48608300 modern money mechanics meccaniche monetarie moderne

7/27/2019 48608300 Modern Money Mechanics Meccaniche Monetarie Moderne

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Modern MoneyMechanics

AWorkbook on Bank Reserves and Deposit Expansion

Federal Reserve Bank of Chicago


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Modern Money MechanicsThe purpose of this booklet is to desmmbehe basic

process of money creation in a ~ac tiona leserve" bank-ing system. l7ze approach taken illustrates the changesin bank balance sheets that occur when deposits in bankschange as a result of monetary action by the FederalReserve System- he central bank of the United States.The relationships shown are based on simplil5ringassumptions. For the sake of simplicity, the relationshipsare shown as ifthey were mechanical, but they are not,as is described later in the booklet. Thus, they should notbe in tw re ted to imply a close and predictable relation-ship between a specific central bank transaction andthe quantity of money.

The introductory pages contain a briefgeneraldesm'ption of the characte*ics of money and how theU S . money system works. m e illustrations in the fbl-lowing two sections describe two processes: f i j irst, howbank akposits expand or contract in response to changesin the amount of reserves supplied by the centml bank;and second, how those reserves are afected by bothFederal Reserve actions and otherjizctm. A final sec-tion deals with some of the elements that modifi, at leasti~ he short Tun, the simple mechanical relationshipbetween bank reserves and deposit money.

Money is s uch a routine pa rt of everyday living thatits existence and acceptance ordinarily are taken for grant-ed. A user may sense that money must com e into beingeither automatically as a resu lt of economic activity or asan outgrowth of some government operation. But just howthis happens all too often remains a mystery.What I s Money?

If money is viewed simply as a tool used to facilitatetransactions, only those media th at are readily accepted inexchange for goods, services, and oth er assets need to beconsidered. Many things- rom sto nes to baseball cards-have served this monetary function through the ages.Today, in the United States , money used in transactions ismainly of three kinds -curren cy (paper money and coinsin the pockets and purse s of the public); demand deposits(non-interest-bearingchecking accounts in banks); andother checkable deposits, such a s negotiable order ofwithdrawal (NOW) ccoun ts, at all depository institutions,including commercial and savings banks, savings and loanassociations, and credit unions. Travelers checks also areincluded in the definition of transactions money. Since $1in currency and $1 in checkable deposits are freely con-vertible into each o ther and both can be used directly forexpenditures, they are money in equal degree. However,only the cash and balances held by the nonbank public arecoun ted in the money supply. Deposits of the U.S. Trea-sury, depository institutions, foreign banks and officialinstitutions, as well a s vault cash in depository institutionsare excluded.

Th is transactions concept of money is the one desig-nated a s M1 in the F ederal Reserve's money stock statis-tics. Broader concepts of money (M2 and M3) include M1as well as certain other ha nc ial assets (such as savingsand time deposits at depository institutions and sh ares inmoney m arket mutual funds) which are relatively liquidbut believed to re pres ent principally investments to theirholders rather than media of exchange. W hile funds canbe shifted fairly easily between transaction balances andthese other liquid assets, the moneycreation process takesplace principally through transaction accoun ts. In theremainder of thi s booklet, "money" means M I.Th e distribution between the currency and depositcom ponen ts of money dep ends largely on the prefe rencesof the public. When a depositor cashes a check or makesa cash withdrawal through an automatic teller machine, heor s he red uces the amount of deposits and increases theamount of cu rrency held by the public. Conversely, whenpeople have more currency than is need ed, some is re-turned to banks in exch ange for deposits.

While currency is used for a grea t variety of smalltransact ions, most of the dollar amount of money pay-men ts in our economy are made by check or by electronic


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transfer between deposit accounts. Moreover, currencyis a relatively small part of the money stock. About 69percent, or $623 bi io n, of the $898 bi io n total moneystock in December 1991,was in th e form of transactiondeposits, of which $290billion were demand and $333billion were other checkab le deposits.What Makes Money Valuable?In the United States neither paper currency nordeposits have value as commodities. Intrinsically, a dollarb ii i s just a piece of paper, deposits merely book entries.Coins do have some intrinsic value a s metal, but generallyfar less than their face value.

What, then, makes these instruments- hecks,paper money, and coins- cceptable at face value inpayment of all debts and for other monetary uses? Mainly,it is the confidence people have that they willbe able toexchange su ch money for o ther financial assets and forreal goods and services whenever they choose to do so.Money, like anything else, derives its value from itsscarcity in relation to its usefulness. Commodities or se r-vices are more or less valuable because there are m ore orles s of them relative to the amounts people want. Money'susefulness is its unique ability to command other goodsand services and to permit a holder to be constantly readyto do so. How much money is demanded depend s onseveral factors, such as the total volume of transactionsin the economy at any given time, the paym ents habits ofthe society, the amount of m oney tha t individuals andbusinesses want to keep on hand to take care of unexpect-ed transactions, and the foregone earnings of holdingtinancial assets in the form of m oney rather than some

other asset.Control of the quantity of money is essential if itsvalue is to be kept stable. Money's real value canbe mea-sured only in term s of what itwillbuy. The refore, its valuevaries inverselywith the general level of prices. Assuminga constant rate of use, if the volume of money grows morerapidly than the rate at which the output of real goo ds andservices increases, prices wi l l rise. This will happen b ecause there will be more money than there willbe goodsand services to spend it on at prevailing prices. But if, onthe other hand, growth in the supply of m oney does notkeep pace with the economy's current production, thenprices will fall, the nation's labor force, factories, and o the rproduction facilitieswill not be fully employed, or both.Just how large the stock of money nee ds to be inorder to handle the transactions of th e economy withoutexerting undue idu en ce on the price level depends onhow intensively money is b e i i sed. Every transactiondeposit balance and every dollar bill is a part of some-body's spendable funds at any given time, ready to moveto other owners as ransactions take place. Some holdersspend money quickly after they ge t it, making these fundsavailable for other u ses. Othe rs, however, hold money forlonger periods. Obviously, when some money remainsidle, a larger total is needed to accomplish any given

volume of transactions.

W ho CreatesMoney?Changes in the quantity of money may originatewithactions of the Federal Reserve System (the central bank),depository institutions (principally comm ercial banks), orthe public. Th e major control, however, rests with thecentral bank.The actual process of m oney creation takes placeprimarily in banks.' As noted earlier, checkable liabilitiesof banks are money. These liabilities are customers ' ac-counts. The y increase when c ustom ers deposit currencyand chec ks and when the p roceeds of loans made by thebanks arecredited to borrowers' accounts.In the absence of legal reserve requ iremen ts, banks

can build up deposits by increasing loans and investmentsso long as they keep enou gh currency on hand to redeemwhatever amoun ts the holders of deposits want to convertinto currency. Th is unique attribute of the banking busi-ness was discovered many centuries ago.It started with goldsmiths. As early bankers, theyinitially provided safekeeping services, making a profit fromvault storage fees for gold and coins deposited with them.People would redeem their "deposit receipts" wheneverthey needed gold or coins to purchase som ething, andphysically take th e gold or co ins to the seller who, in turn,would deposit them for safekeeping, often with the samebanker. Everyone soon found that it was a lot easier simplyto use the deposit receipts directly as a m eans of payment.The se receipts, which became known a s notes, were ac-ceptableasmoney since whoever held them could go tothe banker and exchange them for metallic money.The n, bankers discovered that they could make loans

merely by giving their prom ises to pay, or bank notes, toborrowers. In this way, banks began to crea te money.More no tes couldbe issued than the gold and coin on handbecause only a portion of the no tes outstanding would bepresented for payment at any one time. Enough metallicmoney had to be kept on hand, of cou rse, to redeem what-ever volume of no tes was presen ted for payment.Transaction deposits are the modem counterpart ofbank notes. Itwas a small step from printing notes to mak-

ingbook en tries crediting deposits of borrowers, which theborrowers in turn could "spend" by writingcheck s, thereby"printing" their own money.

