmoney held. Today, if all payment transactionswere counted, including those for stock, bondand real estate purchases, the dollar volumeof check spending to coin and paper currencyspending would be enormous,Only about 3 percent of our money is in coins,and for every 10 cents in small change we keep.we hold about a dollar in paper money. As anation, we hold only about $80 billion of cash,compared with $230 billion of checkbook money.

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Only coln and currency ere real monies becausethe Government says they'r " legal tender."Coin and currency are "legal tender," Money theGovernment says has te be accepted if offered tosettle a debt But that approval doesn't makecash any more real* than checkbook balancesUntil the 1860s, legal tender applied only tocoin. yet even then we user.: more private banknotes and bank deposits as money than coinLegal tender deeignation was given to certain;Goverrmentessued paper currency during theCivil War to win puolic confidence in thepaper money However there has been nomeaningful distinction between 'legal lenderand other U S money since 1933. when Congressmade all coins and currencies legal tender forall public and private debts

Regardless of what any government Says Moneymust have certain characteristics that make itacceptable Without those traits, even 'legaltender- cannot be successful as moneyMOST early monies were not issued bygovernments They were commodities such aSsalt, cattle and runl, that were widely known andeasily sold or used But commodities proved lessthan perfect monies The tobacco used by theearly Virginia settlers is an example

The leaves weren't easily divisible causingdifficulty in -making change The varying pricesfor different grades of tobacco made valuedifficult to determine 11 alSo was hard to carryand store Temperature and humidity changescaused flaking which devalued the leaves Inshort, tobacco lacked many characteristicsneeded to make it work well as moneyFor an item to perfon uccesstuny as money itmust be durable divisible portable and difficultto counterfeit More important as the Virginians'experience shows while any item can Serveas money, it won't work well or last long unless itcan also serve well as a standard and store of value,People's willingness to accept money in anyform, is rooted not in the law hut in money'sability to effectively measure and hold value

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Gold and sliver are the only perfect monies.Gold and silver monies have been used forthousands of years, but they are far from perfectGold and silver always have been desired Thescarcity, luster, and almost mystical appeal ofthe metals made gold and silver acceptable asjewelry, armor and religious symbols Gold andsilver's use as commodities, and people's desirefor them, established the acceptability ofprecious metal money centuries agoBut precious metal like all commodev" monies,proved less than perfect Coins were heavy andaccumulation posed problems of safe transportanci storage Coins also could be remelted,mixed with common metals, and restruck, whichreduced their intrinsic value Gold and silverwere scarce and demand for them generallyexceeded supplies As a result the value ofprecious metal was generally high relative tocommon metalsThe history of American coinage deals largelywith attempts to resolve problems of preciousmetal money

For example Congress issued paper moneyduring the American Revolution because it lackedgold and silver coins and the metal to makethem. In the 1870s, the U S allowed people toexchange silver dollars tor paper dollars becausethe weight and size ot the coins made themunpopular and little used In the late 1960s.rising industrial demand forced silver'selimination from U S coinageToday's U S coins don't contain precious metalThe face value of our coins is greater thanthe value of the metal in the coins We acceptcoins as "token- or -coovenience" moneyfor the small financial transactions of daily Me,such as vending machine purchases, phone callsand tips

The use Of paper currency grew directly out ofthe problems of coins The inconvenience otcarrying and safekeeping large quantities of coincaused people in different societies to exchange

paper receipts for coins or bullion held in anational treasury or private bank More important,paper money was often used to overcome thescarcity ot precious metal coinsPaper money, however also proved less thanperfect The basic problem concerned its sourceWhen money was predominantly gold and silvercoin, governments were prevented from issuingmore coin by the amount of metal in theirtreasuries, dug out of the ground or obtained forgoods sold to other nations Without similarrestrictions on currency. governments and bankscould overissue, reducing the value of each note,and jeopardizing paper money's acceptability bymaking currency a poor store of valueDuring the American Revolution, Congress soover issued continental currency its value almostdisappeared Indeed, the expression -not worth acontinental" was widely used then to connoteworthlessness The colonists were so angeredthat, after independence. Congress didn'tIssue paper money for over 70 years, eventhough it had the Constitutional power to "coinmoney- and -regulate" its valueUntil the Civil War, state-chartered banks issuedtheir own currency In the early 1860s,as many as 10,000 different bank note issuescirculated Banks were pledged to redeem theirnotes for coin or bullion, but because manybanks had only a fraction Of the preciouscoin or metal needed for repayment, and becaL.semany were headquartered In remote regionsthe value of their notes was suspect The resultwas a chaotic currency system in which peoplesometimes accepted bank notes at lessthan face value

