The first chapter in Ashby‘s book, Money Mechanics, is the introductory chapter and it is fairly brief in comparison with other chapters in the book. In this chapter, the author introduces some of the basic concepts that the book entails and builds on these concepts in subsequent chapters as the book progresses. One of the main topics in the chapter is money.
On this topic, Ashby defines what money is, both as an item that serves as a medium of exchange (as most non-economists understand it), and conceptually as most economists view the term. He starts by giving a brief history on the necessity of money and the evolution of currency from the barter trade system to its current form.
He explains that in the barter trade system whereby people would exchange goods and services for other goods and services was hectic and time consuming with one of the reasons being that the buyer had to look for a seller who had the commodity or service that the buyer was looking for.
The buyer also had to make determinations on whether the seller was willing to exchange his or her goods or services with the buyer and whether their terms of exchange would be compatible. Ashby explains that having a general item or items that would be commonly acceptable as a medium of exchange, which is the basic definition of money in trade, makes trade more manageable.
Distinction between currency and money
The author also makes a distinction between currency and money and explains that currency is not always money. According to this concept, three widely acceptable objects qualify as money including coins, paper currency, and checking accounts.
Ashby explains that although non-economists find trouble making the distinction, it is important for economists to understand the difference between the two. He elaborates this theory by stating that whether cash (in the form of paper currency or coins) qualifies as money depends on a few factors with the most important of them being whether the cash is in the U.S money supply.
The U.S money supply involves cash that is in circulation and in use by consumers as opposed to cash under the authority of money creating institutions such as banks. This is the cash in people’s pockets and the cash that they use for their every day needs.
Therefore, if such cash goes into a savings account at a bank and thus its ownership goes to the bank, the cash is no longer in the U.S money supply system and the term money ceases to apply to it. Another important aspect that Ashby discusses in this chapter is the velocity of money. He explains it as the number of times that consumers use a dollar over a specific period, usually a year.
Under this concept, he gives a simple example that helps in the explanation of the theory. He illustrates the concept by using an inference of a dollar passing from one user to another through the purchase of goods and services. That specific dollar facilitates the acquisition of various goods and services by different consumers over a specific period while in circulation.
He notes that velocity is a consumer-controlled concept as it depends on the speed at which consumers apply money in the purchase of goods and services. He gives an example of the length of time it takes an individual to pay bills.
In his second chapter, Ashby discusses different aspects regarding the U.S Treasury Department, the Federal Reserve System, and the banking system. He explains the operations of these institutions coupled with their functions agencies that control them in terms of regulation and supervision.
The U.S Treasury
Ashby explains that the U.S Treasury Department is part of the executive branch of the federal government, which is the level of government that controls the various states in the US independently.
The treasury’s main tasks as set out in Ashby’s discussion include tax collection through the Internal Revenue Service (IRS), sale of treasury securities to supplement the tax revenue, and the production of currency through the operation of the U.S Mint and the U.S Bureau of Engraving and Printing.
Ashby clarifies that although the treasury institution produces currency, it is not responsible for creating money as most of the currency produced goes to the Federal Reserve banks. The treasury does not inject the currency directly into the U.S money supply for circulation and thus it does not become money until such as a point when it is accessible to consumers for use in the purchase of goods and services.
The Federal Reserve System
The Federal Reserve System (FRS) is the second link in the chain towards the creation of money as it involves the remit of currency by the treasury department to the Federal Reserve banks.
In addition, the author makes it clear that the currency deposited to the Federal Reserve banks does not attain money status at this level as these banks serve the purpose of holding money that the treasury department sends and transmitting it to banks, which are the institutions responsible for money creation.
Some of the functions that Federal Reserve banks perform include serving as banks for the federal governments, serving as banks for foreign governments and other foreign institutions, and serving as banks for other banks in the federation.
Although the treasury and the FRS do not create money, they play a big role in regulating the amount of money available for circulation. This regulation is a very important role as it establishes the value of currency in use through regulating conditions such as inflation and deflation.
The author elaborates that making too much currency for circulation causes inflation, thus reducing the value of each dollar as in most cases prices rise to compensate for the increase in supply forcing consumers to use more dollars in the purchase of goods and services.
