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IlsalB
so 0" 750
lUTBOB 'tied.an. David B.
'!'ITL! I Bet rOQ Tboaqh~ •••
115'.tl'1'UTI08 Federal Reserye Bank of 9~w fork. N.r.
poe DAT! Dec 17
IOTE 36p.
.Y1IL1BL! FSO! fublic Info· ~tion Departlen~. Pederal Beserve Bank
of lew fork 3 Liberty Street. Nev York, Nev rc~k
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DBSCiI PTOBS Adult Educa~ion: .Sankinq; Concept Foraation: Credi~
(finance': Econa.1c Develop.ent: *Econoaic !ducation:
Eoono.ics: Pederal ReqQlation: financial policy:
.pinancial SeryiC8$: Governaent ~ole: Instructional
laterials: .8oney ftenaqeaent: *soney Systeas:
Purchaminq: secondary Education: Dnited States
History
IDENTIfIERS .Federal Reserve syste.
lBSTRACT
The bocklet lists and di3pels 1ij economic myths
thl. "1h a discussion of aoney. econoaic concepts, and ~he Federal
Be~~·i.. "e Systea. 'rhe object ive is to help secondary stadents O!: adul ts
undc'":..stand tbe econoaic svstea as relate~ to aone' and banking.
Topics fOCQS cn aoney. bankinq, qold and silver, credit. qovern.ent
role. financial concepts. and interest. For ~hese topics historical
backQroand 1nforaatioD is provided, teras and concepts are defined,
relationships between qovernaent and the banks are pointed out,
Federal Reserve functiGDS and operations lre outlined. and various
types of banks are co.pared. Sa.pIe mytha inclUde "Boney is si.ply
- coin and paper currency." "Gold and silver are the only perfect
.onies.- "Tbe Governaent reduces aoney's ,alue by printinq ~oo .nch
currency." ·Checks are aoney." "Sanks are par~ of the Govern.ent."
-Ill banks are the sa.e,- Niall Street banking interests established
the federal Reserve and control aonetary policy," "The Federal
Reserve controls the a.ount uf currency in circulat.ion." and "Banks
borrow aonev fro. the Federal ~eserve at the discount ra~e and lend
the funds at a hiqher rate tc .ake \:irofit.. fI Cartoon drav!ncrs
illustrate the concept.s discu3sed. (CK)

•••••••••••••••••••••••••••••••••••••••• **•••••••••••••••••••• *.**•••••


• Reproductions sdpplied by EDRS are the best that can be made *
• fro. the o~iqinal Jocuaent. *
.......................................................................
U' O'~AIU MI"TOt tHIALTH .
,auCAT ION &WIL''''.
"AT'O"A L 'NITITU T' OF
IOUCAT lON
THI~ DOCUME NT "A~ aEEN Ii EPIiO·
OuCEO I_ACTL " AS IIECEIII EO FIlOM
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THE PEIl!iON 011 ORGANI ZATION ORIGIN·
ATING IT POINTSO F vIEw Oli OPINION S
STATED DO NOT ""ECE~S ARIL" REPIIE-
SfNT OFJtIC,A L NATIONA L INHITU TE OF
IDUCAT ION POSITIO N 011 POLICY

• 'PERMIS SION TO ~t:PRLlllud !'~IS


I • MATERIAL IN MICROf iCHE' ONLY

H~/;r0R~~J-;~~2
TO THf EDUCA T'ONAl R!.50UR l.t:S
~NFORM ATION CENHH \E:fN~\

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Public Information Department
Federal R£!serve Bank of New York
33 Liberty Street
New York. New York 10045

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P,.,.c.
Most of us acqUire two types of knowledge-
"~ "001 knowledge" and 'fall< knowledge .' Folk
knowledge IS information and "wisdom" passed from
generation to goneratIon or aCQuired on the streets
For example, were often tOld that sItting In a
d,.aft will gIve us a cold SCIence tells uS the
common cole results frorn a V1fUS Yet. stili we
change our seat ;0 avoid a draft We may
acknowledge that drafts only contribute to
lowering our resistance to Infection but we 51111
blame the tJreeza rathAr than the bug
So too most of us hold certain economic
misconceptions folk knowledge cont8lnlng a
germ of truth and a plague of misconcp.pliu n
economiC myths picked up by mlsreadlngs or t"e
acceptance off'lCls from a If lend or relative
Few of us are Immune to (~conomIC myths Of
misconceptions If yuu dunt ttllTlk so I bet you
thought

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T..... of Contents
Before readin g thIs bookle t. indIcat e whethe r
each statem ent below IS true or false After,
check your answe rs and rate yourse lf
Tru~ Fal!;t' Answer on page
Money IS Simply cOin amI paper curren cy [J U 5
Onlv Calf! and curren cy dre real monIes [] [] 7
bec<:IlJse the Govern ment says Iheyre legctl
lender
GOld and stiver are Ita! , pertec l morues rJ [1 9
Gold' backffl g gIves It" dollar lIS V<3!lJe U U 11
The Govern ment r('(lw;e -; money s value by tJ II 13
pnntln g 100 much curren cy
Credll cards are d ne.... form of rnoFley rJ U 15
Check s are monl'y rJ [J 17
Check book mOlley I~ oeille ,;' by LJ [J 19
cunene y depOSll'i>
Banks are part of the Govern ment [J [l 21
Banks are $0 po.... erful Itley can fiX mleres l [1 [J ?3
rales on loans and dep0'311s and (10 Just about
whatev er else Ihey please
All bank!-i are Ihe same U [J 25
Wall Street bankin g InlE)re'jlS establi shed the U LJ 27
Federa l Reserve anrJ control monetary pOliCY
The Federa l Reserv e control~ the amoun t of 0 0 31
curren cy," Circula tIon
Banks borrow moncy from the Federa l Reserve 0 [J 33
at 'he dIscou nt rate and lend the funds at a
hIgher rale 10 make profll

