Subject: Myths About Money 
       Date: Mon, 29 Dec 1997 19:17:17 GMT 
       From: wfhummel@concentric.net (William F. Hummel)

 Newsgroups: sci.econ


What money is and how it works is not well understood by most.
That's not particularly surprising since money is indeed complex.
Unfortunately that has fostered a number of myths and created a
mystique about money and its institutions that perpetuates the
confusion.  Listed below are some myths, and the facts.  If you
want to explore the subject in more detail, visit

http://www.concentric.net/~wfhummel/


Myth 1.  Deficit spending increases the money supply.

Fact.  The money flowing to the private sector due to deficit
spending all returns to the government through the sale of
Treasury securities.  Neither the money supply nor banking system
reserves is directly affected by this circular flow of funds.
However deficit spending can lead indirectly to an increase in
the money supply by increasing the demand for bank-issued credit.

Myth 2.  When money is in short supply, interest rates rise.

Fact.  Money is not like a commodity that can in fact be in short
supply.  Money is created out of thin air when banks and other
intermediaries create new deposits as a result of making loans.
The amount of such lending depends on demand.  Demand in turn
depends on various economic factors, including interest rates.
Thus the size of the money supply depends (in part) on interest
rates, not vice versa.

Myth 3.  Deficit spending causes the interest rate to rise.

Fact.  The interest rate on money is selected and controlled by
the Federal Reserve, and is based primarily and how it views the
inflationary threat.  Nominal interest rates have actually fallen
during most of the period of high annual deficits along with a
drop in inflation.

Myth 4.  A bank is limited in how much it can lend by the amount
of its deposits, in accordance with the reserve requirements.

Fact.  Most large banks fund their lending mainly with borrowed
money rather than depositors" money.  The reserve requirements on
banks do not apply to borrowed money.  A bank's lending is
limited by leverage requirements, i.e. its assets/equity ratio.
It must also meet reserve requirements on demand deposits, but
that is not a fundamental limitation.

Myth 5.  The Federal Reserve controls the size of money supply.

Fact.  The money supply, as measured by the various monetary
aggregates, cannot be directly controlled by the Fed.  Attempts
to do so in the past have led to excessively volatile interest
rates.  The Fed can control the amount of banking system reserves
through its purchase or sale of securities on the open market.
But it cannot force banks to increase the money supply by making
loans against those reserves.  Nor can the banks make loans that
their customers are unwilling to assume.  Loan money comes at a
price.  Thus it is business and consumer demand that determines
the size of the money supply.  The Fed can influence that demand
by its control of interest rates.  In that way it can indirectly
control the money supply, but only with a substantial time lag.

William F. Hummel