The value of money is in its scarcity and thus the two institutions have to ensure that the money becomes scarce enough to have value and regulate the same to retain such value
The banking system
Ashby explains that banks are the points at which the creation of money occurs because they are the points of access for currency for consumers as well as the points where consumers deposit currency and end the circuit of the money supply.
A dollar travels from the Treasury to the Federal Reserve Bank then the banks and becomes money when people withdraw it from their various accounts for everyday use thus entering the money supply system. Due to the crucial role that banks play in the creation of money, federal governments have established various agencies that ensure the supervision and regulation of their operations.
The agencies mainly operate through depositor protection by ensuring there is stability in the monetary system, thus making sure that there is healthy competition in the banking industry and creating consumer protection mechanisms.
In the third chapter of his book, Ashby talks about the effects of the treasury department’s operations on money supply in a state. The author looks at the effects activities such as tax collection, sale of securities, and creation of currency may have on the money supply system. In the book, the author notes that one of the main aspects behind the concept of money is the ownership of currency.
Once the ownership transfers from the consumer to commercial institutions such as banks, it ceases to be money as it is no longer in the money supply system. The treasury department has the mandate to collect taxes through the IRS. Once individuals pay their taxes through the agency, the IRS deposits the money in various specific banks within the localities in tax and loans accounts belonging to the treasury department.
The same case also applies to the money that people use to buy treasury securities such as bonds and shares. In essence, treasury securities reflect as loans from the public to the treasury department as payment for such securities usually occur on dates. However, Ashby explains that Federal Reserve banks are the ones that bear the burden of these loans.
In explaining this concept, the author states that the treasury department usually withdraws the money in the tax and loans accounts at the various banks including money paid for the purchase of treasury securities. The treasury uses the money to pay the government’s operational bills and some of its debts to other countries.
Periodically, the treasury department is supposed to pay back a fraction of the treasury securities with interest, which it does through issuing checks to the individuals, who in turn present them at the various banks in exchange for currency.
The banks immediately credit the checking accounts of these people and loose a matching amount in their reserves. They demand compensation for the treasury securities from the Federal Reserve banks, and thus banks experience no losses in their reserves.
In essence, the amount of treasury securities that people buy from the treasury department form the amount that the public loans to the government through their reserves at banks, which transfers to the Federal Reserve banks. Therefore, the treasury department’s spending has no substantial effect on the money supply or bank reserves.
However, the author states that it is noteworthy that the treasury department collects the amounts in tax and loans accounts just before it applies them in various ways. The logic behind this move is that the amount collected is a lump sum and its application takes some time.
Therefore, collecting the amount before it is applicable would cause deficits in bank reserves and a consequent reduction in the lending ability of most banks leading to a credit crunch, a situation that most federal governments do their best to avoid.
The author is of the view that the creation of currency also has no net effect on money supply. He explains the process of currency supply up to the point where the currency reaches the hands of consumers and becomes money.
The essential point worth noting in this process is that when consumers withdraw currency from their checking accounts, they reduce the balance in the checking accounts by exactly the same amount of cash they hold. Therefore, as both the checking accounts and cash are forms of money, the two remain at equilibrium as an increase in one creates a decrease in the other.
In this chapter, the author discusses how the money creation ability of banks affects money supply. In his discussion, Ashby mentions the different kinds of money that reserve banks have and the effect that lending money has on the various reserves and in turn the money supply system.
The primary reserve is the first reserve that the author explains by elaborating that it lays its basis on a reserve requirement whose calculation is done through the application of a percentage set by the regulatory agencies against the total bank deposits customers make.
The essence of this requirement is the prevention of a scenario where a bank is unable to remit withdrawals at given times due to lack of adequate funding. The banks keep the reserve amounts either in vaults at the banks or in their Federal Reserve accounts.
The second reserve that the author elaborates on is the working reserve, which he explains as an amount in excess of the primary reserve that banks keep at hand to ensure there is a sufficient operational amount for withdrawal by customers.