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IIoMy .. 81mpl, coin Ind . . . . cunene,. Checkbook money works because people are
Montly IS any gsnerally accepr~j medium of confident in the strength, safety and prudence of
exchange, not simply COin and paper currency. the American banking system. Their confidence
Money doesn't have to be intrinsically valuable has been bolstered by Government regUlation of
(valuable," Itself), be issued by a government or commercial banks and Government deposit
be In any special form. In our past. Items insurance. The check clearing and collection
ranging from Iron nails and dried codfish to gun system of the Federal Reserve, the nation's
powder and tobacco have served as money central bank. has also made checkbook money
highly acceptable by speeding checking account
Anything people generally accept in exchange transfers nationwide.
for Items of value is money Money also IS a
standard for measuring value and a means of We've been big check users for quite awhile.
storing purchasing power for future use Any The move began in the post Civil War era, when
Item that has these three traits is money bank deposits became the dominant form of
money held. Today, If all payment transactions
Americans accept three types of money - COin ""ere counted, including those for srock. bond
iSsued by the Treasury, paper currency Issued and real estate purchases, the dollar volume
by Federal Reserve Banks, and checkbook of check spending to coin and paper currency
balances (demand deposits) at banks spending would be enormous.
In analyzlOg economiC activity, many economists
Only about 3 percent of oor money IS in coms,
take a much broader view of money and InClude
and for every 10 cents in small change we keep.
other money-like Items immediately available to we hold about a dollar in paper money. As a
the public for spending, such as passbook nation, we hold only about $80 billion of cash.
savings and other funds depoSited for specific compared with $230 billion of checkbook money.
tll"\8 periods
Oemarad depoSits are the nation's most common
form of money. compriSing about three-quarters
Of all money 10 clfculatlon. This checkbook
money is bOokkeeping money created malOly by
tne nation's commercial banks. Americans prefer
using checkbook money because It performs as
a more efficient medium of exchange than COlO
or currency for many transactions. Check WTlters
have With one blank check the potential for
spending small or large amounts. Since each
cheCk must be Signed before funds are
transferred, checkbook money cannot eaSily be
stolen. In addition, cancelled checks provide
written proof of payments. Since we prize
convenience, safety and recordkeeplng, it's no
wonder that checkbook money is preferred

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onlr COin and currency .... rea' monl. . bee.. .. rhe leaves weren 'l easily dlvlslo le cauSIn g
.... Government uralher',. "'eg•• Iendet'." difficu lty In . 'makIn g chang e" The varyIn g pnces
Com ana curren cy are "logal tender '" money the lor differe nt grades 01 tobacc o made value
Gover nment says has to be accep ted ,f offered to difficu lt to determ ine It al50 wa5 hard to carry
settle a det)' But Ihat approv al doesn l make and slore Tempe rature and hUmlOlty chang es
cash any more rear than checkb ook balanc es caLlsed flaktng wtlll,;h eJeva/uet1· the leave~ In
Until the 18605, legal tender ' applle rj onl~i to short tCJtlacco lacked many charac teristiC S
cotn ye' everl Ihen we uc;e~ more prIVate biil1k neer1ed to make II ~ork well as money
notes and bank <1epos,'s d~ money 'han cOin For c1n ItCfTi 10 perfor: rI ~UCCC~Slullv as money ,t
Logal render ucc,l()nat,on 'NdS gIven'0 cerlaH l
Gover rment- 's5ued pap~r curren cy dUflrlg Ihc
rnu.,1 be eJurdble dIVI~lt)le portab le and dIfficu lt
to ClJUnterfc,t More Import dnt as the Vtrgml ans'
C,Vil War 10 Win puOllc confid ence tn Ihe e){pCrteflCe shows while any II ern can serve
paper mfmey Howev cr, Ihere haf> been no as money It won, worl< well or Idst long unless It
meanin gful dlstlnc tlun betwee n 'lcgi11 lelluer C,J1l also !)crve well a~ d standi:Hd and store 0' value,
and other U S money since 1933, when Congres~
made all cOins and curren CIes legal tender for People 's wIllmg ness to accep t money In any
all public and private debIs lorm IS rooted no' In tr,e law hut in money 's
ablltty to effectI vely measu re anfJ hold value
Regarc1Ie<;s 01 whitt any govern menI says money
must have cerra,n charac teristic s thaI make It
accep table Withou t rhose fra,ls, even legal
tender " cannot be succes sful as money
Most early monie s were not Issuefj by
govern ments They were commo dities such as
salt. cattle and rum. that were Widely known anr1
eaSIly sold or used But comrno dl!lOs proved less
than perfec t monie s The tobacc o used by the
early VIrgInIa settler s IS an examp le

