Basics of Central Banking & Origins of Central Banking Dr. D. Foster – ECO 473 – Money & Banking
Free Banking & Inflation No government control. No government regulation. Entry and exit is free. Subject only to legal requirement to pay off debts.
What limits excess bank note issue? Trust. Extent to which we use bank notes. Fear of a bank run. If loans are sound, then bank should be able to liquidate without loss to depositors. Once started it is impossible to stop. Limited clientele as a day-to-day restraint. Conclusion: Free banking non-inflationary
Other Free Banking Issues Forces at work to consolidate; weakens restraint. But, forming cartels is quite unlikely. International gold flows would still limit a monopoly bank. Hume/Ricardo “specie flow price mechanism.” Fractional reserve banking as causing boom/bust cycle. Mises: “[F]reedom in the issuance of banknotes [will narrow] down the use of banknotes…”
Central Banking Government privilege or control. Monopoly on note issue. Tend to centralize holding of gold. Can prevent individual bank collapse. Will expand (contract) the MS by expanding (contracting) bank reserve deposits. Assuming banks are “fully loaned up” the MS is: Notes in circulation + (1/rr)*(Bank reserves) Since banks earn their profits by creating new money and lending it out, banks will keep fully loaned up unless highly unusual circumstances prevail. (136)
Free Banking vs. Central Banking With free banking what happens to the MS when depositors cash out some of their DD for banknotes? Nothing. Only the form of the MS changes; from DD to banknotes.
Free Banking vs. Central Banking With central banking what happens to the MS when depositors cash out some of their DD for banknotes? The bank loses liabilities to the CB. To restore reserve balance, loans, DD and MS must fall.
Central Banking – The Bank of England Created in 1694 Bought gov’t bonds and issued notes. Held all government debt. Notes were not “legal tender,” but widely accepted. Insolvent in 2 years. Parliament allowed them to suspend specie payment. Brief competition (Nat’l Land Bank; South Seas) 1708: monopoly on bank notes & short term loans. Late 1700s, massive suspension lasted 24 years. 1833: notes made legal tender. Peel Act – limit fractional reserve notes Failed to recognize deposits as money.
Basics of Central Banking & Origins of Central Banking Dr. D. Foster – ECO 473 – Money & Banking