Although the law does not require banks to keep this additional sum in hand, some banks experience more traffic than others do in terms of customer, and thus they keep the additional sum in hand for convenience. At times, banks also experience net withdrawals. Ashby defines these withdrawals as withdrawals above the amount a customer has in his or her checking account.
Since the law forbids the banks from using deposits from other customers to facilitate a customer’s net withdrawal, banks use their working reserves instead. He notes that working reserves do not prevent the likelihood of net withdrawals, but they prepare bank for the eventualities so that the bank still has sufficient reserves on which to operate.
The third type of reserve that the author discusses is the secondary reserve. He describes this as a reserve in excess of both the primary and working reserves. The main use of this reserve is to generate revenue for the bank, as a bank is a business institution that aims at the generation of profits.
After banks establish their primary and working reserves, they apply the rest of the reserves in revenue generating projects and investments. However, there are restrictions to the types of investments and projects that banks can get involved in with regard to the risks that such investments involve.
The author gives an example of such investments as treasury securities by stating that they are safe, generate interest on the reserve, and are easy to liquidate when the need arises. The securities in this case are a form of secondary reserve.
The main point that the author makes with regard to money supply and bank lending activities is that when banks lend to customers, they increase the amount of money in supply as they provide the customer with more money than s/he has in his/her checking account.
Therefore, although checking accounts and cash ordinarily cancel each other out in bank transactions, in this case the cash is in excess of what the customer has in the real sense and thus creating an increase in money supply. Banks thus have to exercise caution and due diligence in their lending habits.
This chapter of the book is mainly about the Federal Resource System (FRS) and its influence on money supply. Ashby lays out three main tools that the FRS uses to influence money supply, by giving a concise description of each of the tools and their role with regard to money supply.
One of the tools that Ashby mentions in the chapter is open-market operations. He explains that they involve the purchase and sale of outstanding treasury securities, although in this case, the treasury leaves the function of transacting the securities to the Federal Reserve.
The FRS sells and buys such securities directly from the security owners without involving banks, although it applies the use of intermediaries such as brokers who conduct door-to-door transactions. The effect that such transactions have on the money supply is that they affect the flow of cash in the money supply system without the involvement of checking accounts thus causing a direct increase or decrease in the money supply.
Whether the money supply increases or decreases depends on whether the transactions by the FRS are sales or purchases, with sales injecting money in the money supply system and purchases resulting in the inverse effect.
The second tool that the FRS utilizes is its mandate to adjust the level of reserve requirements thereby affecting bank reserves. This tool aims at regulating bank reserves and ensuring that banks do not create too much money because of excesses in bank reserves.
Ashby explains that the FRS has the mandate to set the percentages that banks have to meet in terms of primary reserves against the amounts they receive on checking accounts.
By reducing the required percentage on primary reserves, the FRS facilitates an increase in the ability that banks have in giving loans to customers. As earlier mentioned, loans create an increase in money supply thus the FRS utilizes this tool to increase or decrease the amount that banks can give in loans as appropriate.
In order to ensure the cushioning of banks against negative effects that come with redistribution of reserves due to various reasons, the FRS offers temporarily borrowed reserves appropriately according to the circumstances. The author gives an example of a bank in an area where the main economic activity is farming.
He explains that in such an area, the likelihood that cash deposits increase during harvest seasons and reduce during planting seasons is high.
Therefore, the FRS provides temporary loans to banks to enable them have sufficient revenue during the planting season, which they then pay back during the harvesting season when deposits increase thus creating an increase in reserves. In this way, banks in the area can have a steady supply of reserves regardless of the season and without inconveniencing the customer.
The author also adds that the regulation of monetary policy in banking institutions facilitates the creation and depletion of reserves, thus controlling the amount available to a bank for distribution to customers. He mentions the federal funds market and explains that the policies that banks set on the amount of federal funds rates that other banks can pay influences the amount of reserves that banks keep.
The federal funds markets operate through interbank borrowing, where banks with fewer reserves can borrow from those with an excess in the same. The disadvantage of this method is that the minimum amount a bank can borrow is usually high, thus smaller banks are unable to use such facilities. Therefore, smaller banks would want to ensure that they reduce on lending to avoid such situations.