Until after the establishment of the FederalReserve System in December 1913, the U Sdidn't have an -elastic" currency, a currencywhose supply could expand or contract asbusiness activity and public demand changed

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Gold "backing" glvee the dollar Its value.Until 1968. U S currency had to be partiallybacked by gold However, gold never gave thedollar its value The dollar's value always hasbeen determined by the amount of goods andservices it can buy its purchasing powerGold backing was required through most of U Shistory as a means of restraining Governmentovenssuance of paper money and improvingpublic confidence, and, therefore, theacceptability of paper moneyWhen the Federal Reserve was established.Congress required the 12 Reserve Banks to backtheir currency. known then as Federal ReserveBank notes and today as Federal Reserve notes,with 40 percent gold and 100 percent "eligiblepaper" (short-term IOUs of businesses andfarmers) The eligible paper requirement wasreduced to 60 percent in 1917 Gold was boughtfrom the Treasury Ehgible paper was obtainedfrom commercial banks that presented thesecustomer IOUs as collateral for loansEssentially, only those IOUs representingcommercial bank loans made to expandmanufacturing or farm output were designated

"eligible" as collateral by the Federal Reserve

The backing requirements on Federal Reservenotes were designed to regulate currencyissuance automatically to the pace of theeConomy's growth, since only increased businessactivity and bank lending could generate theCollateral necessary for more note issuanceBacking requirements were liberalized andreduced over the years, as we gained betterinsight into how the economy works and howmoney should be regulatedBy the 1930s. Congress allowed Reserve Banksto use assets other than eligible paper. such asU S. Government securities, to back currency. Bythe 1940s. Congress slashed the goldrequirement to 25 percent and in 1968 eliminatedgold backing entirely

Federal Reserve notes are still "backed"dollar-for-dollar by the assets of the ReserveBanks About 85 percent ot these assets cons s1of Government securities the Federal Reserveeurchased over the years The remaimng 15

celit consists of gold certificates representing,?dges against the Treasury's gold supply

Reserve Banks no longer have to use their goldcertificates this way, but many still doCurrency backing isn't relevant in today'seconomy Currency cannot be redeemed," orexchanged, tor Treasury gold or any other assetused as backing The question of lust whatassets back" Federal Reserve notes has littlebut bookkeeping significanceMoney's value, however is highly relevant.Maintaining the dollar', nue means maintainingits purchasing power ,esing pricesinflation--reduce purchasing power. stable prices keeppurchasing power strong,Too muc!I money results in excess spendingWhen consumers, businesses and governmentsspend excessively, they compete for the availablesupply of goods and services and force pricesup When prices rise, the purchasing power ofmoney falls To keep purchasing power strong,then, the supply of money must not increase toorapidly

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The Government reduces money's value byprinting too much currency.The Bureau of Engraving and Printing inWashington, D C., a unit of the Treasury.is responsible for printing the nation's currencyBut its orders to print come from the 12Federal Reserve Banks, not the Presidentor Congress. The Reserve Banks, not theTreasury, determine how much currency isprinted, based mainly on estimates of commercialbank and public cash demands. Under thisarrangement, the Government can't print moreFederal Reserve notes to pay its bills or debts.Since most U.S. money is checkbook money, theprinting presses have little to do with thebuying power of money. Maintaining money'svalue involves the Federal Reserve's control overcommercial banks that create most checkbookbalances.

