A couple months ago I was reading Linsey’s post at WiseBread “5 Financial Holidays I’d Like to See”and one of them was FED Day. Well that started me down a path to learn more about our banking institution and how the Federal Reserve (FED) tries to manage the economy. So to share what I have learned we need a few definitions to get us started.
Inflation – A progressive increase in the general level of prices brought about by an expansion in demand or the money supply or by autonomous increases in costs. (Dictionary.com)
Deflation – A reduction in the level of total spending and economic activity resulting in lower levels of output, employment, investment, trade, profits and prices. (Dictionary.com)
Central Bank – A public institution that usually issues the currency, regulates the money supply, and controls the interest rates in the country. (Wikipedia)’
Fractional Reserve Banking – A type of banking where depositors invest base money into a bank and the bank uses it to maintain highly liquid reserves to repay expected customer withdrawals and pay for bank operations and gives a credit to their account which the bank ensures the customer can use as money. The bank only needs to keep a fraction of the money in reserve and so the rest can be used to make loans (though it appears that the depositor holds the full amount due to the credit). (Wikipedia)
Fractional Reserve Banking
The part I found most interesting to read is the Fractional Reserve Banking which explains how money is “created” by the banks. Really what happens is that you give your money to the bank, the bank puts an IOU in your account and then loans out the money up to the amount that they need to keep in reserve to satisfy the withdrawals that normally happen.
NOTE: In the case of the United States the reserve requirements are 10% for checking if your bank holds more than $58.8 million in deposits and 3% for institutions with more than $10.7 million but less than $58.8 million. (Federal Reserve) Note that Savings accounts and time deposits (CDs) are not the deposits they are talking about and actually these deposits have a reserve rate at 0%.
So to see how this works in life let us take a person that has a checking account at a large (more than $58.8 million) bank and our person deposits $100 into the account. The bank is required to keep %10 of that $100 as a reserve (they may keep more to satisfy the demands of a normal person though). So they then loan out $90 to someone. Well our original person still believes he has $100 that he can use whenever and his friend got a loan of $90 so it appears that there is $190 in the system. Now if the depositor writes a check for $50 the bank has to pay it, but of course they only have $10 in reserve of which only $5 is available. So the bank goes to the Federal Reserve (or another bank) and borrows the $45 additional dollars they need cover their IOU and pays the check written by the person. Of course they might be able to sell or call the loan of the $90 they gave and also pay the check.
Of course banks have a lot of depositors and people with large balances usually will use less than the reserve requirement which the bank can use to cover other people’s withdrawals and they usually keep more in reserve than the required amount anyway. Take Bank of America for instance in their Annual Report you see that they are holding $117 billion dollars in cash (page 244) and $1 Trillion in deposits (page 238) or a ratio of around 11.7%. So they would have to have people withdraw without any deposits, around $17 billion dollars before they would need to raise money to reach their reserve requirements, and that is if ALL the deposits were in checking accounts (which they are not).
Now inflation is very simple, the increase in price due to more perceived money, more demand or increase in raw components. Take a bushel of corn (about 1.25 cubic feet) for instance, corn requires water, sun, correct temperatures, and nutrients to produce. As water becomes more scarce the price of water increases as people are willing to pay more for water (it just takes a few to raise the price). Also as the price of oil increases the fertilizer used by farmers also increases since oil byproducts are used in fertilizer. So as these raw resources increase in price the raw cost for a bushel of corn increases. Farmers still need to make a profit similar to the previous crop and so they increase their price and thus the price of corn increase. In addition as more people demand 2nd tier foods (beef, chicken, or other foods that use corn to produce) the greater demand rests on corn. Finally it is also easier to acquire money as interest rates for loans are low and you don’t have to think on how much it costs when you swipe your credit card. Also you remember that a CC purchase is a loan so remembering that in Fractional Reserve Banking we get that money you just used from a person’s bank account that did not decrease, thus the money supply increased because you used your credit card.
Now deflation in the common usage is the reduction in price. However it can be an indicator of reduction in the economic activity. For example if a factory produces a widget and less people start buying that widget the company might reduce prices to sell all the widgets it makes. This reduction in price to generate the same volume usually results in a lower income resulting in the company needing less people and so it fires its workers to trim costs (or the head management takes a pay cut). This results in those workers no longer having the ability to buy products and so more people lose their jobs and the cycle repeats.
So with this overview of the financial system hopefully you can start making your own decisions to get the results you want. For example if you want to make the dollar stronger you need to remove dollars out of the system. One way is to withdraw them and stuff them into a mattress (since that cash can no longer be loaned out with an IOU in your account) or you can look for banks that hold a high reserve of their cash so the multiplicative effect is reduced.
Note: For the scenario where you take out cash you will need a large portion of the population to withdraw the cash for the banks to reduce their loan/investment holding to bring the reserves back.
In the end the more you understand the system the better you are at managing your financial welfare in that system. And remember we ALL are responsible for the rising prices. (Of course this is excluding the one person who doesn’t have money in the bank, doesn’t use credit, hunts/grows their own food and basically doesn’t use or affect the financial system).