Inorder to describe the moneycrea tionprocess a s simply as possible, theterm Bank " used in this booklet should be understood to encom pass alldepository nstitutions. Since the Depository InstitutionsDeregulation andMonetary Control Act of 1980, ll depository institutions have been permit-ted to offer interest-bearing transaction accounts to certain customers.Transaction accounts (interest-bearing as well as demand deposits onwhich payment of interest is still legally prohibited) at all depositoryinstitutions are subject to the reserve requirements set by the FederalReserve. Thus an such institutions, not just comm ercial banks, have thepotential for creating money.


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What Iimits the Amount of MoneyBanksCan Create?

If deposit money canbe created so easily, what is toprevent banks from making too much- ore than sufti-cient to keep the nation's productive resources fully em-ployed without price inflation? Like its predecessor, themodem bank must keep available, to make payment ondemand, a considerable amount of currency and funds ondepositwith the central bank. The bank must be preparedto convert deposit money into currency for those deposi-tors who request currency. It must make remittance onchecks written by depositors and presented for paymentby other banks (settle adverse clearings). Finally, it mustmaintain legally required reserves, in the form of vault cashand/or balances at its Federal Reserve Bank, equal to aprescribed percentage of its deposits.

The public's demand for currency varies greatly, butgenerally follows a seasonal pattern that is quite predict-able. The effects on bank funds of these variations in theamount of currency held by the public usually are offset bythe central bank, which replaces the reserves absorbed bycurrency withdrawals from banks. Oust how this is donewill be explained later.) For all banks taken together, thereis no net drain of funds through clearings. A check drawnon one bank normallywillbe deposited to the credit ofanother account, if not in the same bank, then in someother bank.

These operating needs influence the minimumamount of reserves an individual bankwillhold voluntarily.However, as long as this minimum amount is less thanwhat is legally required, operating needs are of relativelyminor importance as a restraint on aggregate deposit ex-pansion in the banking system. Such expansion cannotcontinue beyond the point where the amount of reservesthat all banks have is just sufficient to satisfy legal require-ments under our "fractional reserve" system. For example,if reserves of 20 percent were required, deposits couldexpand only until they were five times as large as reserves.Reserves of $10 million could support deposits of $50mil-lion. The lower the percentage requirement, the greaterthe deposit expansion that can be supported by each addi-tional reserve dollar. Thus, the legal reserve ratio togetherwith the dollar amount of bank reserves are the factors thatset the upper limit to money creation.What Are Bank Reserves?Currency held in bank vaults may be counted aslegal reserves as well as deposits (reserve balances) at theFederal Reserve Banks. Both are equally acceptable insatisfaction of reserve requirements. A bank canalwaysobtain reserve balances by sending currency to its ReserveBank and canobtain currency by drawing on its reservebalance. Because either can be used to support a muchlarger volume of deposit liabilities of banks, currency incirculation and reserve balances together are often refer-red to as "high-powered money" or the "monetary base."Reserve balances and vault cash in banks, however, are notcounted as part of the money stock held by the public.

4 Modem MoneyMechanics

For individual banks, reserve accounts also serve asworking balances? Banks may increase the balances intheir reserve accounts by depositing checks and proceedsfrom electronic funds transfers as well as currency. Orthey may draw down these balances by writing checks onthem or by authorizing a debit to them in payment forcurrency, customers' checks, or other funds transfers.Although reserve accounts are used as workingbalances, each bank must maintain, on the average for therelevant reserve maintenance period, reserve balances atthe Reserve Bank and vault cash which together are equalto its required reserves, as determined by the amount ofits deposits in the reserve computation period.

Where Do Bank Reserves Come From?Increases or decreases in bank reserves can resultfrom a number of factors discussed later in this booklet.From the standpoint of money creation, however, theessential point is that the reserves of banks are, for themost part, W i t i e s of the Federal Reserve Banks, and netchanges in them are largely determined by actions of theFederal Reserve System. Thus, the Federal Reserve,through its abiity to vary both the total volume of reservesand the required ratio of reserves to deposit liabilities,influences banks' decisionswith respect to their assets anddeposits. One of the major responsibilities of the FederalReserve System is to provide the total amount of reservesconsistentwith the monetary needs of the economy atreasonably stable prices. Such actions take into consider-ation, of course, any changes in the pace at which moneyis being used and changes in the public's demands forcash balances.The reader should be mindful that deposits andreserves tend to expand simultaneously and that the Fed-eral Reserve's control often is exerted through the market-place as individual banks find it either cheaper or moreexpensive to obtain their required reserves, depending onthe willingness of the Fed to support the currentrate ofcredit and deposit expansion.While an individual bank canobtain reserves bybidding them away from other banks, this cannot be doneby the banking system as a whole. Except for reservesborrowed temporarily from the Federal Reserve's discountwindow, as is shown later, the supply of reserves in thebanking system is controlled by the Federal Reserve.Moreover, a given increase in bank reserves is notnecessarily accompanied by an expansion in money equalto the theoretical potential based on the required ratio ofreserves to deposits. What happens to the quantity of

ZPart f an individual bank's reserve account may represent its reservebalance used o meet its reserve requ irements while another part may beits required clearing balance on which earning s credits are generated topay for Federal Reserve Bank servic es.


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moneywillvary, depending upon the reactions of thebanks and the public. A number of slippages may occur.What amount of resmeswillbe drained into the public'scurrency holdings? To what extentwill the increase intotal reserves remain unused as excess reserves? Howmuch will be absorbed by deposits or other liabiities notdefined as money but against which banks might alsohaveto hold reserves? How sensitive are the banks to policyactions of the central bank? The significance of thesequestionswillbe discussed later in this booklet. The an-swers indicate why changes in the money supply may bedifferentthan expected or may respond to policy actiononly after considemble time has elapsed.In the succeeding pages, the effects of various trans-actions on the quantity of money are described and illus-trated. The basic working tool is theT ccount, whichprovides a simple means of tracing,step by step, the effectsof these transactions on both the asset and liabity sides ofbank balance sheets. Changes in asset items are entered

on the left half of theT nd changes in liabiities on theright half. For any one transaction, of course, there mustbe at least two entries in order to maintain the equality ofassets and liabiities.

Introduction 5


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Bank Deposits-How l%ey Expand or ContractLet us assume that expansion in the money stock isdesired by the Federal Reserve to achieve its policy objec-tives. One way the central bankcan initiate such an expan-sion is through purchases of securities in the open marketPayment for the securities adds to bank reserves. Suchpurchases (and sales) are called "open market operations."How do open market purchases add to bank reservesand deposits? Suppose the Federal Reserve System,through its trading desk at the Federal Reserve Bank ofNew York, buys $10,000 of Treasury bills from a dealer inU.S. government securitie~.~n today's world of computer-ized financial transactions, the Federal ReserveBankpays for the securities with an "electronic" check drawnon itself! Via its "Fedwire" transfer network, the FederalReserve notifies the dealer's designated bank (BankA)

that payment for the securities shouldbe credited to (de-posited in) the dealer's account at BankA At the sametime,BankA's reserve account at the Federal Reserveis credited for the amount of the securities purchase.The Federal Reserve System has added $10,000 of securi-ties to its assets, which it has paid for, in effect, by creatinga liability on itself in the form of bank reserve balances.These reserves on Bank As books are matched by$10,000 of the dealer's deposits that did not exist before.See illustration 1.How the Multiple Expansion Process Works

If the process ended here, there would be no "multi-ple" expansion, i.e., deposits and bank reserves wouldhave changed by the same amount However, banks arerequired to maintain reserves equal to only a fraction oftheir deposits. Reserves in excess of this amount maybeused to increase earning assets- oans and investments.Unused or excess reserves earn no interest Under currentregulations, the reserve requirement against most transac-tion accounts is 10 percent5 Assuming, for simplicity, auniform 10 percent reserve requirement against all transac-tion deposits, and further assuming that allbanks attemptto remain fully invested, we can now trace the process ofexpansion in deposits which can ake place on the basis ofthe additional reserves provided by the Federal ReserveSystem's purchase of U.S. government securities.The expansion process may or may not begin withBankA, depending on what the dealer doeswith the mon-ey received from the sale of securities. If the dealer imme-diately writes checks for $10,000 and allof them aredeposited in other banks, BankA loses both deposits andreserves and shows no net change as a result of the Sys-tem's open market purchase. However, other banks havereceived them. Most likely, a part of the initial depositwillremainwith BankA, and a partwillbe shifted to otherbanks as the dealer's checks clear.