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Gold and .,Iv., .... tile only perfect mon....
Gold and Silver monies have been used for
paper recelp ls for cOins or bullIon hele1,n a
natIOnal treasu ry or prIvate bank More Import ant.
thousa nds of years, bul they :He far trom perfec t paper money was often used to overco me the
Gold and Silver alwavs have bet>n ueSlre d The scarcit y of ~rec,ous metal cOins
scarcit y. lustor and almost mystic al appea l of
the metals made gold and Silver accep table as Paper money , howev er also provm1 less than
Jewelry, armor am] religiOUS symbo l:; Gold and perfec t Thf? baSIC proble m conce rned ItS source
Silvers use ~lS cornmo dllres and people 's deSire When money was pre(1omlnantly gold and Silver
for them. estdl,jl shec1l he accep lablllty of COin govcrn ments were preven ted from ISSUIng
precIo us rnelal money cenlun es ago more COin by the amoun t of melal In Ihelr
treasur ies. dug out of thE~ ground or obtain ed for
But preclou~ melal lIke allcom modl'Y " mOfllf?S, goods 501(110 other nal,ons Wlthoul srnHlar
provec1 less It'liin perfec l COins were t1e,h'y and reslrlc llons on curren cy govern ments and banks
aCCUfr!UICltlon pOJel1 prnr)lerr,s :)f safe Ir iinspo rl coul(1o ver'ssu H ret1ucmg Ihe value of each note,
riflCJ Slor age COinS also could be remellec].
and leopar fl1llng paper money 's dccep liib,llly by
mixed With ~omrnon mOlals, ancl restruCk, which making curren cy a poor slore of value
reduce d Ihfllr Intru'SIC value Gold anC1 sliver
were scarce and deman d for Ihem genera lly DlJflng the Amenc an Rel/olut,on, Congr ess so
excee ded ~upphes As a rosun lhe value of over Issued conI menIal curren cy Its value almost
prOCIOus rnf'!tal was gerwrn lly high relative to (1,sappea red Indeed , the expres sion not worth a
commo n meld Is contIn ental" was WIdely used then to conno te
worthle ssness The colonis ts were so angere d
The history of Amenc an cOinage deals largely that, after Indepe ndenc e. Congr ess dldn'l
With attemp ts to resolve proble ms of precIOUS Issue paper money for over 70 years, even
melal money Ihough It had the C"nstl tutlona l power to'col n
For examplt> Congre ss Issu(!l1 paper money money ' and 'regula te" Its value
during the AmCrican Rp.volutlon bHcau se It lacked Unlilth e Civil War, slate·c hartere d banks Issued
gold and Silver coms and the metal to make Ihelf own curren cy In the early 1860s,
them In the 18705, the U S allowe d people to as many as 10,000 differe nt bank nole Issues
exchan ge Silver dollars for paper dollars becau se clfcula ted Banks were pledge d to redeem their
the weIght and size of the cOins made them notes for COin or bullton. but beCalJSe many
unpop ular and httle used In tho late 19605. banks had only a fractio n of the preCIous
(Ising mdustf lal ,1emand forced Silver's COin or melal neede d for repaym ent. and beca... se
ehmina hon from U S COinage many were headq uartere d m remOle reglor1s
Teday' s U S COIns don't contain preCIous rpetal Ihe value of thelf notes was suspe ct The result
The face value of our COinS IS greate r than was a ChaotJc curren cy system In which people
the value of the rnHlal rn the COinS We accep t sometI mes accep ted bank notes at less
cems as "foken " or 'co,we nlence " money than face value
for the small fmanelal transa cllons of dativ life, Unt,l after the eSlabl lshmen t of the Federa l
such as vendin g fll,Jchm e purcha ses phone cdlls
Reserve System In Decem ber 1913, the U S
and lipS dIdn't have an'ela stlc" curren cy, a curren cy
The use of paper curren cy grew dlfecfl y out of whose supply could expan d or contra ct as
the proble ms of coms 1he InGonVE~nlence of buslf1ess acllvlty and publiC deman d chang ed
carrYin g and safeke epmg large Quantities of corn
cause d people In differe nt SOCieties 10 excha nge