The Federal Reserve does this in three waysFirst, the Federal Reserve Act requirescommercial banks that are members of theSystem to keep "reserves- as coin and currencyin their vaults or balances at their districtReserve Bank. By raising the percentage ofreserves that must be held, the Federal Reservereduces banks' ability to create more moneyLowering reserve requirements increases banks'money creating ability.

Second. the Federal Reserve lends money.generally tor only a day or two, to banks thatbelong to the Federal Reserve System. It chargesthem interest, called the "discount rateChanges in the thscount rate have the effect ofmaking Federal Reserve loans more or lessattractive to member banks.The most important control is open marketoperationsbuying arid selling U S Governmentsecurities through a network of almost threecitizen private dealer firms. When the FederalReserve sells securities from its $100 billionportfolio, dealers pay with checkbook money thatis taken out of circulation when the checkbookfunds are transferred from the dealer's bank tothe Federal Reserve. When the Federal Reservebuys securities, it pays with checkbook money,increasing money in circulation.

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Credit cards aro a now form of money.Credit cards aren't a form of money, but a

"deferred payment" device, a means o' ataintnggoods and services by promising to pay laterCredit card transactions are similar to loansWhen you use a credit card, the card company,sometimes an affihate of a large bank, payswhat you owe to the merchant directly andimmediately In time, you receive a bill from thecredit card company which you can either payfully, or partially. with cash or checkbook moneyUntil yOu pay. the credit card company isextending you credit for which you will payinterest after a short period Many people.however, pay their credit card bills within themonth billed and avoid interest chargesMany credit cards carry a "credit line," amaximum amount the Issuer will lend you. A$1.000 credit line allows you to accumulate$1,000 in unpaid purchases or cash advances.Credit lines are prearranged loans that becomeeffective when used. an arrangement commonlyused by large companies.All bank lending depends on the availability ofreserves, which are determined by the FederalReserve When the Supply of reservesis small and credit card users draw on theircredit lines, banks have to reduce loans to othercustomers. Commercial banks alone lent about$12 billion through credit cards and similar plansin 1976, about 10 percent of their loans toindividuals that year.

Even though credit cards aren't money. theyaffect the way we spend money and, in thatsense, are Important to understanding people'spurchasing behaviorFor this reason, some economists believe lines ofcredit given on credit cards should be countedas part of the nation's "money supply"atechnical measure of the funds the public hasavailable for immediate spending. They arguethat many important spending decisions arebased not lust on the amount of cash andcheckbook money people have on hand, but onindividuals' holdings of financial assets, such assavings deposits, stocks and bonds, as well aSthe availability of credit

15

Clinks w money.Checks aren't money in themselves. They are simplyorder forms instructing banks to move checkbookdeposits, which are money, from one account toanother. Those checkbook deposits arebookkeeping entries, numbers on banks' ledgersand in their computers.

Banks don't keep cash in vhecking accounts anddon't transfer currency or coin when acting on acheck's instructions. Checkbook deposits aretransferred between accounts and banks asbookkeep!ng entries only .

In 1977, the nation's 14,800 commercial banksheld about $230 billion of checkbook deposits forindividuals, businesses and governments.

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Checkbook money I. "crested" by currencydeposits.COMmercial banks create checkbook moneywhenever they grant a loan, simply by addingnew deposit dollars to accounts on their books inexchange for a borrower's IOU

Money creation bookkeeping isn't gimmickry Farfrom it Banks are creating money based on aborrower's promise to repay (the IOU), which, inturn, is often secured or backed by valuableitems the borrower owns (collateral)

Someone obtaining an auto loan, for example,might use the new car as collateral A homeimprovement loan might be secured by Me valueof the house being improved Business loansmay be secured by physical assets, such asmachines. factories and inventories, or may be

"unsecured," backed only by the company'searnings record and expectations or generalcredit worthinessBanks create motley by "monetizing- the privatedebts of businesses and individuals That is, theycreate amounts of money against the value ofthose IOUs

To create money, however, banks must have"excess" reserves, funds exceeding those theyare legally required to hold Banks belonging tothe Federal Reserve System must abide by theSystem's requirements. Banks that aren'tmembers are subject to the reserve requirementsof the state that chartered them,

Even without legal rules, prudent bankingdictates that some "required" reserves be held.Bankers know that. on any given day, they willhave to pay out coin and currency to peoplecashtng personal checks They also know thatthey will have to transfer reserve balancesas checks drawn against acCounts they hold arepresented for payment by other banks. Meetingthese routine transactions requires that tiankshold some reserve funds.