6 Modem Money Mechanics

It does not really matter where this money is at anygiven time. The important fact is that these deposits do notdisappear. They are in some deposit accounts at all times.All banks together have $10,000 of deposits and reservesthat they did not have before. However, they are notrequired to keep $10,000 of reserves against the $10,000of deposits. All they need to retain, under a 10 percentresenre requirement, is $1,000. The remaining $9,000 is"excess reserves." This amountcan be loaned or invested.See illustration 2.

If business is active, the bankswith excess reservesprobablywillhave opportunitiesto loan the $9,000. Ofcourse, they do not really pay out loans from the moneythey receive as deposits. If they did this, no additionalmoney would be created. What they do when they makeloans is to accept promissory notes in exchange for creditsto the borrowers' transaction accounts. Loans (assets)and deposits (liabilities) both rise by $9,000. Reserves areunchanged by the loan transactions. But the deposit cred-its constitute new additions to the total deposits of thebanking system. See illustration 3.

3Dollar amounts use d in the various illustrations do not necessarily bearany resem blance to actual transactions. For example, open market opera-tions typically are condu cted with many dealers and in amounts totalingsevera l billion dollars.'Indeed, many transactions today are accomplished hrough an electronictransfer of funds between accounts rather than through issuance of a papercheck. Apart from the timing of posting, the accounting entries are thesame whether a transfer is made with a paper check or electronically. Theterm "check," herefore, is used for both typ es of transfers.SFor ach bank, the reserve requirement is 3 percent on a specified baseamount of transaction accounts and 10percent on the amount above thisbase . Initially, the Monetary Control Act set thi s base amount- alled the"low reserve tranche"- t $25 million, and provided for it to changeannually n line with the growth in transaction deposits nationally. The lowreserve tranche was $41 .1 million in 1991 and $42.2 million in 1992. T heGarn-St Germain Act of 1982 further mo diied these requirements byexemp ting the first $2 million of reservab le iabilities from reserve requir ements. Like the low reserve tranche, the exem pt evel is adjusted each yearto reflectgrowth in reservable liabilities. The exempt level was $3.4 millionin 1991 and $3.6million in 1992.


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Deposit Ezpansion

1

The customer deposit at Bank A likely will be transfeerred, in part, to other banks and quickly loses its identity amid the hugeinterbank flow of deposits.

When the Federal Reserve Bank purchases government securities, bank rese rves increase. This happensbecause the seller of th e securities receives payment through a credit to a designated deposit accountat a bank (BankA) which the Federal Reserve effects by crediting the rese rve account of Bank A

Assets Liabilities Assets LiabilitiesU.S.governmentsecurities + 10,000

Expansion tak es place only if the b anks that holdthese exce ss reserves (Stage1banks) increase

2

I their loans or investments. Loans aremade by Assets Liabilities

Reserve accounts: Reserves withBank A + 10,000W .R. Banks + 10,000

AS a result, all banks taken together now have Total reservesgained from new deposits ..................... 10.000"excess" reserves on which deposit expansion less: Requiredagainst new depositscan take place. (at 10 percent) ........................................ 1,000equals Excess reserves ................................................ 9,000

crediting the borrower's deposit account, i.e.,by creating additional deposit money.

Customerdeposit + 10,000

Deposit Expansion and Contraction 1 7

Loans + 9,000 ~~pBorrowerdeposits + 9,000


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ntis is the beginning of the dejPosit expansion pmcess.In the first stage of the process, total loans and deposits ofthe banks rise by an amount equal to the excess reservesexisting before any loans were made (90 percent of theinitial deposit increase). At the end of Stage 1, depositshave risen a total of $19,000 (the initial $10,000 providedby the Federal Reserve's action plus the $9,000 in depositscreated by Stage1banks). See illustration 4. However,only$900 (10 percent of $9,OOO) of excess reserves havebeen absorbed by the additional deposit growth at Stage1banks. See illustration 5.

The lending banks, however, do not expectto retainthe depositsthey create through their loan operations.Borrowers write checks that probablywillbedeposited inother banks. As these checks move through the collectionprocess, the Federal Reserve Banks debit the reserveaccounts of the paying banks (Stage1banks) and creditthose of the receiving banks. See illustration 6.Whether Stage1banks actuallydo lose the depositsto otherbanks or whether any or allof the borrowers'checks are redeposited in these same banks makes nodifference in the expansion process. If the lending banksexpect to lose these deposits- nd an equal amount ofreserves- s the borrowers' checks are paid, theywillnotlend more than their excess reserves. Like the original$10,000 deposit, the loanaeated deposits maybe transferred to other banks, but they remain somewhere in thebanking system. Whichever banks receive them alsoacquire equal amounts of reserves, of which all but 10percentwillbe "excess."Assuming that the banks holding the $9,000 of d eposits created in Stage1 n turn make loans equal to their

excess reserves, then loans and depositswil l rise by afurther $8,100 in the second stage of expansion. Thisprocesscan continue until deposits have risen to the pointwhereall the reserves provided by the initial purchase ofgovernment securities by the Federal Reserve Systemarejust sufficient to satisfy reserve requirements against thenewly created deposits. (See pages 10and 1I . )The individual bank, of course, is not concerned asto the stages of expansion in which it may be participating.Mows and outflows of depositsoccur continuously. Anydeposit received is new money, regardless of its ultimatesource. But if bank policy is to make loans and invest-ments equal to whatever reserves are in excess of legalrequirements, the expansion processwill be carried on.

How Much Can Deposits Expandin the Banking System?

The total amount of expansion that can ake placeis illustrated on page 11. Carried through to theoreticallimits, the initial $10,000 of reserves distributed within thebanking system gives rise to an expansion of $90,000 inbank credit (loans and investments) and supports a total of$100,000 in new deposits under a 10 percent reserve r equirement. The deposit expansion factor for a given

8 Modern Monqr Mechanics

amount of new reserves is thus the reciprocal of the r equired reserve percentage (1/.10 = 10). Loan expansionwillbe less by the amount of the initial injection. The multi-ple expansion is possible because the banks as a groupare like one large bank in which checks drawn againstborrowers' deposits result in credits to accounts of otherdepositors, with no net change in total reserves.Expansion through Bank Investments

Deposit expansioncan proceed ii-om investmentsas well as oans. Suppose that the demand for loans atsome Stage1banks is slack These banks would thenprobably purchase securities. If the sellers of the securitieswere customers, the banks would make payment by credit-ing the customers' transaction accounts; deposit liabiitieswould rise just as f loans had been made. More likely,these banks would purchase the securities through deal-ers, paying for them with checks on themselves or on theirreserve accounts. These checks would be deposited inthe sellers' banks. In eithercase,the net effects on thebanking systemare identicalwith those resulting fromloan operations.


