Tuesday, March 10, 2015

How central banking works

The Mises Institute has a link to a site where you can find an out-of-print booklet called Modern Money Mechanics: A Workbook on Bank Reserves and Deposit Expansion, published originally by the federal reserve bank of Chicago.  For those interested in how the current monetary system works, it is not completely unreadable and is consistent with my understanding, though it refers occasionally to M3, an outdated money supply measure.  Here is an excerpt:

Let us assume that expansion in the money stock is desired by the Federal Reserve to achieve its policy objectives. One way the central bank can initiate such an expansion is through purchases of securities in the open market. Payment for the securities adds to bank reserves. Such purchases (and sales) are called "open market operations."

How do open market purchases add to bank reserves and deposits? Suppose the Federal Reserve System, through its trading desk at the Federal Reserve Bank of New York, buys $10,000 of Treasury bills from a dealer in U. S. government securities.(3)  In today's world of computerized financial transactions, the Federal Reserve Bank pays for the securities with an "telectronic" check drawn on itself.(4) Via its "Fedwire" transfer network, the Federal Reserve notifies the dealer's designated bank (Bank A) that payment for the securities should be credited to (deposited in) the dealer's account at Bank A. At the same time, Bank A's reserve account at the Federal Reserve is credited for the amount of the securities purchase. The Federal Reserve System has added $10,000 of securities to its assets, which it has paid for, in effect, by creating a liability on itself in the form of bank reserve balances. These reserves on Bank A's books are matched by $10,000 of the dealer's deposits that did not exist before.

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If the prose in the above gets too thick to be digested, try Murray Rothbard's The Mystery of Banking (PDF), especially Chapter XI.  CENTRAL BANKING: THE PROCESS OF BANK CREDIT EXPANSION, beginning on page 161.

Rothbard also explains in detail (pp. 47-55) the counterfeiting process, beginning with a monetary system based on gold coin and extended to one based on irredeemable paper money.  

Oddly enough, the FRB of Chicago doesn't mention counterfeiting in its explanation.

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