The Mystery of Banking

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checked in order to save the banking system. But to the extent
that gold is still used by the public, the same impact on reserves
still holds. Thus, suppose that gold flows in, say, from South
Africa, either from outright purchase or as a result of an export
surplus to that country. If the importers from South Africa deposit
their gold in the banks, the result is an increase by the same
amount in bank reserves as the banks deposit the gold at the Cen-
tral Bank, which increases its gold assets by the same amount. The
public’s demand for gold remains a factor of decrease of bank
reserves. (Or, conversely, the public’s increased deposit of gold at
the banks, that is, lowered demand for gold, raises bank reserves
by the same amount.) 
So far, we have seen how the public, by its demand for gold
or nowadays its demand for cash in the form of Central Bank
notes, will help determine bank reserves by an equivalent factor
of decrease. We must now turn to the major instruments by which
the Central Bank itself helps determine the reserves of the bank-
ing system. 
3. L
OANS TO THE
B
ANKS
One method by which the Central Bank expands or contracts
total bank reserves is a simple one: it increases or decreases its
outstanding loans of reserves to various banks. In the mid-nine-
teenth century, the English financial writer Walter Bagehot
decreed that the Central Bank must always stand ready to bail out
banks in trouble, to serve as the “lender of last resort” in the
country. Central Banks generally insist that borrowing from them
is a “privilege,” not a right conferred upon commercial banks,
and the Federal Reserve even maintains this about members of the
Federal Reserve System. In practice, however, Central Banks try
to serve as an ultimate “safety net” for banks, though they will not
lend reserves indiscriminately; rather, they will enforce patterns
of behavior upon borrowing banks. 
In the United States, there are two forms of Federal Reserve
loans to the banks: 
discounts
and 
advances
. Discounts, the major
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form of Fed loans to banks in the early days of the Federal
Reserve System, are temporary purchases (
rediscounts
) by the
Central Bank of IOUs or discounts owed to banks. These days,
however, almost all of the loans are outright advances, made on
the collateral of U.S. government securities. These loans are
incurred by the banks in order to get out of difficulty, usually to
supply reserves temporarily that had fallen below the required
ratio. The loans are therefore made for short periods of time—a
week or two—and banks will generally try to get out of debt to
the Fed as soon as possible. For one thing, banks do not like to be
in continuing, quasi-permanent debt to the Fed, and the Fed
would discourage any such tendency by a commercial bank. 
Figure 10.6 describes a case where the Central Bank has
loaned $1 million of reserves to the Four Corners Bank, for a
two-week period. 
Four Corners Bank
Assets
Equity & Liabilities
IOU to Central
Bank
+ $1 million
Reserves
+ $1 million
Central Bank
Assets
Equity & Liabilities
IOU from Four
Demand deposit to
Corners Bank + $1 million
Four Corners Bank + $1 million
F
IGURE
10.6 — C
ENTRAL
B
ANK
L
OANS TO
B
ANKS
Thus, the Central Bank has loaned $1 million to the Four
Corners Bank, by opening up an increase in the Four Corners
checking account at the Central Bank. The Four Corners’ reserves