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As a result of the process so far, total assets andtotal liabiities of allbanks together have risenAssetsReserves withF.R. Banks + 10,000Loans + 9,000Total + 19.000

LiabilitiesDeposits:Initial + 10,000Stage I

+ 19,000

Excess reserves have been reduced by the Total reserves gainedfrom initial deposii............................ 10,000.............mount required against the deposits created less: Requiredagainst initialdeposits 1,000............ ......y the loans made in Stage1. lets: Required against Stage I deposits 900 1,900eq& Excess reserves ........................................................ 8,100

Whydo hese bankssm ncreasing their loansand deposits when they still have excess reserves?

.. because borrowers write checks on theiraccounts at the lending banks. As these checksI I are deposited in the payees' banks and cleared, Assets Liabilitiesthe deposits created by Stage 1 oans and an Reservesvequal amount of reserves may be transferred r .R. Banksto other banks. vith - 9,000

Deposit expansion hasjust begun!

Borrowerdeposits - 9,000

Assets Liabilities Assets LiabilitiesJ

Deposit Erpansionand Contmctwn 9

Reserve accounts: Reserves withStage I banks - 9,000 2 F . R . Banks + 9,000Other banks + 9,000Deposits + 9,000


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7

8

toStage 3banks

Expansion continues as thebanks hat haveexcess reserves increase their loans by thatamount, crediting borrowers' deposit accounts Assets Liabilitiesin the process, thus creating still more money.

9

Loans + 8,100

NOW he banking system's assets and liabilitieshave risen by 27,100.Assets Liabilities

..........................But there arestill 7,290 of excess reserves in the Total reservesgained from initialdeposits 10,000............banking system. less: Required against initial deposits 1,000less: Required against Stage I deposii ............ 900less: Required against Stage 2 deposits ............ 8 10 ....a

It should be understood tha t the stages of expansion occur neither simultaneously nor inthe sequence demibe d above. Some banks use their re sm es incompletely or only after aconsiderable time lag, while others expand assets on the basis of expected reseme growth.m e process is, infact, ontinuous and may never reach its theoretical limits.

Borrowerdeposits + 8,100

Reserves withF.R Banks + 10,000Loans:Stage I + 9,000Stage 2 + 8,100Total + 27,100

......................................................q& Excess reserves 7,290

10

10 1 Modem M m q M a h a t u b

Deposits:Initial + 10,000Stage I + 9,000Stage 2 + 8,100Total + 27,100

As borrowers make payments, these reserveswill be further dispersed, and the process can continue throughmany more stages, in progressively smaller increments,until the entire 10,000 of reserves have been absorbedby deposit growth. As is apparent from the summary tableon page 11, more than tw&hiidsof the depositexpansion potential is reached after the first ten stages.


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HowOpen Market Sales Reduce Bank Reservesand DepositsNow suppose some reduction in the amount ofmoney is desired. Nonnally this would reflect temporaryor seasonal reductions in activity to be h awed since, ona year-to-year basis, a growing economy needs at leastsome monetary expansion. Just as purchases of govern-

ment securities by the pederal Reserve Systemcan previde the basis for deposit expansion by adding to bankreserves, sales of securities by the Federal Reserve Systemreduce the money stock by absorbing bank reserves. Theprocess is essentially the reverse of the expansion stepsjust described.Suppose the Federal Reserve System sells $10,000 ofTreasury b i s o a U.S. government securities dealer andreceives inpayment an "electronic" check drawn on BankA As this payment is made, BankA's reserve account ata Federal Reserve Bank is reduced by $10,000. Asa result,the Federal Reserve System's holdings of securities andthe reserve accounts of banks are both reduced $10,000.The $10,000 reduction in Bank As deposit liabilities consti-tutes a decline in the money stock. See illustration 11.

Contraction Also Is a Cumulative ProcessWhile BankA may have regainedpart of the initialreduction in deposits from other banks as a result of inter-bank deposit flows, all banks taken together have $10,000less in both deposits and reserves than they had beforethe Federal Reserve's sales of securities. The amount ofreserves freed by the decline in deposits, however, is only$1,000 (10 percent of $10,000). Unless the banks that losethe reserves and deposits had excess reserves, theyareleftwith a reserve deficiency of $9,000. See illustration 12.Although they may borrow from the Federal ReserveBanks to cover this deficiency temporarily, sooner or laterthe bankswill have to obtain the necessary reserves insome other way or reduce their needs for reserves.One way for a bank to obtain the reserves it needsis by selling securities. But, as the buyers of the securitiespay for them with funds in their deposit accounts in thesame or other banks, the net result is a $9,000 decline insecurities and deposits at all banks. See illustration 13.At the end of Stage 1of the contraction process, depositshave been reduced by a total of $19,000 (the initial$10,000resulting from the Federal Reserve's action plus the $9,000

in deposits extinguished by securities sales of Stage1banks). See illustration 14.However, there is now a reserve deficiency of $8,100at banks whose depositors drew down their accounts topurchase the securities from Stage1banks. As the newgroup of reservedeficient banks, in turn, makes up thisdeficiency by selling securities or reducing loans, furtherdeposit contraction takes place.Thus, contraction proceeds through reductions indeposits and loans or investments in one stage after anoth-er until total deposits have been reduced to the point

12 / Modem MoneyMnhanics

where the smaller volume of reserves is adequate to support them. The contraction multiple is the same as thatwhich applies in the case of expansion. Under a 10 percentreserve requirement, a $10,000 reduction in reserves wouldultimately entail reductions of $100,000 in deposits and$90,000 inloans and investments.As in the case of deposit expansion, contraction of

bank deposits may take place as a result of either sales ofsecurities or reductions of loans. While some adjustmentsof both kinds undoubtedly would be made, the initial im-pactprobably wouldbe reflected in sales of governmentsecurities. Most types of outstanding loans cannot becalled for payment prior to their due dates. But the bankmay cease to make new loans or refuse to renew outstand-ing ones to replace those currently maturing. Thus, deposits built up by borrowers for the purpose of loan retirementwould be extinguished as loans were repaid.

There is one important difference between the expan-sion and contraction processes. When the Federal ReserveSystem adds to bank reserves, expansion of credit anddepositsmay take place up to the limits permitted by theminimum reserve ratio that banks are required to maintain.But when the System acts to reduce the amount of bankreserves, contraction of credit and depositsmust take place(except to the extent that existing excess reserve balancesand/or surplusvault cash are utilized) to the point wherethe required ratio of reserves to deposits is restored. Butthe signi6cance of this difference should not be overempha-sized. Because excess reserve balances do not earn inter-est, there is a strong incentive to convert them into earningassets (loans and investments).


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Assets Liabilities Liabilities

11

U.S. government Reserve accounts: Reserves with 1 Customersecurities -1 0, 00 0 BankA - 10,000 W F . R anks - 10,000 deposit - 10,000

When the Federal Reserve Bank sells government securities, bank reserves decline. This happens because the buyerof the securities makes payment through a debit to a designated deposit account at a bank (BankA), with the transfer offunds being effected by a debit to Bank A's reserve account at the Federal Reserve Bank.

lXis reduction in the customer deposit at Bank A may be spread among a number of banks through h te dan k depositflows

Contraction-Stage 1IThe bankswith the reserve deficiencies (Stage1banks) can sellgovernment securities o acauire

12

1 I reserves, but this causes a decline in the debs its &sets Liabilities

The loss of reserves means that allbanks taken Total reserves lostfrom deposawithdrawal ...................... 10,000together now have a reserve deficiency. less Reserves freed bydeposii decline(at 10 percent) ..................................................... 1,000equals Mciency in reservesagainst remaining depostts . 9,000

and reserves of the buyers' banks. U.S. governmentsecurities - 9,000Reserves with

+ 9,000

As a result of the process so far, assets and totaldeposits of allbanks together have declined 19,000.