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Gold "backing" Ilv...... do.Ia, Ita VI'u•. Federal Reserve notes ate stili "backed"
Unt,l 1968, US currency had to be parllally dollar-far-dollar by the assets of the Reserve
backed by gold However. gold never gave the Banks About 85 percent of Ihese assets conSist
dollar Its value The dollar's value always has of Government securities the FtJderal Reserve
been determined by the amount of goods and purchased over the years The rerr.aln:ng 15
services It can buy . Its purchasing power , 'rcent conSists of gold cerltf,rates representing
~. I?dges against the Treasury's gold supply
Gold backmg was requIred through most of U S
Ht:serve Banks no longer have to use thelf gold
history as a means of restraining Government
certifIcates thIS way, but many sllU do
overlSSudnce of paper money and ImprovlMg
pubhc confidence. and, therefore, the Currency backing Isn! relevant In today's
acceptability of paper money economy Currency can no! be . redeemed," or
oxcrtanged for Treasury gOld or any other asset
When the Federal Reserve was establIshed.
USf~(J as backing The questIon of Just what
Congress reqUIred the 12 Reserve Banks to tjack
thel: currencV. known thefl a'S Feder al Reserve assets back' Federal Reserve notes has Iltlle
Bank notes and today as Federal Reserve notes, but hookkeepmg significance
with 40 percent gOld and 100 percent 'eligible Money's value, however IS highly relevant
paper" (Short-term IOUs of busmesses and Maintaining the dolla(~ lIue means maintaining
farmers) The eligible paper requirement was Its purchaSing power 11.Stng pr,ces-lMflatlon--
reduced to 60 pelcent In 1917 Gold WdS bought reduce purchaSing power, stable pflces keep
from the Treasury Eligible paper was obtained purchaSing power strong,
from commercial banks that pre5ented these Too mUC!1 money results In excess spending
cuSfomer IOUs as collateral for loans When consumers, bUSinesses and governments
Essenhally, only thoSe IDUs representtng spend excessively, they compete for the available
commerCial banI( loans made to expand supply of goocs and services and force pflces
manufactuflng or farm output were deSIgnated up When prices flse. the purchaSing power of
"eligible" as collateral by the Federal Reserve money falls To keep purchaSing power strong,
The backing reqUIrements on Federal Reserve then, the supply of money must not Increase too
notes were deSigned to regUlate currency rapidly
issuance automatically to the pace of the
ecrmomy's growth, smce only Increased bUSiness
actiVity and bank lendmg could generate the
collateral necessary fOf more note Issuance
Backing requirements were Itber ahzed and
reduced over the years, as we gained better
inSight Into how the aconomy works and how
money should be regulated
By the 1930s. Congress allowed Reserve Banks
to use assets other than eligible paper, such as
US Government secuntles, to back currency By
the 19409, Congress slashed the gold
requirement to 25 percent and In 1968 eliminated
gold back1nt:, entirely

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TIle Govwnment reducn man.,'. v.SUe by Second. the Federal Reserve lends money.
prlnUng too muctl currency. generllfly for only a day or two, to banks that
The Bureau of Engraving and Prinllng In belong to the Federal Reserve System It charges
Washinglon,O C, a unit of the Treasury. Ihem inlerest, called the "dIscount rate ..
I!. responsible for printing the nahon's currency Changes in the Jtscounl rate have the effect of
But its orders 10 print come from the '2 making Federal Reserve loans more or less
Federal Reserve Banks, not the President attractive to member banks.
or Congress. The Reserve Banks, not Ihe The most important control IS open market
Treasury, delermlne how much currency IS operatlons-ouylnQ and selling U S Government
printed. based mainly on estimates of commercial securtties through a network of almost three
bank and public cash demands Under this dvzen privale dealer fIrms. When Ihe Federal
arrangement. the Government can't punt more Reserve sells securities from lIs $100 billion
Federal Reserve notes to pay its bIlls or debts. pl'Jr!follo. dealers pay with checkbook money that
Since most U.S money IS checkbook money, the IS laken out of circulation when the checkbof)k
printing presses have liltle 10 do with the funds are transferred from the dealer's bank to
buying power of money. Maintaining money's the Federal Res~rve. When the Federal Reserve
value involves Ihe Federal Reserve's control over buyt securifies. it pays with checKbook money,
commerCial banks that create most checkbook increasmQ money In Circulation
balances.
The Federal Reserve does this in three ways
Flfst, the Federal Reserve Act requires
commercial banks that are members of the
System to keep "reserves" as COin and currency
in their vaults or balances at their district
Reserve Bank. By ralsmg the percentage of
reserves thaI must be held, Ihe Federal Reserve
reduces banks' ability to create more money
Lowering reserve requirements increases banks'
money creating ability.

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CndIt card8 ..... ,... form of money. Even though credIt cards aren't money. !hey
CredIt cards aren't a form of money, bu' a affect 'he way we spend money and. in that
"defer red payme nt" device , a m~ans a' :ltammg sense, arf3 Important to unders tandin g people 's
gOOds and services by promls mg 10 pa)' laler purcha sing behav ior
CredIt card transactIons are similar to loans
For thiS reason, some econo mists beheve lines of
When you use a credIt card, Ihe C<Jru compa ny, credIt gIven on credit cards should be counte d
sometImes an affiliate of a large bank, pays as part of the nation's "mone y suppl y"-a
what you owe to the merchant directl y and techn,cal measure of the funds the public has
ImmedIately In tIme. you receIve a bIll from the avariabl3 for Immediate spend ing. They argue
credIt card compa ny which you can eIther pay that many Important spend mg deciSions are
fully, or partially. with cash or checkb ook money based not lust on the amoun t of cash and
Until you pay. the credIt card compa ny IS checkb ook muney peo~le have on hand, but on
e>\tendmg you credit for whIch you Will pay indiViduals' holdIn gs of financial assets, such as
Interest after a short period Many people , savmgs depOSits, stocks and bonds , as well as
however, pay theIr credit card bIlls within the the availabIlity of credIt
month billed and aVOId Interest charge s
Many credit cards carry a "credl t Ime," a
maXimum amoun t the Issuer WIll lend you. A
$1,000 credIt line allows you to accum ulate
$1.000 In unpaId purcha ses or cash advan ces.
CredIt lmes are prearr anged loans that becom e
effecti ve when used. an arrang ement commo nly
used by large companies.
All bank lending depen ds on the availabIlIty of
reserves whIch are determ ined by the Federal
Reserve When the supply of reserves
.s small and cred.t card users draw on their
credit ltnes, banks have to reduce loans to other
customers Comm ercial banks alone lent about
$12 bIllIon throug h credIt cards and simIlar plans
In 1976, about 10 percen t of thelf loans to
IndlYlduals that year

