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F. GENERAL CREDIT AND MONETARY POLICY

28. Discuss the factors that determine the quantity of money and its adequacy for the functioning of the economy. Cover the influence of Federal Reserve credit policies over changes in the quantity of money.

In this discussion, money is defined to mean both demand and time deposits as well as currency and coins. Demand deposits, currency, and coins are all transferred freely in the making of payments. Time deposits, while immediately a store of value which is not directly transferable, are considered by the public as part of cash assets and are readily convertible at par into other forms of money. At the present time bank deposits are by far the most important form of money. Paper currency and coins form only a small part of the money supply. Under the monetary system in this country the supply of money is responsive in the main to the needs of commerce, industry, agriculture, and government, to the trend of the country's international financial transactions, and to the desire of businesses and individuals to hold cash balances. The principal source of new money is credit extended by the banking system. Bank loans to finance production and trade or for other purposes, or bank investments in corporate or government securities supply money which the recipients may use for payments or may themselves hold in the form of bank deposits or currency. While individual recipients may quickly pass the money on to others in making expenditures, the money continues in existence until it is used by someone to repay a bank loan or to buy securities from a bank.

Factors responsible for changes in the total money supply may affect either bank deposits or currency. The forms in which the aggregate money supply is held reflect the preferences and conveniences of individuals and businesses; and although they affect materially the structure and operations of our financial institutions, they do not ordinarily have great significance from the standpoint of the adequacy of the over-all supply of money.

Factors affecting the supply of money

In general, the most important determinant of the aggregate supply of money is the lending and investing activity of commercial banks, which itself reflects the current demand for credit by private and public borrowers, the public's desire to hold cash balances, the available supply of bank reserves, and attitude of banks toward lending and investing.

Bank lending and the money supply.-When a commercial bank makes a loan, it generally gives the borrower a deposit with itself-a deposit which, if the loan adds to the grand total of bank credit outstanding, was not previously in existence. The borrower may write a check upon the deposit, which may in turn be deposited in another bank. In this case, the first bank loses both deposits and cash resources, but these remain in existence in another bank. The same thing happens when a bank purchases an investment security from a nonbank investor. It makes a payment which ordinarily results in increased deposits in some bank within the banking system. Conversely,

NOTE TO CHART 4.-Demand deposits adjusted exclude interbank and U. S. Government deposits and cash items in process of collection. Time deposits include those in Postal Savings System, mutual savings banks, and commercial banks.

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when a borrower repays a loan, his deposit is reduced, without an equivalent increase elsewhere; and the money supply is reduced by that amount. Likewise, when a nonbank investor buys a security from a bank, he normally makes payment by drawing down his bank deposit, which then ceases to exist as a part of the money supply.

The influence of bank reserves.-The amount of loans and investments which commercial banks can make depends only in part on the demand for credit and the judgment by bankers of the creditworthiness of borrowers. It depends also upon the reserve position of the banks. Under our fractional-reserve system, banks are required to hold reserves equal to some percentage of their deposit liabilities. Member banks of the Federal Reserve System are required to hold their legal reserves in the form of deposits with the Federal Reserve Banks. At the present time, the reserves required behind demand deposits of member banks range from 14 to 24 percent, depending on the class of bank, and those behind time deposits are 6 percent. Reserve requirements of nonmember banks vary by States; they are shown in the reply to Question F-44.

Since total reserve requirements of member banks actually average about 16 percent, member bank deposits can expand (assuming adequate demand for bank credit) by about six times the amount of any increase in bank reserves; that is, deposit liabilities of the banking system can rise by about $600 for every $100 addition to reserves held. If reserve requirements were 10 percent, then deposit liabilities could increase by about $1,000 for $100 addition to reserves. Thus the response that banks can make to the aggregate demands for credit is influenced by their reserve position, which in turn depends upon both the reserves available and the reserve requirement percentages.