Assets Liabilities Assets LiabilitiesJStage 1contraction has freed 900of reserves, but Liabilitiesthere is still a reserve deficiency of 8,100. Reserves with Deposits:F.R. Banks

US.government Stage Isecurities 9,000Total - 19.000

Reserve accounts: Reserves withStage I banks + 9,000 9 F . R . Banks - 9,000Ot he r banks - 9,000

I Futthn ontractionmust ake #lace!

Deposits - 9,000

Deposit E*palrtion and C ontraction 13


14/40

Bank Reserves-How l%ey ChangeMoney has been detined as the sum of transactionaccounts in depository institutions, and currency and trav-elers check s in the hands of the public. Currency is som ething almost everyone uses every day. Therefo re, whenmost people t h i i of money, they think of currency. Con-

trary o this popular impression, however, tmtlsactiolrdeposits are the most sign iscant part of the money stockPeople keep enough currency on hand to effect small fac eteface transactions, but they write checks to cover mostlarge expenditures. Most businesses probably hold evensmaller amounts of currency in relation to their total tr an sactions than do individuals.Since the m ost important component of money istransaction deposits, and since these deposits must be s u pported by reserves, the central bank's influence over mon-

ey hinges on its control over the total amount of re serv esand the conditions und er which banks can obtain them.Th e preceding illustrations of the expansion andcontraction processes have demonstrated how the centralbank, by purchasing and selling government securities,can deliberately change ag gregate bank re serves in orderto affect deposits. But open market operations are onlyone of a number of kinds of transactions or developmentsthat cause changes in reserves. Some changes originatefrom actions taken by th e public, by th e Treasury Depart-ment, by the banks, o r by foreign and international institu-tions. Other changes arise from the service functions andoperating needs of the Reserve Banks themselves.The various factors that provide and absorb bankreserve balances, toge ther with symbols indicating theeffects of th ese developments, are listed on th e oppositepage. This tabulation also indicates the nature of the bal-ancing entries on the Federal Reserve's books. C o heextent that the impact s absorbed by change s in banks'vault cash, the Federal Reserve's books are unaffected.)

Independent Fadors Versus PolicyActionIt is apparent that bank reserv es are affected in sev-eral ways thatare independen t of th e control of the cen tralbank. Most of the se "independent? elem ents are chang ing

more or le ss continually. Sometimes their effects may lastonly a day or two before beiig reversed automatically.This happens, for instance, when bad weather slows up th echeck collection process , giving rise to an au tomatic in-crease in Federal Reserve cred it in the form of "float."Other influences, such a s chan ges in the public's currencyholdings, may pers ist for longer pe riods of time.Still other variations in bank rese rves result solelyfrom th e mechanics of institutional arrangeme nts amongthe Treasury, the Federal Reserve Banks, and the deposi-tory institutions. The Treasury, for example, keeps part ofits operating cash balance on deposit with banks. Butvirtually all disbursements are made from i ts balance in

I4 I Modern Money Mechanics

the Reserve Banks. As is shown later, any buildup in bal-ances at the Reserve Banks prior to expenditure by theTreasury causes a dollar-fordollar drain on bank reserves.In contrast to these independent elements that affectreserves are th e policy actions taken by the Federal R eserve System. The way System open market purchases andsales of securities affect reserves has already been d escribed. In addition, there are two oth er ways inwhich theSystem can affect bank rese rves and potential deposit vol-ume directly:first, through loans to depository institutions;and second, through c hanges in reserve requirement per-centages. A change in the required reserve ratio, of course,does not alter the dollar volume of reserves directly butdoes change the amount of deposits that a given amount ofreservescansupport.Any change in reserve s, regardle ss of its origin, hasthe sam e potential to affect deposits. Therefo re, in order toachieve the ne t reserve effects consistent with its monetarypolicy objectives, the Federal Reserve System continuouslymust take account of what the independent factors aredoing to reserves and the n, using its policy tools, offset orsupplement hem as the situation may require.By far the largest number and amount of the S ystern's gross open market transactions are undertaken tooffset drains from or additions to bank reserves from non-Federal Reserve sources that m ight otherwise cause abruptchange s in credit availabiity. In addition, Federal Reservepurc hases and /or sales of securities are made to providethe reserve s needed to support the rate of money growthconsistentwith monetary policy objectives.In this section of the booklet, several kinds of trans-actions that canhave important week-to-week effects onbank reserve s are traced in detail. Other factors that nor-mally have only a small influence are described briefly onpage 35.


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Facton Changing Reserve Balances-lndefiendent and

Assets Liabilities

Public actions ....................................................................ncrease in currency holdings ..................................................................ecrease in currenc y holdingsTreasury, bank, and foreign actions

Increase in Trea sury deposits in F.R. Banks ...........................................Decrease in Treasu ry de posits i n F.R. Banks .........................................Go ld purchases (inflow) o r increase in official valuation* ...................Go ld sales (outflo w)* ..................................................................................Increase in SDR certificates issued* .........................................................Decrease in SDR certificates issued* ......................................................Increase in Treasury curren cy outstanding* ..........................................Decrease in Treasury currency outstanding* ........................................Increase in Treasury cash holdings* .........................................................Decrease in Treasury cash holdings* ......................................................increase in service-related balances ladjustments..................................Decrease i n service-related balancesladjustments ...............................Increase in foreign and oth er depos its in F.R. Banks ...........................Decrease in foreign and o the r deposits in F.R. Banks .........................

Federal Reserve actions ...............................................................................................................................................................Increase in Federal Reserve float .............................................................Decrease in Federal Reserve float .....................................................................................ncrease in assets deno minated i n foreign currencies

.......................ecrease in assets denominated in foreign currenciesincrease in oth er assets** ..................................................................................................................................................ecrease in o the r assets**Increase in o th er liabilities** ........................................................................................................................................ecrease in ot he r liabilities**Increase in capital accounts** ....................................................................................................................................ecrease in capital accounts**

* These factors rep resen t assets and liabilities o f the Treasury. Changes in them typically affect reserve balances throug ha related change in the Federal Reserve Banks' liab ility "Treasury deposits."

** Included in "O the r Federal Reserve accounts" as described o n page 35.*** Effect on excess reserves. Tot al reserves are unchanged.Not e: T o the exte nt that reserve changes are in the fo rm o f vault cash, Federal Reserve accounts are not affected.

Facton flfectitzg Balk Reserves 15


16/40

Changes in the Amount ofCuvmcyHeld by the PublicChanges in the amount of currency held by thepublic typically follow a fairly regular intramonthly pattern.Major changes also occur over holiday periods and during

the Christmas shopping season- imes when people findit convenient to keep more pocket money on hand. (Seechart.) The public acquires currency from banks by cash-ing checks6 When deposits, which are fractional reservemoney, are exchanged for currency, which is 100 percentreserve money, the banking system experiences a netreserve drain. Under the assumed 10 percent reserverequirement, a given amount of bank reservescan supportdeposits ten times asgreat,but when drawn upon to meetcurrency demand, the exchange is one to one. A $1 in-crease in currency uses up $1 of reserves.