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ca.au •• IIIOIMY.
Checks aren't money in themselves. They are stmply
Ofdel' forms instructing bank& to move checkbook
deposits, which are money, from one account to ..
another. Those checkbook depoSits are
~inO entrie$, numbers on banks' ledgers
and In their computers.
BankS don't keep cash in "hecking accounts and
don', transfer currency or coin when acting on a
check's instructions. Checkbook deposits are
transferred between accounts and banks as
bookkeeplng entries only.
tn 1917. the nation's 14,600 commercIal banks
held about 5230 billion of checkbook deposits for
individuals, businesses and governments.

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CIIeckbook mone, I. "created" hu currency

Commercial banks create checl<book money


whenever they grant a loan. SImply by adding
It a bank has excess reserves It can create an
amount of money equal to that excess: It can
grant a loan Borrowers wflle checks against
their new depOSIts When these checks are
new deposit dollars 10 accounts on their books In deposited at other banks. tnose banks collect
exchange for a borrower's IOU payment from the borrowers bank Bankers know
Mtlney creatIon bookkeeping Isn't gimmickry Far that when other banks present borrowers' checks
from It Banks are creating money based on a for payment, they WIll have to transfer reserves
borrower's promIse to repay (the IOU), WhiCh, ,'1 on a dollar-far-dollar baSIS
turn, is often secured or backed by valuable If a bank creates an amount greater than Its
Items the borrower owns (collateral) excess reserves, It also would lose some reqUITed
Someone obtaining an auto loan, for example, reserves and face temporary ViolatIon of
mIght use Ihe new car as col'aleral A home requirement rules Prolonged ViolatIon of
Improvement loan mighI be secured by rne value reqUIrement rules subjects banks 10 penaltIes So
of the house being Improved BUSIness loans they tend to match lending to excess reserves A
may be secured by phYSIcal assets. such as bank short of reqUired reserves usually Will
machines. factorIes and mventortes. or may be borrow from another bank Member banks can
"unsecured," backed only by the companys also borrow from the Federal Reserve
earnings record and expectations or general As newly cre?led checkbook dollars move from
credit WOfl"mess bank to bank. banks g81OlOg excess reserves
Banks create money by "monetIZing" the private can make additIonal loans As a group. banks
debls of bUSinesses and IndiVIduals That 15, they are capable of creating money m a multIple way,
create amounts of money agamst the \talue of Currently. our banktng system theoretically can
those IQUs ganerate a sevenfold Increase 10 total money
creatIon With a given amount of excess reserves,
To create money. however, hanks must have
"excess" reserves. funds exceeding those they Money multlphcaflOn, rather than currency
are legally requlfed to hold Banks belong 109 to depoSIts, accounts for most of our $230 billon of
the Federal Reserve System must abide by the checkbook money Banks hold only about $34
System's requirements. Banks that aren't billion In reserves. Only $8 billIon of that total is
members are sublect to the reserve requirements cash, the remaining rest;lrves are depOsit
of the state thaI chartered them. balances at Federal Reserve Banks Reserves
are the base on whIch the banking system has
Even without legal rules. prudent bank 109 generated the bulk of the nation's cheCkbook
dictates that some "requIred" reserves be held money.
Bankers know that. on any given day, they will
have to payout com and currency to people
cashmg personal checks They also know that
they WIll have to transfer reserve balances
as checks drawn agamst accounts they hold are
presented fOf payment by other banks_ Meeting
these routine transactions requires thac cames
hold some reserve funds