It a bank has excess reserves. it can create anamount of money equal to that excess; it cangrant a loan Borrowers write checks againsttheir new deposits When these checks aredeposited at other banks, those banks collectpayment from the borrower's bank Bankers knowthat when other banks present borrowers' checksfor payment, they will have to transfer reserveson a dollar-for-dollar basis

If a bank creates an amount greater than itsexcess reserves, It also would lose some requiredreserves and face temporary violation ofrequirement rules Prolonged violation ofrequirement rules subjects banks to penal! es SOthey tend to match lending to excess reserves Abank short of required reserves usually willborrow from another bank Member banks canalso borrow from the Federal Reserve

As newly created checkbook dollars move frombank to bank, banks gaining excess reservescan make additional loans As a group, banksare capable of creating money in a multiple way,Currently, our banking system theoretically cangenerate a sevenfold increase in total moneycreation with a given amount of excess reserves.Money multiplication, rather than currencydeposits, accounts for most of our $230 billon ofcheckbook money Banks hold only about $34billion in reserves. Only $8 billion of that total iscash, the remaining reserves are depositbalances at Federal Reserve Banks Reservesare the base on which the banking system hasgenerated the bulk of the nation's checkbookmoney.

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Banks its part of the GovermnentMany banks carry very official-sounding names,like "Bank of Amenca" and "State Bank ofAlbany," but they aren't run by, owned, or partof government

Commercial banks are privately ownedbusinesses trying to earn profits primarily bylending money to other businesses and toindividuals Don't get the wrong impression fromthe government type seals on their windowsBanks must be licensed to operate The license,called a -charter," is given either by the FederalGovernment (Comptroller of the Currency) or thegovernment of the slate in which the bank wantsto operate Banks choosing Federal charters,about one-third of all commercial banks,must have the word "National" in their ni .1-eor the letters -N A (National Associatioia aftertheir title State.chartered banks don't have touse the word "State" in their names, but many doBanks must meet government rules andregulations Banks with Federal charters, forexample, Must pin the Federal Reserve System,the independent agency Congress created toregulate the nation's flow of money and creditState-chartered banks may loin the FederalReserve, an option &Men by only 10 percent ofthe nation's 9,800 state-chartered banks

Banks belonging to the Federal Reserve maydisplay a seal on their main window indicatingthey are a "member of the Federal ReserveSystem Member banks are subject to manyFederal Reserve regulations and can borrowmoney from Reserve Banks for short periods tomeet unexpected Customer withdrawals or otherClaims exceeding funds on hand FederalReserve membership doesn't make a bank a

"member" of the Federal Government.

Regardless of charter, banks can join another"Federal" organizaticn, the Federal DepositInsurance Corporation (FDIC) Congressestablished the FDIC in 1933 to Insure depositorsagainst loss when a bank fails Virtually all U Scommercial banks are FDIC members Most havea seal on their main door or near tellers'windows indicating that deposits ate insured upto a maximum. which Congress sets, of $40.000per account But again. that "membership"doesn't mean the bank is part of, run by, orowned by the Government

Most commercial banks in this country are small,locally owned businesses, with no branches, justa few employees, and only a few million dollarsof deposits Relatively few commercial banks arebig businesses with many branch offices andthousands of employees These big banks,however, hold a relatively larger share of thebanking system's deposits than the small bankSConcentrated mainly in mayor cities, these bigbanks, like Chase Manhattan and Chemical Bankin New York City, and Bank of America in SanFrancisco, are owned by stockholdts. Theirownership shares are bought and sold publicly onthe stock exchanges

Commercial banks try to earn profits forstockholders by lending money and by investingin Federal, state and local government securities.Most commercial bank loans are to businesseswhich need funds for such purposes as buyingraw rnatenals and modernizing factories.

