The Mystery of Banking

Which
of its own
actions or liabilities should the Fed try to control? The Friedman-
ite favorite is the 
monetary base
: Fed liabilities, which consist of
Federal Reserve notes outstanding plus demand deposits of com-
mercial banks at the Fed. It is true that Federal Reserve actions,
such as purchasing U.S. government securities, or lending reserves
to banks, determine the size of the monetary base, which, by the
way, rose by the alarmingly large annual rate of 9.4 percent from
mid-November 1981 to mid-April 1982. But the problem is that
the monetary base is not a homogeneous figure: It contains two
determinants (Federal Reserve notes outstanding + bank reserves)
which can and do habitually move in opposite directions. Thus, if
people decide to cash in a substantial chunk of their demand
deposits, FRN in circulation will 
increase
while bank reserves at
the Fed will 
contract
. Looking at the aggregate figure of the mon-
etary base cloaks significant changes in the banking picture. For
the monetary base may remain the same, but the contractionist
impact on bank reserves will soon cause a multiple contraction in
bank deposits and hence in the supply of money. And the con-
verse happens when people deposit more cash into the commer-
cial banks. 
A more important figure, therefore, would be total bank
reserves, which now consist of Federal Reserve notes held by the
258
The Mystery of Banking
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banks as vault cash plus demand deposits at the Fed. Or, looked
at another way, total reserves equal the monetary base minus FRN
held by the nonbank public. 
But this does not end the confusion. For the Fed now 
adjusts
both the monetary base and the total reserve figures by changes
in reserve requirements, which are at the present changing slowly
every year. 
Furthermore, if we compare the growth rates of the adjusted
monetary base, adjusted reserves, and M-1, we see enormous
variations among all three important figures. Thus, the Federal
Reserve Bank of St. Louis has presented the following table of
growth rates of selected monetary aggregates for various recent
periods:
7
Period
Adj. Monetary Base Adj. Reserves
M-1
6/81–8/81
4.0 %
1.3 %
3.8 %
8/81–10/81
-2.1
-14.2
2.5
10/81–12/81
9.3
9.4
11.6
12/81–2/82
10.7
19.3
8.7
While total reserves is a vitally important figure, its determi-
nation is a blend of public and private action. The public affects
total reserves by its demand for deposits or withdrawals of cash
from the banks. The amount of Federal Reserve notes in the
hands of the public is, then, completely determined by that pub-
lic. Perhaps it is therefore best to concentrate on the one figure
which is totally under the control of the Fed at all times, namely
its own
credit. 
Federal Reserve Credit is the loans and investments engaged
in by the Fed itself, any increase of which tends to increase the
Conclusion
259
7
Federal Reserve Bank of St. Louis, 
Monetary Trends
(March 25, 1982),
p. 1.
Chapter Seventeen.qxp 8/4/2008 11:38 AM Page 259

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monetary base and bank reserves by the same amount. Federal
Reserve Credit may be defined as the assets of the Fed minus its
gold stock, its assets in Treasury coin and foreign currencies, and
the value of its premises and furniture. 
Total Fed assets on December 31, 1981 were $176.85 billion.
Of this amount, if we deduct gold, foreign currency, Treasury cash
and premises, we arrive at a Federal Reserve Credit figure of
$152.78 billion. This total consists of: 
1. float-cash items due from banks which the Treasury 
has not yet bothered to collect: $10.64 billion 
2. loans to banks: $1.60 billion 
3. acceptances bought: $0.19 billion 
4. U.S. government securities: $140.4 billion
Clearly, loans to banks, despite the publicity that the discount
(or rediscount) rate receives, is a minor part of Federal Reserve
Credit. Acceptances are even more negligible. It is evident that by
far the largest item of Federal Reserve Credit, amounting to 79
percent of the total, is U.S. government securities. Next largest is
the float of items that the Fed has so far failed to collect from the
banks. 
Changes in Federal Reserve Credit may be shown by compar-
ing the end of 1981 figures with the data two years earlier, at the
beginning of 1980. Total Reserve Credit, on the earlier date, was
$134.7 billion, a rise of 13.4 percent in two years. Of the partic-
ular items, loans to banks were $1.2 billion in the earlier date, a
rise of 33.3 percent in this minor item. The float’s earlier figure
was $6.2 billion, a rise in this important item of 71.0 percent for
the two years. The major figure of U.S. government securities had
been $126.9 billion two years earlier, a rise of 10.6 percent in this
total. 
If we take gold as the original and proper monetary standard,
and wish to see how much inflationary pyramiding our Federal
Reserve fractional reserve banking system has accomplished on