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1
811ftu .... pM of the GOHfftment. Regardless of charter, banks can IGItl another
Manv banks carry very othclal-soundlng names, "Federal" organ,za!:c:" the Federal DepOSIt
like "Bank of America" and 'State Bank of Insurance CorporatIon (FDIC) Congress
Albany," but they aren't run by, owned, or part establtshed the FDIC In 1933 to Insure depositors
of goverl"ment against losS when a bank lalls VIrtually all U S
CommercIal bankS are prtv8lCly owned commerCial banks are FDIC members Most have
b'JSlneSSes ,rYlng to earn profits prlmanlV by a seal on their main door or near tellers'
lending money 10 other bUSinesses and 10 WIndows mOleatlng that depOSits are Insured up
,"d,vlduals Don't get the wrong ImpreSSion from to a ma)umum. which Congress sets, of $40.000
~er account But aga,n. thai "membershIp"
the government· type sp.als on their Windows
doesn't mean the bank IS part of, run by, or
Banks musl be Ircensed to operate The license, owned by the Government
called a 'charter," IS gIven either by the Federal
Government (Comptroller of Ihe Currency) or the Most commercial banks ,n Ihls country are small,
government of lhe state In which the bank wants locally owned bUSinesses, wl1h no branches, lust
to operate Banks ChOOSing Federal charlers, a few employees, and only a few million dollars
about ona-thlrd of all commerCial banks, of depOSits Relatively few commerCial banks are
must have Ihe word "National" In their nr -"e bIg busmesses With many branch offices and
or the leners'N A "(NatIonal ASSoclatlo:" after rhousands of employees These bIg banks.
thelf title Slate· chartered banks don·t have 10 however, hold a relatively larger share 01 the
use the word" State" In their names. bul many do banking system's depOSits than the small banks,
Concentraled mainly In maier Cities, these bIg
Banks must meet government rules and banks, like Chase Manhatlan and Chemical Bank
regulallons Banks With Federal charters, for m New York City, and Bank of America," San
example, must lOIn Ihe Federal Reserve System. FranCISco. are owned by S10ckhold1!ts Their
the Independenl agency Congress created to
0'
regulate the nallon's flow money and credit
Stste-chartered banks may lOin the Federal
ownership shares are bought and sold publicly on
the stock exchanges
Reserve, an optIon cl"osen by only 10 percent of CommerCIal banks try to earn profrts for
the nation's 9,800 state-chartered banks stockholders by lending money and by ,"vesting
In Federsl, state and local government secufltles.
Sanks betongmg to the Federal Reserve may Most commercial bank loans are to businesses
display a seal on the1f rY'lQIfl wmdow md,catmQ which need funds tor such purposes as buying
they are a "member of the Federal Reserve raw mateflals and moderniZing faclones
System" Member banks are subject to many
Fedsral Reserve regulatIons and can borrow Although many of the largest banks aim most of
money from Reserve SankS for short peflods to their advertising at consumers. only about 52,50
meet unelCp.'9cted custonler Withdrawals or other of eve,y $10 lenl by commercial banks are
claims exceedmg funds on hand Federal "consumer"'oans About $3,50 of every $10 lent
Reserve membershIp doesn't make a bank a are "commercial and Itldustrial" loans, Real
"member" ot the Federal Government estate loans take about $3, and loans to financial
firms. farmers, or others about $1 of every $10
lent,

.. 21
., ~

-,~ ~

;,-';'"

<~"- '

..
BanIll .... 10 powerful they can flx Intareat In recent years. regulators have focused on bank
rllt.. on loan. Ind depoaita and do Jual Iboul lend 109 and adverllslng practices Recent
whaleVtll .... die, ,...... leglslallon, for example has aimed at ehminatlng
Banks cannot do whatevor they please Their raCial and seKual dlscflmmatlon In lending and
marketplace 'power" and their ability to "f'~" requIres that borrowers be mformed of the
mterest rales are hIghly restricted by overlapping precise conditions and terms of loans
layers of laws and government rules and CommerCial banks must conform to Federal and
regulattons, and by aC~lve competition among state laws on Interest charged on some loans
banks and other Imanctal institutions and Interest paId on depOSits State 'usury" laws
There are lour Federal agenClos that have bank set the legc.l Intere:;t rale IIlTHt on loans to
regulatory responSibilities Federally chartered IndIVIduals State governments also determIne
banks are regulated by the C'Jmptrolier of the ma)(IfTllH~ rates on reSidential mortgage loans
Currency, part of the Treasury Department that and maXimum rales Slate-chartered banks
serves as the Federal Government's bank can pay on Interest-earning (time) depOSits
chartering agency Since all federally chartered In 1933, Congress prOhibited ccrnmerclal banks
banks must belong to the Federal Reserve from ~aYlng Interest on checKmg account funds
System, they are also sublect to the central (demand depOSits) At the same lime, Congress
bank's rules gave rhe Federal Reserve power to sel ceIlings
Nonmember banks are regulated by both the on whdt member commerCial banks could pay In
charterm9 stale government and the Federal mterest on time depoSits Member banks.
DepoSit Insurance Corporallon In addllton, all however, are limited to the maximum rates
banks are sub/t"ctlO the authOrity of the Justice established by the stales Since Ihe 19305. the
Department. 11 the,r act,vIlles appear to Violate FDIC's Interest rate ceilings have matched those
antitrust laws Imposed by the Federal Reserve and s,"ee 1912.
so have all slate ceilings All commerCial banks.
The hroad goal vI governmenl regulatIon of
then, have the same Interest rate limits
banks IS 10 safeguard the public's money by
making sure banks are operahng prUdently CommerCIal banks. however. do not charge
Federal and state laws. for example, prohibit the same rates for stmllar loans or pay the same
banks from Investing In common stocks, and IImll rates for Similar depOSits. CommerCial banks
the maximum loan they can make to one borrower actively compete against each other and against
'thflft InslltutiOns" - savings banks. savings and
Furthermore, banks cannot open new branches. loan aSSOCiations and credit unions-for
merge WIth other banks. affiliate With other depOSits and many types of loans.
bUSinesses, such as credit card companies. or
change bUSiness hours unless Ihe regUlatory illS not uncommon for banks In the same area
agencies say okay to have different automObile, home Improvement
or mortgage loan rates, diNerent rates on savings
and time depOSits and different charges for
f,nanClal servlces.lSuch as money orders,
personalized checks. and cheCking accounts