Suppose a bank customer cashed a $100 check toobtain currency needed for a weekend holiday. Bankdeposits decline $100 because the customer pays for thecurrencywith a check on his or her transaction deposit;and the bank's currency (vault cash reserves) is also r educed $100. See illustration 15.Now the bank has less currency. It may replenishits vault cash by ordering currency from its Federal Reserve Bank- aking payment by authorizing a chargeto its reserve account. On the Reserve Bank's books, thecharge against the bank's reserve account is offset by anincrease in the liability item "Federal Reserve notes." See

illustration 16. The Reserve Bank shipment to the bankmight consist, at least in part, of US. coins rather thanFederal Reserve notes. All coins, as well as a small amountof paper currency still outstanding but no longer issued,are obligations of the Treasury. To the extent that shipments of cash to banks are in the form of coin, the offset-ting entry on the Reserve Bank's books is a decline in itsasset item "coin."

The public now has the same volume of money asbefore, except that more is in the form of currency andless is in the form of transaction deposits. Under a 10percent reserve requirement, the amount of reserves re-quired against the $100 of deposits was only $10, while afull$100 of reserves have been drained away by the disbursement of $100 in currency. Thus, if the bank had noexcess reserves, the $100 withdrawal in currency causes areserve deficiency of $90. Unless new reserves are pro-vided from some other source, bank assets and depositswill have to be reduced (according to the contraction pro-cess described on pages 12 and 13) by an additional $900.At that point, the reserve deficiency caused by the cashwithdrawal would be eliminated.When CurrencyReturns to Banks, Reserves Rise

After holiday periods, currency returns to the banks.The customer who cashed a check to cover anticipatedcash expenditures may later redeposit any currency stillheld thafs beyond normal pocket money needs. Most of it

16 / Modern Money Mechanb

Currency held by the publicweekly averages, billions of dollars, not seasonally adjusted

probably will have changed hands, and itwillbe depositedby operators of motels, gasoline stations, restaurants, andretail stores. This process is exactly the reverse of thecurrencydrain, except that the banks to which currencyis returned may not be the same banks that paid it out.But in the aggregate, the banks gain reserves as 100percent reserve money is converted back into fractionalreserve money.When $100 of currency is returned to the banks,deposits and vault cash are increased. See illustration 1ZThe banks cankeep the currency as vault cash, which alsocounts as reserves. More likely, the currencywill beshipped to the Reserve Banks. The Reserve Banks creditbank reserve accounts and reduce Federal Reserve noteliabiities. See illustration 18. Sice only $10 must be held

against the new $100 in deposits, $90 is excess reservesandcangive rise to $900of additional deposits.To avoid multiple contraction or expansion of depositmoney merely because the public wishes to change thecomposition of its money holdings, the effects of changesin the public's currency holdings on bank reserves nor-mally are offset by System open market operations.

6The same balance shee t entrie s apply whether the individual physicallycashes a papercheck or obtains currency by withdrawing cash through an-automati; tkller machine. - -'Under curr ent reserve accounting regulations, vault cash reserv es areused to satisfy reserve requirem ents in a future main tenance period whilereserve balances sati* requirem ents in the current period. As a result,the imp act on a bank's curr ent reserve position may differ from that shownunless the bank restores its vault cash position in the c urre nt period viachanges in its reserve balance.


17/40

15! When a depositor cashes a check, bothdeposits and vault cash reserves decline.I Assets LiabilitiesVault cashreserves Deposits -100

Assets Liabilities Assets LiabilitiesReserve accounts: Vault cash + I0 0Bank A ReserveswithF.R. notes + I0 0 F.R. Banks - 100

16

When currency comes back to the banks, bothdeposits and vault cash reserves rise.

If the bank replenishes its vault cash, its account at the Reserve Bank isdrawn down in exchange for notesissued by the Federal Reserve.

AssetsVault cashreserves +I00

Liabilities

If the currency is returned to the Federal Reserve, reserve accounts are credited and Federal Reservenotes are taken out of circulation.

Assets Liabilities AssetsVault cash - 100Reserves wi thFA . notes F.R. Banks + I 0 0

Liabilities

FactorsAfecting Bark Reserues 17


18/40

Changes in US. TreasuryDeposits in Federal B a n kReserve accoun ts of depository institutions consti-tute the bulk of th e deposit liabilities of th e Federal Re-serve System. Other institutions, however, also m & ~ nbalances in the Federal Reserve Banks- ainly th e U.S.Treasury, foreign central banks, and international ha nc ialinstitutions. In general, when the se balances rise, bankreserves fall, and vice versa. 'I'his occurs because thefunds u se agencies to build up th eir deposits inthe Res s ultimately com e from depo sits inbanks. Gonvem ly, recipien ts of payments from theseagencies normally deposit the fu nds in banks.the collection process these banks receive crereserve accounts.

rtant nonbank depo sitor is the US.Treasury. Part of the Treasury's opeis kept in the Federal Reserve Banks,depository institutions all over the co un m , in d l e d'Treasury tax and loan" m & L ) note accounts.a&) Disbursements by the Treasury, hmade against its balances at the Federal Reserve. Thus,transfers from banks to Federal Reserve Banks are m adethrough regularly scheduled "calls"on TT&L balances toassure tha t sufficient fun ds are available to cover Tre asurychecks as they are presented for payment8

Calls on TT&L note accounts drain rese rves frornthe bank s by the full amount of the transfer as fun ds movefrorn the TT&L balances (Via charges to bank reserveaccounts) to Treasury balances at the Reserve Banks.Because reserves are not required against TT&L noteaccounts, these transfers do not reduce required reserv es?SupposeaTreasury call payable by Bank A amountsto $1,000. Th e Federal Reserve Banks are authorized totransfer the am ount of th e Treasury call from Bank Asreserve account at the Federa l Reserve to the account ofthe U.S. Treasury at the Federal Reseme. As a result ofthe transfer, both reserv es and TT&L note balances of th ebank are reduced. On the books of the Reserve Bank,bank reserves decline and T reasury deposits rise.

This withdrawal of Tre asu ry funds willcause a reserve deficiency of $1,000 since no resem es ar ereleased by the decline in lT&Lnote accounts at deposi-tory institutions.

As the Treasury makes expen ditures, check s h w non its balances in the Reserve Banks are paid to th e public,and these funds iind their way back to ba nks in the form ofdeposits. Th e banks receive reserve credit equalb he fullamount of th ese deposits although the correspondingincrease in the ir required rese rves is only 10 percent ofthis amount.Modem MoneyMechanics

-- -- -- --- --Operating cash balance of the US. Treasuryweekly averages, billions of dollars, n ot seasonally adjusted

Suppose a governmen t employee deposits a $1,000check in Bankk he bank sends the check toits Federal Reserve Bank for collection. The Reserve Bankthen cre dits BankATs reserve account and charges theTreasury's account. As a result, the bank gains both re-serves and deposits. While there is no change in the as-se ts or total liabilities of the Reserve Banks, the fundsdrawn away from the Treasury's balances have been shift-ed to bank reserve accounts.One of the objectives of th e TT&L note program,which req uires depository institutions that want to holdTreasury funds for more than o ne day to pay interest onthem, is to allow the T reasu ry to hold its balance at theReserve Banks to the minimum consistent with curren tpayment needs. By m a i n M n g a fairly co ns m t balance,

large dra ins from or add itions to bank reserv es from wideswings in the Treasury 's balance that would require exten-sive offsetting open market op erations can be avoided.Nevertheless , there are still periods when th ese fluctua-tions have large reserve effects. In 1991, for example,week-to-week chan ges in Tre asury dep osits at the ReserveBanks averaged only $56 million, but ranged from "$4.15b ii o n to +$8.57 billion.

