In short, the public’s holding of cash is a
factor of decrease
of
bank reserves. That is, if the public’s holding of cash increases,
bank reserves immediately
decrease by the same amount
, whereas
if the public’s holding of cash falls, bank reserves immediately
increase by the same amount
. The movement of bank reserves is
equal and inverse to the movement in the public’s holding of
cash. The more cash the public holds, the greater the anti-infla-
tionary effect, and vice versa.
The public’s demand for cash can be affected by many factors.
Loss of confidence in the banks will, of course, intensify the
demand for cash, to the extent of
breaking the banks by bank
runs. Despite the prestige and resources of the Central Bank, bank
runs have been a powerful weapon against bank credit expansion.
Only in 1933, with the establishment of the Federal Deposit
Insurance Corporation, was the government of the U.S. able to
stop bank runs by putting the unlimited taxing and counterfeiting
power of the federal government behind every bank deposit.
Since 1933, the FDIC has “insured” every bank deposit (up to a
high and ever-increasing maximum), and behind the FDIC—
implicitly but powerfully—is the ability of the Federal Reserve to
print money in unlimited amounts. The commercial banks, it is
true, are now far “safer,” but that is a dubious blessing indeed; for
the “safety” means that they have lost
their major incentive not to
inflate.
Over time, one powerful influence toward a falling demand
for cash is the growth of clearing systems, and devices such as
credit cards. People then need to carry less cash than before.
2
On
the other hand, the growth of the underground economy in
recent years, in order to avoid income taxes and other forms of
government regulation, has required an increase in strictly cash
transactions, transactions which do
not appear on the books of
Central Banking: Determining Total Reserves
147
2
But note that our previous concept of “cash balances” includes not
only cash but also demand deposits and any other form of money, whereas
now we are dealing with the public’s demand for
cash
per se as against
deposits or other forms of money.
Chapter Ten.qxp 8/4/2008 11:38 AM Page 147
any government-regulated bank. In fact, it is now customary for
economists to try to gauge the extent of illegal,
underground
transactions by estimating the increase in the proportion of cash
transactions in recent years.
The major movement in the public’s demand for cash is sea-
sonal. Traditionally, the public cashes in a substantial amount of
demand deposits before Christmas in order to use cash for tips or
presents. This has a deflationary seasonal effect on bank reserves.
Then, in January, the cash pours back into the banks, and reserves
rise once again.
Generally, the Fed keeps watch on the public’s
demand for cash and neutralizes it accordingly, in ways which will
be explored below.
2. T
HE
D
EMAND FOR
G
OLD
As in the case of the demand for cash in the form of Central
Bank notes, an increase in the public’s demand for gold will be a
factor of decrease in lowering bank reserves, and a fall in the
demand for gold will have the opposite effect. Under the gold
standard, with a Central Bank (as in the U.S. from 1913 to 1933),
almost all of the gold will be deposited in the Central Bank by the
various banks, with the banks getting increased reserves in return.
An increase in the public’s
demand for gold, then, will work very
similarly to an increased demand for Central Bank notes. To
obtain the gold, the public goes to the banks and draws down
demand deposits, asking for gold in return. The banks must go to
the Central Bank and buy the gold by drawing down their
reserves.
The increase in the public’s demand for gold thus decreases
bank reserves by the same amount, and will,
over several months,
exert a multiple deflationary effect over the amount of bank
money in existence. Conversely, a decrease in the public’s demand
for gold will add the same amount to bank reserves and exert a
multiple inflationary effect, depending on the money multiplier.
Under the present fiat standard, there are no requirements
that the Central Bank redeem in gold,
or that gold outflows be
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