Although many of the largest banks aim most oftheir advertising at consumers, only about $250of every $10 lent by commercial banks are

"consumer" loans About $350 of every $10 lentare "commercial and industrial" loans. Realestate loans take about $3, and loans to financialfirms, farmers, or others about $1 of every $10lent .

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flanks are so powerful they can fix interstrates on loans and deposits and do just aboutwhatever else they please.Banks cannot do whatever they please Theirmarketplace "power" and their ability to "f',<"interest rates are highly restricted by overlappinglayers of laws and government rules andregulatiOn3. and by active competition amongbanks and other financial institutions

There are four Federal agencies that have bankregulatory responsibilities Federally charteredbanks are regulated by the Comptroller of theCurrency, part of the Treasury Department thatserves as the Federal Government's bankchartering agency Since all federally charteredbanks must belong to the Federal ReserveSystem, they are also sublect to the centralbank's rules

Nonmember banks are regulated by both theChartering State government and the FederalDeposit insurance Corporation In addition, alibanks are subject to the authority of the JusticeDepartment, if their activities appear to violateantitrust laws

The broad goal of government regulation ofbanks is to safeguard the public's money bymaking sure banks are operating prudentlyFederal and state laws, for example, prohibitbanks from investing in common stocks, and limitthe maximum loan they can make to one borrower

Furthermore, banks cannot open new branches,merge with other banks, affiliate with otherbusinesses, such as credit card companies, orchange business hours unless the regulatoryagencies say okay

In recent years, regulators have focused on banklending and advertising practices Recentlegislation, for example, has aimed at eliminatingracial and sexual discrimination in lending andrequires that borrowers be informed of theprecise conditions and terms of loansCommercial banks must conform to Federal andstate laws on interest charged on some loansand interest paid on deposits State -usury- lawsset the legal interest rate limit on loans tOindividuals State governments also determinemaximum rates on residential mortgage loansand maximum rates state-chartered bankscan pay on interest-earning (time) deposits

In 1933, Congress prohibited commercial banksfrom paying interest on checking account funds(demand deposits) At the same time, Congressgave the Federal Reserve power to set ceilingson what member commercial banks could pay ininterest on time deposits Member banks,however, are limited to the maximum ratesestablished by the states Since the 1930s, theFDIC's interest rate ceilings have matched thoseImposed by the Federal Reserve and since 1972,so have all state ceilings All commercial banks.then, have the same interest rate limits

Commercial banks, however, do not chargethe same rates for similar loans or pay the samerates tor similar deposits. Commercial banksactively compete against each other and against-thrift institutions" savings banks, savings andloan associations and credit unionstordeposits and many types 01 loans.It is not uncommon for banks in the same areato have different automobile, home improvementor mortgage loan rates, different rates on Savingsand time deposits and different charges forfinancial services, such as money orders,personalized checks, and checking accounts,

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All banks are the same."Savings" and "commercial" banks differ in manyrespects First, they have different corporateforms Savings banks are "mutually" owned bydepositors, not stockholders They are run bynonsalaried boards of trustees, not corporatedirectors Earnings aren't paid to private ownersas dividends but distributed to depositors asinterest on savings

Savings banks collect individuals' savingsand channel those funds mainly intohome mortgdges Commercial banks takedemand deposits and make profits by lendingand investing

The ability of thrift institutions to lend money formortgages is linked to depositors' savingsbehavior Many people deposit money in thriftinstitutions because they offer a nood interestreturn on savings However, whe.) interest ratesrise in the nation's credit markets, better returnsoften can be obtained by putting savingselsewhere Fewer deposits mean fewermortgages, and fewer mortgages generally leadto less home building and more unemployment inthe construction trades In addition, manyindustries that depend on a strong housingmarket, such as furniture and appliance makers,also suffer from reduced sales.

In the 1960s, Congress established a furtherdistinction between savings banks andcommercial banks by allowing thrift institutions topay savings depositors a rate above the ceilingimposed on commercial banks. This small ratedifferential was designed to keep thrift depositinflows strong enough to buttress the mortgageand housing markets.

