Tuesday, April 23, 2013

Wondering what 'debt ceiling' is? [Part 2]

We stopped the last time at the 'Federal Gold Reserve' concept that came up in Die Hard 3.

A gold reserve is the gold held by a central bank or nation intended as a store of value and as a guarantee to redeem promises to pay depositors, note holders (e.g., paper money), or trading peers, or to secure a currency. (Details here)

A very good explanation of the term 'store of value' can be found here. A snippet from the same below.
While these items (like gold) may be inconvenient to trade daily or store, and may vary in value quite significantly, they rarely or never lose all value. This is the point of any store of value, to impose a natural risk management simply due to inherent stable demand for the underlying asset. It need not be a capital asset at all, merely have economic value that is not known to disappear even in the worst situation. In principle, this could be true of any industrial commodity, but gold and precious metals are generally favored because of their demand and rarity in nature, which reduces the risk of devaluation associated with increased production and supply.

 This means that it is not necessary for 'all of a nation's currency value equivalent' to be present in the gold reserve but just a minimal fraction that is necessary to 'secure' the currency from collapsing.
 However, the gold reserves at the Federal Bank of New York (that appears in Die Hard 3) is kinda a different store that was a result of a Gold Reserve Act in 1934 that outlawed most private possession of gold, forcing individuals to sell it to the Treasury, after which it was stored in United States Bullion Depository at Fort Knox and other locations. This act was reverted later though in 1975. More details here and here.

The general definition of a central 'reserve' bank in Wikipedia here was as follows:

 The primary function of a central bank is to manage the nation's money supply (monetary policy), through active duties such as managing interest rates, setting the reserve requirement, and acting as a lender of last resort to the banking sector during times of bank insolvency or financial crisis.
A ton of the terms above did not make sense again as well J

 The reserve requirement (or cash reserve ratio) is a central bank regulation that sets the minimum fraction of customer deposits and notes that each commercial bank must hold as reserves (rather than lend out). These required reserves are normally in the form of cash stored physically in a bank vault (vault cash) or deposits made with a central bank. More details here

 A lender of last resort is an institution willing to extend credit when no one else will. The term refers especially to a reserve financial institution, most often the central bank of a country, intended to avoid bankruptcy of banks or other institutions deemed systemically important or 'too big to fail'. More details here

 Another question that crops up is - How do interest rates help manage economic growth and stability? Let's try to answer this in the next part in this series.

1 comment:

Shyam said...

Awesome topic for investigation/understanding Ji.

Apparently, the fractional reserve limits practiced in most financial institutions allows them to lend out upto 9 times the held value...

Here are some related links-

Peter Joseph challenges much of the conventional monetary/market systems...and tries to expose the fatal flaws in the status quo for economic policies/practices

Some chapters of the movie linked below discusses this in great detail...