| | | | | | | Curiosity 8.2: What Is a NOW Account? | | | | | | | | | | In 1970 a mutual savings bank in Massachusetts discovered a loophole in Fed regulations that prohibited payment of interest on checking accounts. It created a special kind of check called a negotiable order of withdrawal (NOW). Accounts on which NOW's could be written were not legally checking accounts, so they could pay interest. | | | | | | | | | | This is an example of a financial innovation that caused trouble for the M1 money-supply measure. Growth in NOW accounts caused M1 to omit a significant amount of transactions motley. Eventually, NOW accounts were included in M1, as they should be, in the category ''other checkable deposits." | | | | | |
| | | | | checking accounts and should have been counted in M1. As the use of ATS accounts grew, M1 balances became more and more misleading as a measure of transactions balances. Finally, the Fed recognized the existence of such accounts and included them in the M1 measure in the category "other checkable deposits." | | | | | | | | | 3. Financial deregulation. Nonbank financial institutions mutual savings banks, credit unions, and savings-and-loan associations were at one time not allowed to have checking accounts, so their deposits were not included in M1. As these institutions circumvented this regulation in imaginative ways, M1 which only measured checkable deposits in commercial banks became misleading as a measure of the nation's transactions balances. Current monetary aggregate measures include deposits at all financial institutions. | | | | | | | | | 8.2
Fractional Reserve Banking | | | | | | | | | Regardless of what measure of the money supply is employed, we must first understand how our banking system operates to understand how the central bank controls the money supply. The key thing to recognize is that banks can create money by extending loans. If a bank loans you $1,000, you sign a legal agreement with the bank, and it simply opens an account in your name with a balance of $1,000. This $1,000 is now counted as part of the economy's money supply: it has been created by this bank out of thin air! | | | | | | | | | When a bank creates money out of thin air like this, it is taking a chance, hoping that you and other depositors will conduct financial transactions by using checks rather than cash. If you wanted to withdraw the $1,000 in cash, it could be embarrassing for the bank. Because it created the $1,000 deposit out of thin air, it may not have $1,000 in cash to give you! | | | | | | | | | To guard against this kind of embarrassment, banks refrain from creating money (loans) in unlimited quantities. Most customers make transactions by writing checks so that banks are continually experiencing increases and decreases in deposit balances as checks clear, and | | | | |