The amount of reserves that banks have is affected by various domestic and international factors. The most important among domestic factors are changes in the volume of Federal Reserve Bank credit outstanding. The Reserve Banks can supply additional reserves by making advances to banks or by buying bills or securities in the market and can absorb reserves by reversing these operations. Increases and decreases in the amount of currency held by the public may also respectively exert a drain on bank reserves or add to them. Changes in Treasury deposits with the Federal Reserve Banks, or in cash held by the Treasury in its own vaults, and also changes in the amount of currency issued by the Treasury, may also affect the volume of bank reserves, but these are either relatively small or of a temporary nature. The most important among the international factors is the movement of gold, which links the monetary system of the United States with the monetary systems of other countries. In our monetary system gold has a dual function. The United States is on a gold standard internationally, in that gold and dollars are freely interchangeable (at a fixed ratio at $35 per ounce of gold) in settlement of transactions between monetary authorities. Domestically, practically all of our gold stock serves as a basis for the reserves of the Federal Reserve Banks, which are required to hold gold certificates, amounting to at least 25 percent, against Federal Reserve notes and deposit liabilities. These deposits with the Federal Reserve Banks in turn provide the basis for the reserves of the commercial banking system. Thus, movements of gold arising from our surpluses or deficits in international accounts add to or reduce our gold stock and hence our monetary

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reserves. These reserves in effect place a ceiling on the volume of Federal Reserve credit that can be extended without penalty, and thus might tend to limit the amount of money which the Federal Reserve can provide. In practice, however, the reserve ratios have generally not been a limiting factor and Federal Reserve policies have generally been determined on the basis of the needs of the economy rather than on Reserve Bank gold reserve ratios. More immediately, an inflow of gold results directly in additional deposits and bank reserves, while an outflow of gold contracts deposits and bank reserves. If the amount of bank reserves is increased, then the banks will be in a position to expand credit and deposits by a multiple of that amount. If, on the other hand, the amount of reserves is decreased, banks will be under pressure to contract credit and deposits.

It is important to note that a single bank does not create deposit money on a multiple basis of reserves. Each bank lends only what it has in excess reserves or excess cash assets. It is limited in this respect because the borrower will typically transfer the deposit to another depositor in another bank. A bank's new loans thus tend to increase the calls on it for cash, and thereby to reduce its cash resources. But since the deposits and the reserves do not leave the banking system but are merely transferred from bank to bank, the banking system as a whole can and does expand money by a multiple of its reserves. Adequacy of the money supply

The amount of money in the economy is related in large part to the demand of the public for loans and the willingness of banks to satisfy this demand. From this point of view the money supply is responsive to the changes in economic activity, and the volume of money at any one time is a reflection of thousands of individual decisions made by business and individual borrowers and by many banks. In responding to the increased demand for loans as the economy expands, the banking system supplies the money needed by a growing economy. To the extent that the Federal Reserve System is in a position to affect the availability of reserves, the volume of money may also reflect the views of the System, based on its appraisal of the total credit and business situation, as to the extent to which credit should be tightened or eased at any given time in order to contribute to economic stability and economic progress.

Criteria for "enough" money.-There is enough money when the quantity is sufficient to support the volume of spending necessary to support a high level of production and employment, without leading to spending at a rate which would outstrip the supply of available goods and services at prevailing prices and result in an inflationary rise in prices. As noted, an economy which is expanding tends to require a gradually increasing money supply.

Ideally, the amount of money should adjust itself to the periodic waves of pressure for increased or decreased holdings of money on the part of the public. For example, at times businesses and consumers may increase their expenditures by using existing cash balances more intensively (what economists call "increasing outlays relative to cash balances" or "increasing the velocity of circulation of money"). If this happens when productive resources are fully utilized and prices are tending to rise, it is desirable that pressure be exerted to restrain so far as possible further expansion in the amount of money in the economy. Conversely, if heightened uncertainty should cause busi

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