23

.... 6
-- .. ", ..,-_._--,----
---_._---- -----
,I

AU .......,.. tile ame. One entlcal difference between savings and


"SavIngs" and "commercIal" banks dIffer In many commerCial banks traditIonally has been in the
respects First, they have dIfferent corporate way they lend money Commercial banks lend by
forms Savings banks are "mutually" owned by creating new checkbook deposits Savings
depositors, not stockholders They are run by banks and Similar thrift institutIons Simply payout
nonsalaned boards of trustees, not corporate eXlstmg funds lefl by depOSitors.
dtrectors EarnIngs aren't paId to private owners In recent years, many states, particularly in the
as diVIdends but dlstnbuted to depositors as Nor!heast, have changed thelf laws to lift
mterest on savmgs reslrlctlons confining thrift ,"st,tutlon operations
Savings banks collecllndlvlduals' savIngs mainly 10 acceptIng savtngs depOSits and
and channel those funds mainly Into grantmg mortgages Thnfts In more than 20
home mortgd(]eS CommercIal banks lake stales can now prOVide some form of
demand deposlls and make profIts by lendIng checkbook-type account
and investing Mosl of these accounts, however, don't hold
The ability of Ih"'t InstitutIOns to lend money for newly created checkbook money. but rather the
mortgages IS !Inked te depoSItors' savmgs savings that depOSitors have transferred into
behavior Many people depoCilt money In thnft them to pay bIlls. These accounts comprise only
InSlltutlons because they o11er a nood Inlerest a fracflon of the nation's total checkbook deposits.
relurn on savings However, whe.l mterest rates If thrift ·lnstitutions obtain broadj;1r powers to
flse 10 the natIon's credIt markets. better returns make loans other than long-term mortgages, they
oflen can be obtained by puttIng savings
undoubtedly would begin creating money in
elsewhere Fewer depOSIts mean fewer
much the same way as their commercial bank
mortgages, and fewer morlgages generally lead
counterparts, by adding new deposit dollars to
to less home bUIlding and more unemploymenl in
checking accounts. For now, most thrift
me construction Irades In addItIOn, many institutions payout loans with special checks
tnduSlfles that depend on a strong housmg
against funds on hand. or funds deposited at a
market, such as furnIture and appliance makers,
commercial bank, not by creating new demand
also suffer from reduced sales,
deposits.
tn the 19605, Congress established ~ further
distinction between savings banks and
comm"rClal banks by allowtng thrift mslltulions to
pay savings depositors a rate above the cellmg
ffTlposed on commercial banks, ThiS small rate
differential was designed to keep thrift depOSit
inflows strong enough to buttress the mortgage
and housmg markets.

25

28
_3:-~
~f

==------

~.­
_._- _--:-_--'--&-\.1
. . . . . . . benId"l ..........tIbIJIMcI tM The 12 regional Reserve Banks aren't
, . . . . . . . . . . . . Mel aontrollftOftllUy poUoy. Government institutions but corporations
In 1913, the most vocal opposition to the Federal nominally "owned" by member commercial
Reserve came from the Wan Street banking banks. who must buy special. nonmarketable
community. In part. that opposition stemmed trom stock in their district Federal Reserve Bank. Each
the intent of Congress to establish the Federal Reserve Bank has nine directors, each of
Reserve with built in "checks and balances" whom serves three-year staggered terms. As
specIfically to insure that monetary policy-making stockholders, member banks elect the majority of
would be decentraltzed and made in the the directors (six) but only three bankers can
broad national interest The System's structure. serve on a board.
organization and relationship to Congress make it The Federal Reserve Act requires that three
impossible for any interest group to domInate directors of each Reserve Bank bp appointed by
monetary policy. the Board of Governors. They may not be
The Federal Reserve System ~onsisrs of rhree bankers. Of the six elected directors, three must,
interlocking parts - a seven-member. by law. be actively engaged In some
Washington-based Board of Governors. 12 commercial. agricultural or industrial lob. The
regional Reserve Banks. and 5.600 member Federal Reserve Act also prohibits the six
commercial banks. "nonbanking" directors from being affiliated
The Board of Governors IS a Government with a bank in any way. Thus. the nominal
agency- Each Governor.$ appointed to a 14-year "owners" of the Reserve Banks, the
term by the Presidenr of the U.S. with the advice private member commercial banks. have only
and consent of the Senate. Terms are staggered three of the nine directors' seats at each
for an appointment every two years. By law. Reserve Bank.
Governors must come from dIfferent regions of Moreover. the three banking directors must be
the country. and "fair representation" must be representative of the entire banking industry. not
given to financial. agricultural. industrial and just the big banks. Member commercial banks
commercial Interests in their selection. Only two vote for their directors according to size.
of the present Governors have Substantive with small, medium and farge banks each electing
banking experience. Four are economists and one banking director. Thus, the most powerful
one was a corporation presiden,. banks cannot dominate the banking directors.
In the 1970&. the New York Reserve Bank's
directors have included chairmen and presidents
of corporations and banks throughout the New
York Federal Reserve District SUt educators.
a civil rights activist. law firm partners. and the
president of a philanthropic organization also
have been recent New York Reserve Bank
directors.