When theTreasuryk balance at the Federal Reserve rises above expectedpayment needs, the Treasury m y place the excess funds in lT &L noteaccounts lfirough a "direct investment." The accounting entries are thesame, bu t of opposite signs, as those shown when funds are transferredfrom lT&L note accounts to Treasury deposits at the Fed.*Tmpaymenb eceived by institutions designated as Federal taxdepositar-ies initially are credited to reservable demand deposits due to the U.S.govement. Because such tax payments typically come from reservabletransaction accounts, required reserves are not materially affected on thisday, On thenext businessday,however, whenthesefundsareplacedeitherin a nonreservable note account or remitted to the Federal Reserve forcredit to the Treasury's balance at the Fed, required reserves decline.


19/40

Assets

19

Liabilities Assets Liabilities

When the Treasury builds up its deposits at the Federal Reserve through"calls" n ?T&L note balances,reserve accounts are reduced.

Reserve accounts: Reserves withBank A - 1.000 f---,F.R BanksU.S.Treasurydeposits +1,000

Treasury tax andloan note account - 1,000


20

Reserve accounts: Reserves withBank A + 1.000U .R. BanksU.S.Treasurydeposits - 1.000

Checks written on the Treasury's account at the Federal Reserve Bank are deposited in banks. As these arecollected, banks receive credit to their reserve accounts at the Federal Reserve Banks.

Private deposits + 1.000

FactonMeetingBank RCSCNCS 19


20/40

Changes ilzFederal Reseme FloatA large proportion of check s drawn on banks anddeposited in othe r banks is cleared (collected) through theFederal Reserve Banks. Some of these checks are credit-ed immediately to the r e s e m accounts of the depositingb& and are collected the same day by debiting thereserve accounts of th e banks on which the chec ks aredrawn. All checks are cred ited to the accounts of thedepositing banks according to availability schedulesrelated to the time it normally takes the Federal Reserve tocollect the checks, but rarely more than two business daysafter they are received at the Reserve Banks, even thoughthey may not yet have been collected due to processing,m sp om tio n, or other delays.The reserve credit given for checks not yet collectedis included in Federal Resenre On the books ofthe Federal Reserve Banks, balance sh eet float, o r state-ment float as it is sometimes called, is the differencebe-

tween the asset account "items in process of collection,"and the liabiity account "deferred credit items." State-ment float is usually positive since i t is more often th e casethat reserve credit is given before the checks are actuallycollected than the o the r way around.Published data on Federal Reserve float are basedon a "reserves-fadof' framework rather than a balanceshee t accounting kamework. As published, Federal Re-serve float includes statement float, as dehned above, a swell as float-related "as-of' adjustments." These adjust-ments represent corrections for errors that arise in pro-cessing transactions related to Federal Reserve pricedservices. As-of adjustments do not change the balancesheets of ei ther the Federal Reserve Banks or an individ-ual bank. Rather they are corrections to the bank's reserveposition, thereby affecting the calculation of w hether o rnot the bank meets its reserve requirements.

An Increase in Federal Reservek i n k ReservesAs float rises, total bank reserves rise by the sameamount. For example, suppose Bank A receives checkstotaling $100 drawn on Banks B, C, and D, all in distantcities. Bank A increases the accounts of its depositors$100, and send s the items to a Federa l Reserve Bank for

collection. Upon receipt of the checks, the Reserve Bankincreases its own asset account "items in process of collec-tion," and increases its liability account "deferred credititems" (checks and othe r items not yet credited ta thesending banks' reserve accounts). As long as these twoaccounts move together, there is no change in float or intotal reserves from this source. See illustmtiotz 21.On the next business day (assuming Banks B, C,and D are o ned ay deferred availability points), the Re-serve Bank pays Bank A. The Reserre Bank's "deferredcredit items" account is reduced, and BankA's reserveaccount is increased $100. If these items actually akemore than one business day to collect so that "items in

10 / Modem Mo my Mechanics

Federal Reserve float (including as-of adjustments)annual averages, billions of dollars8process of collection* are no t reduced that day, the creditto Bank A represents an addition to total bank reservessince the reserve accounts of B anks B, C , and D will nothave been comm ensm tely reduced.= See iEZusl.ration22.A Decline in Fed Reserve Float ReducesBamk Remrves

Only when the checks are actually collected fromBanks B, C, and D does the float involved in the above ex-ample disappear- items in p rocess of collectioni' of th eReserve Bank decline as the reserve accoun ts of Banks B,C, and D are reduced. See illustration 23.On an annual average basis, Federal Reserve floatdeclined dramatically from 1979 through 1984, in part

reflecting actions taken to implement provisions of th eMonetary Control Act that directed the Federal Reserve toreduce and price float. (Set: chant.) Since 1984, FederalReserve float has been fairly stable on an annual averagebasis, but often fluctuates sharply over sho rt periods.From th e standpoint of the effect on bank reserves, thesignificant aspect of float is not that it exists but th at itsvolume chan ges in a difticdt-to-predictway. Float canincrease unexpectedly, for example, if weather conditionsground planes transporting checks to paying banks forcollection. However, such pe riods typically are followedby on es where actual collections exceed new items beingreceived for collection. Thus , reserves gained from floatexpansion usually are quite temporary.

'"Federal Reserve float also arises from other funds transfer senticesprovided by the Fed, such as wire transfers, securities transfers, andautomatic clearinghouse transfers."As-ofadjustments also are used as one means of pricing float, as discussedon page 22, and for nonfloat-related corrections,asdiscussed on page 35.I2If the checks received from BankA had been erroneously assigned a two-day deferred availability, then neither statement float nor reserves wouldincrease, although both should. Bank A's reserve position and publishedFederal Reserve float data are corrected for this and similar errors throughasof adjustments.


21/40

Assets

21

Items in processof collection +I00

When a bank receives deposits in the form of checksdrawn on other banks, it can send them to the FederalReserve Bank for collection. (Required reserves are not affected immediately because requirements apply tonet transaction accounts, i.e., total transaction accounts minus both cash items in process of collection anddeposits due from domestic depository institutions.)


Assets

Deferred Cash items incredit items +I00 processof collection +I00

22

Liabilities AssetsDeferred Cash items incredit items - 100 process ofReserve accounts: collection - 100BankA Reserveswith

F.R. Banks +I00

Deposits +I00

If the reserve account of the payee bank is credited before the reserve accounts of the paying banks are debited,total reserves increase.

Liabilities

Assets

23

Items in processof collection - 100

But upon actual collection of the items, accounts of the paying banks are charged, and total reserves decline.

Liabilities Assets LiabilitiesReserve accounts:

Bank B- 100Bank D

Fac ton qdFecting Bank R-LS 21


22/40

Changes in Service-Related Balancesand A&&mentsIn order to foster a safe and efficient payments system,the Federal Reserve offers banks a variety of payments ser-vices, Prior to passage of the Monetary Control Act in 1980,the Federal Reserve offered its services free, but only tobanks that were members of the Federal Reserve System.The Monetary ControlAct directed the Federal Reserve tooffer its services to all depository institutions, to charge forthese services, and to reduce and price Federal Reservefloat.13 Except for float, all services covered by the Act werepriced by the end of 1982. Implementation of float pricingessentially was completed in 1983.The advent of Federal Reserve priced services ledto several changes that affect the use of funds in banks' re-serve accounts. As a result, only part of the total balances inbank reserve accounts is identified as "reserve balances"available to meet reserve requirements. Other balances held

in reserve accounts represent "service-related balances andadjustments (to compensate for float)." Service-related bal-ances are "required clearing balances" held by banks that useFederal Reserve services while "adjustments" represent bal-ances held by banks that pay for float with as-of adjustments.An Increase in Required Clearing B b c e sReduces Reserve Balances

Procedures for establishing and maintaining clearingbalances were approved by the Board of Governors of theFederal Reserve System in February 1981. A bank may berequired to hold a clearing balance if it has no required re-serve balance or if its required reserve balance (held to satis-fy reserve requirements) is not large enough to handle itsvolume of clearings. Tmically a bank holds both reserve bal-ances and required clearing balances in the same reserveaccount. Thus, as required clearing balances are establishedor increased, the amount of funds in reserve accounts identi-fied as reserve balances declines.

