Federal Reserve System, Plan

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From the course by Columbia University

Economics of Money and Banking

493 ratings

Columbia University

Economics of Money and Banking

493 ratings

The last three or four decades have seen a remarkable evolution in the institutions that comprise the modern monetary system. The financial crisis of 2007-2009 is a wakeup call that we need a similar evolution in the analytical apparatus and theories that we use to understand that system. Produced and sponsored by the Institute for New Economic Thinking, this course is an attempt to begin the process of new economic thinking by reviving and updating some forgotten traditions in monetary thought that have become newly relevant. Three features of the new system are central. Most important, the intertwining of previously separate capital markets and money markets has produced a system with new dynamics as well as new vulnerabilities. The financial crisis revealed those vulnerabilities for all to see. The result was two years of desperate innovation by central banking authorities as they tried first this, and then that, in an effort to stem the collapse. Second, the global character of the crisis has revealed the global character of the system, which is something new in postwar history but not at all new from a longer time perspective. Central bank cooperation was key to stemming the collapse, and the details of that cooperation hint at the outlines of an emerging new international monetary order. Third, absolutely central to the crisis was the operation of key derivative contracts, most importantly credit default swaps and foreign exchange swaps. Modern money cannot be understood separately from modern finance, nor can modern monetary theory be constructed separately from modern financial theory. That's the reason this course places dealers, in both capital markets and money markets, at the very center of the picture, as profit-seeking suppliers of market liquidity to the new system of market-based credit.

From the lesson

Introduction, continued

The next two lectures are meant to introduce a key analytical tool, the balance sheet approach to monetary economics, that we will be using repeatedly throughout the course. As inspiration, first I provide a concrete example of how the approach works by "translating" the Allyn Young reading into the balance sheet language. I follow that with a more systematic introduction to this essential tool.

Civil War Finance, Legal Tenders7:05

National Banking System, Origins6:28

National Banking System, Instability5:57

Federal Reserve System, Plan6:32

Federal Reserve System, Actual6:47

Meet the Instructors

Perry G Mehrling
Professor
Economics, Barnard College

[SOUND]

So we got the Fed.

There were attempts, he tells us about them, attempts to create the Fed

by the bankers themselves but they, of course, were not viewed as trustworthy.

Ultimately it was President Wilson who, who got it,

who got it through just in time for for World

War I to use it, for World War I finance, which I'm going to come to in a moment.

The history of American central banking is a history of war finance.

let

me show you what the idea was of the Fed.

This was how, this is just turning into balance sheets,

okay, what it is that Young is saying in words there.

So you can, you can connect these things back up.

He says there are, under the Federal

Reserve system, there are three sorts of levels.

Okay, not dissimilar to, to this here.

Okay, there are the member banks.

[NOISE]

There are the

reserve banks.

Which are sprinkled around the country.

In fact, they're in exactly the same place as the, as

the, reserve banks were before in the, in the private sector.

So there's one in Boston, in San Francisco, and all those sorts of things.

And, then there's the Federal Reserve system.

And this is the, sort of central, central bank.

And the idea of the system was this. That any member bank, okay.

It, it's just a bank. It's making loans to its local customers.

Farmers, merchants, people, main street. Okay.

These are Main Street banks. So they're making loans, and they're

making loans by expanding their balance sheet, possibly, their own deposits, okay?

This is good.

This is what we want, supporting business, supporting Main Street.

We want these banks to be able to do this.

Okay, what constrains these banks from doing this is a fear that if

these deposits are withdrawn, you won't

have sufficient reserves to make those payments.

Okay.

We don't want these banks to worry about that, okay.

And how do we make, because then they make loans.

[INAUDIBLE]

. We want them to make these loans.

So we, we create this system of discounts

in order for them to replenish their reserves.

If they run out of reserves, they can

always get more from their local reserve bank.

And the way you do that, okay?

Is by using these loans themselves.

As collaterals, as collateral for borrowing

from the Federal Reserve Bank, okay.

This is called discount loan, okay? So you're borrowing.

You're borrowing from the Federal, Federal Reserve system.

By using this loan as, as, as collateral, okay?

[SOUND]

[INAUDIBLE]

, or by even selling it to the.

If it's, if it's in a certain form, you could even

sell it to the federa-, to the, to the reserve bank.

And the reserve bank will give you reserves.

[SOUND]

[SOUND]

For

this.

Okay. This is the alchemy of banking.

Once again, notice the member bank is able to make loans.

Good loans to customers with out fear of running out of reserves.

Why?

Because you can use those loans to borrow

from the reserve banks to get more reserves.

And why?

Because the reserve banks can create reserves on their own balance sheet.

The are expanding their new balance sheets.

They're from thin air.

These are new reserves in the system. They weren't there before.

Elastic reserves.

Not like the national banking system. Okay.

Well, that's all very fine and good

if you're making a transfer to another bank, but

what if these deposits are withdrawn in, in notes?

Okay.

What about that? Have you thought about that?

Yeah, they thought about that. And here's, here's how that works.

OK. These reserve banks have the right to

rediscount [CHALK]

at the Federal Reserve

which prints money.

Little green pieces of paper. This is how he's explaining it.

This is not exactly how it works today, okay.

So just be aware of that.

I'm just translating what he says into balance sheets so that you can.

Under, understand it.

but the point is these things.

[SOUND]

These things are cash money. Right.

These are deposits in a bank.

Okay.

These things are cash money that can circulate.

Okay. So cash also is elastic.

The supply of cash also is elastic and can expand and contract to meet demand.

That's the whole idea of the Fed.

The whole idea the Fed was founded on was the notion That were

living in this agricultural country where

the demand for, for money fluctuates seasonally.

So we need to have the supply of money fluctuating seasonally.

Okay.

The demand for deposits fluctuates sea, seasonally, so we need

to have the supply of reserves back those deposits fluctuate seasonally.

And we created a system for that, that was based on the idea that banks would be

taking their loans to Main Street, and using them to acquire these reserves and

these notes. That was the idea.

If you read the Federal Reserve Act, that what it says.

It says, we''re going to, the assets of the reserve banks Are

supposed to be, these discounts, which are essentially loans to Main Street.

That's, that's how it was sold by President Wilson.

Okay?

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