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One critical difference between savings andcommercial banks traditionally has been in theway they lend money Commercial banks lend bycreating new checkbook deposits Savingsbanks and similar thrift institutions simply pay outexisting funds lett by depositors.In recent years, many states, particularly in theNortheast, have changed their laws to liftrestrictions confining thrift institution operationsmainly to accepting savings deposits andgranting mortgages Thrifts in more than 20states can now provide some form ofcheckbook-type accountMost of these accounts, however, don't holdnewly created checkbook money, but rather thesavings that depositors have transferred intothem to pay bills. These accounts comprise onlya fraction of the nation's total checkbook deposits.

If thrift institutions obtain broader powers tomake loans other than long-term mortgages, theyundoubtedly would begin creating money inmuch the same way as their commercial bankcounterparts, by adding new deposit dollars tochecking accounts. For now, most thriftinstitutions pay out loans with special checksagainst funds on hand, or funds deposited at acommercial bank, not by creating new demanddeposits,

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Wad Street banking Interests established theFederal Reserve and control monetary policy.In 1913, the most vocal opposition to the FederalReserve came from the Wall Street bankingcommunity. In part, that opposition stemmed fromthe intent of Congress to establish the FederalReserve with built in "checks and balances"specifically to insure that monetary policy-makingwould be decentralized and made in thebroad national interest. The System's structure.organization and relationship to Congress make itimpossible for any interest group to dominatemonetary policy.

The Federal Reserve System consists of threeinterlocking parts a seven-member,Washington-based Board of Governors, 12regional Reserve Banks, and 5,800 membercommercial banks.

The Board of Governors is a Governmentagency. Each Governor is appointed to a 14-yearterm by the President of the U.S. with the adviceand consent of the Senate. Terms are staggeredfor an appointment every two years. By law,Governors must come from different regions ofthe country, and "fair representation" must begiven to financial, agricultural, industrial andcommercial interests in their selection. Only twoof the present Governors have substantivebanking experience. Four are economists andone waS a corporation president.

The 12 regional Reserve Banks aren'tGovernment institutions but corporationsnominally "owned" by member commercialbanks, who must buy special, nonmarketablestock in their district Federal Reserve Bank. EachReserve Bank has nine directors, each ofwhom serves three-year staggered terms. Asstockholders, member banks elect the majority ofthe directors (six) but only three bankers canserve on a board.

The Federal Reserve Act requires that threedirectors of each Reserve Bank be appointed bythe Board of Governors. They may not bebankers. Of the six elected directors, three must,by law, be actively engaged in somecommercial, agricultural or industrial job. TheFederal Reserve Act also prohibits the six

"nonbanking" directors from being affiliatedwith a bank in any way. Thus, the nominal

"owners" of the Reserve Banks, theprivate member commercial banks, have onlythree of the nine directors' seats at eachReserve Bank.

Moreover, the three banking directors must berepresentative of the entire banking industry, notjust the big banks. Member commercial banksvote for their directors according to size,with small, medium and large banks each electingone banking director. Thus, the most powerfulbanks cannot dominate the banking directors.In the 1970s, the New York Reserve Bank'sdirectors have included chairmen and presidentsof corporations and banks throughout the NewYork Federal Reserve District. But educators,a civil rights activist, law firm partners, and thepresident of a philanthropic organization alsohave been recent New York Reserve Bankdirectors.

Reserve Bank directors appoint Reserve Bankpresidents. who serve with the Board ofGovernors on the System's key policy-makingbody. the Federal Open Market Committee(FOMC) Directors appointments of presidents.however, must be approved by the Board ofGovernors

The FOMC, which meets monthly in Washington,D C. Io decide the course of monetary policy,consists of all seven Governors and five ReserveBank presidents, four of whom serve one-yearterms on a rotating basis The president of theNew York Reserve Bank, who traditionallyserves as FOMC vice chairman, is the onlyReserve Bank president who serves as apermanent Comnitttee member

FOMC decisions aren't secret. A summary of thedeliberations and record of policy actions aremade public about 30 days after each meeting.A record of the vote of each member of the

'Committee appears after the formal policydecision, called the "directive." Dissenting votesare recorded with the reasbns for the dissent.The 30-day delay is designed to avoid creatingexcessive reactions to policy moves that mighthinder the functioning of markets and the orderlyimplementation of policy decisions.What's more, the chairman of the FederalReserve Board of Governors formally reports toCongress every three months on the course ofmonetary policy and the Federal Reserve'slong-term objectives. In addition, SystemGovernors routinely testify on key economic andbanking issues before House and Senatecommittees.