27
an
Reserve Bank directors appoint Reserve Bank FOMC decisions aren't secret. A summary of the
presldcrll5. who serve Wlt~l the Board of deliberations and record of policy actions are
Governors on the Syslern's key policy-making made public about 30 days after each meeting.
body. the Federal Open Markel Commillee A record of the vote of each member of the .
(FOMC) Directors' appointments of presidents. . Commillee appears after the formal policy
however. must be approvecj by the Board of decision, called the "directive." Dissenting votes
Governors are recorded with the reasons for the dissent.
Tt10 FOMC, which meels monthly In Washington, The 30-day delay is designed to avoid creating
DC 10 decide the course of monetary polley, excessive reactions to policy moves that might
consists of all seven Governors and live Reserve hinder the functioning of markets and the orderly
Bank presidents, four of whom serve one-year implementation of policy decisions.
terms on a rotalmg basIs The president of lhe What's more. the chairman of the Federal
New York Reserve Bank, who traditionally Reserve Board of Governors formally reports to
serves as FOMC vice chairman. IS !he only Congress every three months on the course of
Reserve Bank president who serves as a monetary policy and the Federal Reserve's
permanent Committee member long-term objectives. In addition, System
Governors routinely testify on key economic and
banking issues before House and Senate
commillees.
The Federal Reserve is unique among I
government-type institutions in that it is
"independent" within the Federal Government.
Congress specifically structured the Federal
Reserve so that monetary policy judgments and
actions would be made non politically. The
14-year term .ur System Governors is an
example of that intent.

,~ 1

I.._~~~---_._-----------_._-----_._-------------------_.....I
......__....,..._
...•"'J.,.....;.,...,.,..-- ..."..,..-_--......-.......- ~ ...... • _
""<',

·.'·.Neither the System'S monetary policies nor its


. '1;>anking activities are designed to guarantee
~'·profits for anyone.
-Almost all Federal Reserve earnings come from
the interest paid by the U.S. Government on the
. $100 billion or so of Government securities the
System acquired over the years for monetary
policy purposes. "
,So far in the 1970s the System earned more
I

than $5 billion a year. Almost all of the Federal


Reserve's earnings are returned to the U.S.
Treasury. Funds retained by the System are used
to pay the budgeted expenses of the Reserve
Banks and the Board, maintain a small surplus,
and pay the 6 percent atatutory dividend on the
ReservE:. Bank stock held by member banks.
Member commercial banks don't share in the
System's earnings.

29
_______.._ . , . . . _ .__.__._-------_.-----_-1
, fl.""

-,

.. -"".~' .. ,.,.
TIle ....... "..... c:onIrola the I8ICMIftt of .
curNllCf In cJrcuIatIoL
The Federal Reserve doesn't control the amoYnt
of "cuffency" in circulation. The pu~ic does. The
Federel Reserve. however. determines the total
amount of "money" in Circulation.
When people want mors currency, they cash
checks at their banks. When banks want more
currency, they purchase it from their Reserve
Bank with the checkbook money they have on
deposit as part of their required reseNes. Since
currency in circulation increases only when
check~ deposits dedine, the total amount of
money remains unchanged. Only the composition
of the money supply changes when the pU~ic
atters the form in which it holds money balances.
The pub!ic has shown, O\l&r the years. a very
strong preference tor checkbook money over
cash. At particular times of the year, however,
such as in December, thjs long-term preference
smfts CS8Ctdedfy toward cash, and more than $2
bitlion in currency and COlO leave the banking
system. In January, demand shifts back to
checkbook money. and cash returns to the
banking system.
The Federal Reserve doesn', try to alter public
preferences. but accommodates them by selling
currency to banks to meet public demands and
accepting currency deposits to reserve accounts
.. demands slacken.

31

.. ' ,"" ,r
.<
l~=============~~f"==- ~
-. ".-. ----. -. ~
. . . . 1Ionow IftOMY tram Federal R•••, .
.. 1M clllOOUftt nile and lind functe It •
....... ,... to lUlU profit.
Bantes can't borrow money 'rom the Federal
Reserve to lend at a higher rate, even if they
want to. The Federal Reserve. not commerCial
banks determines the rules for borrowing at the
discount rate. These rules restrict borrowing to
snort·run, temporary. seasonal or emergency
needs, Banks that borrow too mUCh, too often,
for too long, or for the wrong reasons, will soon
hear from the Federal Reserve. Because banks
know the rules and understand the Federal
Reserve's fundamental central bank '9'e as a
"lender of last resort," they rarely try to abuse
the borrowing privilege.
Commercial banks get the reserves that support
their loans and investments by attracting
individual and corporate funds with interest
payments on time deposIts, by borrowing
reserves from other banks. or by selling assets,
such as Government securities.
When the Federal Reserve was established, the
worldngs of the economy weren't as well
understood as today. In those days. banks could
readily replenish the funds they lent to farmers
and to buSinesses engaged in buying raw
materials and manufacturing finished goods by
borrowing from the Federal Reserve. Economic
theory indicated that. since "commerCiallcans"
helpt.d lncrea58 production and create more
jObs, accom"'Odating banks would help feed
economic expansion. To encourage the additional
tending and spending that would generate
upansion, the discount rate would be reduced .
. . To dlseourage lending, the rate would be raised.
Today, the Federal Reserve no longer fOltow8 the
"commercial loan theory" of discount lending.
lending at the discount rate is now used as a
"safety valve" that provides funds to individual
banks onty when necessary.

33

.,.: -,'''. "

:.- .. :.'- ;~.,.- .. -.. _,- '-..,-'.