The Federal Reserve is unique amonggovernment-type institutions in that it is

"independent" within the Federal Government.Congress specifically structured the FederalReserve so that monetary policy judgments andactions would be made nonpolitically. The14-year term ;or System Governors is anexample of that intent.

3

: Neither the System's monetary policies nor its'tanking activities are designed to guaranteeprofits for anyone.

Almost all Federal Reserve earnings come fromthe interest paid by the U.S. Government on the$100 billion or so of Government securities theSystem acquired over the years for monetarypolicy purposes..So far, in the 1970s the System earned morethan $5 billion a year. Almost all of the FederalReserve's earnings are returned to the U.S.Treasury. Funds retained by the System are usedto pay the budgeted expenses of the ReserveBanks and the Board, maintain a small surplus,and pay the 6 percent statutory dividend on theReservb Bank stock held by member banks.Member commercial banks don't share in theSystem's earnings.

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The Federal Reserve controls the amount ofcurrency in circulation.The Federal Reserve doesn't control the amountof "currency" in circulation. The public does. TheFederal Reserve, however, determines the totalamount of "money" in circulation.

When people want more currency, they cashchecks at their banks. When banks want morecurrency, they purchase it from their ReserveBank with the checkbook money they have ondeposit as part of their required reserves. Sincecurrency in circulation increases only whencheckbook deposits decline, the total amount ofmoney remains unchanged. Only the compositionof the money supply changes when the publicalters the form in which it holds money balances.The public has shown, over the years, a verystrong preference tor checkbook money overcash. At particular times of the year, however,such as in December, this long-term preferenceshifts decidedly toward cash, and more than $2billion in currency and com Leave the bankingsystem. In January, demand shifts back tocheckbook money, and cash returns to thebanking system.

The Federal Reserve doesn't try to alter publicpreferences, but accommodates them by sellingCurrency to banks to meet public demands andaccepting currency deposits to reserve accountsas demands slacken.

31

Ranks borrow money from the Federal Reserveat Ow dimwit rate am* land the hands at ahighr rete to make prottt.Banks can't borrow money from the FederalReserve to lend at a higher rate, even if theywant to. The Federal Reserve, not commercialbanks determines the rules for borrowing at thediscount rate. These rules restrict borrowing toshort-run, temporary, seasonal or emergencyneeds. Banks that borrow too much, too often,for too long, or for the wrong reasons, will soonhear from the Federal Reserve. Because banksknow the rules and understand the FederalReserve's fundamental central bank rsile as a

"lender of last resort," they rarely try to abusethe borrowing privilege.

Commercial banks get the reserves that supporttheir loans and investments by attractingindividual and corporate funds with interestpayments on time deposits, by borrowingreserves from other banks. Of by selling assets.such as Government securities.

When the Federal Reserve was established, theworkings of the economy weren't as wellunderstood as today. In those days, banks couldreadily replenish the funds they lent to farmersand to businesses engaged in buying rawmaterials and manufacturing finished goods byborrowing from the Federal Reserve. Economictheory indicated that. since "commercial loans"hetPed Increase production and create morelobs, accommodating banks would help feedeconomic expansion. To encourage the additionallending and spending that would generateexpansion, the discount rate would be reduced.

-To discourage lending, the rate would be raised.Today, the Federal Reserve no longer follows the

"commercial loan theory" of discount fending.Lending at the discount rate is now used as a

"safety valve" that provides funds to individualbanks on'y when necessary.

Duch: Row Zimmermanillustristiims' Jos A Smith