Suppose BankA wants to use Federal Reserve servicesbut has a reserve balance requirement that is less than itsexpected operating needs. With its Reserve Bank, it is deter-mined that BankA must maintain a required clearing balanceof $1,000. If BankA has no excess reserve balance, itwillhave to obtain funds from some other source. Bank A couldsell $1,000 of securities, but this will reduce the amount oftotal bank reserve balances and deposits. See illrkstration 24.

Banks are billed each month for the Federal Reserveservices they have used with payment collected on a speci-fied day the following month. All required clearing balancesheld generate "earnings credits" which can be used only tooffset charges for Federal Reserve services.14 Alternatively,banks can pay for services through a direct charge to theirreserve accounts. If accrued earnings credits are used to payfor services, then reserve balances are unaffected. On theother hand, if payment for services takes the form of a directcharge to the bank's reserve account, then reserve balancesdecline. See illustrafian25.

22 Mu dai Mon ey M~ c kan lo

Service-related balances and adjustmentsweek ly averages, billions of dollars, n ot seasonally adjusted

-Of Adjushen ts ReduceIn 1983, the Federal Reserve began pricing explicitlyfor float,15specifically "interterritory" check float, i.e., floatgenerated by checks deposited by a bank served by one Re-serve Bank but h w n on a bank served by another ReserveBank. The depositing bank has three options in paying forinterterritory check float it generates. It can use its earningscredits, authorize a direct charge to its reserve account, orpay for the float with an as-of adjustment. If either of the firsttwo options is chosen, the accounting entries are the same aspaying for other priced services. If the as-of adjustment o ption is chosen, however, the balance sheets of the ReserveBanks and the bank are not directly affected. In effect whathappens is that part of the total balances held in the bank's

reserve account is identified as being held to compensate theFederal Reserve for float. This part, then, cannot be used tosatisfy either reserve requirements or clearing balance re-quirements. Float pricing as-of adjustments are applied twoweeks after the related float is generated. Thus, an individualbank has sufticient time to obtain funds from other sources inorder to avoid any reserve deficiencies that might result fromfloat pricing as-of adjustments, If all banks together have noexcess reserves, however, the float pricing as-of adjustmentslead to a decline in total bank reserve balances.Week-to-week changes in service-related balances andadjustments can bevolatile, primarily reflecting adjustments

to compensate for float. (See cilart,) Since these changesare known in advance, any undesired impact on reserve bal-ances can be offset easily through open market operations,'T he Act specified that fee schedules cover services such as checkclearing and collectio n, wire transfer, automated clearingh ouse, settle-ment, sec uriti es safekeeping, noncash collection, Federal Reserve float,and any new serv ices offered.M" Eam ings reditsn are calculated by multiplying the actual averagec l e a ~ galance held over a maintenance period, up to that required plusthe clearing balance band, times a rate based on th e average federal fundsrate. The clearing balance band is 2 percent of the required clearingbalance or $25,000,whichever amount is larger.*W hil e ome types of float are priced directly, the Federal Reserve pricesother types of float indirectly, for examp le, by including the co st of float inthe per-item fees for the priced service.


23/40

When Bank A establishes a required clearingbalance at a Federal Reserve Bank by selling

- balance +1.000Assets

securities, the reserve balances and deposits of Assetsother bank s decline. U.S. governmentsecurities - 1,000Reserve accou ntw it h F.R. Banks:Required clearing

Liabi l i t iesReserve accounts:Required clearingbalances:Bank A +1,000 4-Reserve balances:

Liabi l i t ies

Liabi l i t iesReserve accountsw ith F.R Banks:

Oth er banks - 1,000

Deposits .. - 1,000

When Bank A is V ie d monthly for Federal Reserve services used, it can pay for these se rvices by havingearnings credits applied and/or by authorizing a direct charg e to its reserve account Suppose Bank A ha saccrued earn ings credits of $100 ut incurs fees of $125.The n both m ethods would be used. On the FederalReserve Bank's books, th e lia biity account "earnings credits d ue to depository institutions" declines by$100and Bank As reserve account is reduced by $25. Offsetting these entries is a reduction in the Fed's (other)asset account "accrued service income." On BankA'sbooks, the accounting entries might bea $100 educ-tion to its asset account "earnings credit du e from Federal Reserve Banks " and a $25 eduction in its reserveaccount, which are offset by a $125decline in its liabiity 'accounts payable." While an individual bank mayuse different accounting entrie s, the net effect on rese rves is a reduction of $25, he am ount of billed fees thatwere paid through a direct charg e to BankAs reserve accou nt

AssetsAccrued serviceincome - 125

Liabi l i t ies AssetsEarnings credits Earnings creditsdue to depository due fro minst itutions F.R Banks - 100Reserve accounts: Reserves wi th- 25 H F . R anks - 25

Liabi l i t iesAccountspayable - 125

FacfonmetingBark R m e s 23I


24/40

Changes in Loans toDepository Institutions Loans to depository institutionsmonthly averages, billions of dollars, not seasonally adjustedPrior to passage of th e Monetary Contro l Act of 1980,only banks that w ere mem bers of the Federal Reserve Sys-tem had regular access to t he Fed's "discount window."

Since then, all institutions having deposits reservable underthe Act also have been able to borrow from the Fed. Underconditions set by the Federal R eserve, loans are availableunder th ree credit programs: adjustment, seasonal, and ex-tended credit.16 T he average amo unt of ea ch type of discountwindow credit provided varies over time. (See rlrn~-fWhen a bank borrow s from a Federal Reserve Bank, itborrows reserves . T he acquisition of reserves in this mann erd i e m in an important way from the cases already illustrated.Banks normally borrow adju stme nt credit only to avoid re-serve deficiencies or overdrafts, not to obtain exce ss re-serves. Adjustment credit borrowings, therefore, arereserves on which expansion has already taken place. How

can this happen?In their efforts to accom modate custome rs as well as tokeep fully invested, banks frequently make loans in anticipa-tion of inflows of loanable funds from dep osits or moneymarket sources. Loans add to bank dep osits but not to bankreserves. Unless excess reserves can be tapped, banks willnot have enough reserves to m eet the reserve requirem entsagainst the new depo sits. Likewise, individual banks mayincur deficiencies throu gh unexpected deposit outflows andcorresponding losses of reserves through clearing s. Otherbanks receive these depo sits and can increase their loansaccordingly, but th e banks that lost them may not be able to

reduce outstandin g loans or investments in o rder to restoretheir reserves to required levels within the required timeperiod. In either case, a bank may borrow reserves tempo-rarily from its Reserve Bank.Suppose a customer of Bank A wants to borrow $100.On the basis of the managem ent's judgmen t that the bank'sreserves will be sufticient to provide th e n ecessary funds, th ecustomer is accommodated. Th e loan is made by increasing"loans" and crediting the custom er's deposit account. NowBankAs depo sits have increase d by $100. However, if re-serves are insufticient to sup port the higher deposits, Bank Awill have a $10 reserve deficiency, assuming requ irements of10 percent. See zllustratlo~z26. Bank A may temporarily

borrow the $10 from its Federal Reserve Bank, which makesa loan by increasing its asset item "loans to deposito ry institu-tions" and crediting Bank A's reserve account. Bank Agains reserves and a correspon ding liability "borrowings fromFede ral Reserve Banks." See tlitutruiito~z 7To repay borrowing, a bank m ust gain reserves throug heither deposit growth or asset liquidation. 3cr ~llrrstrntio~z%A bank makes payment by authorizing a debit to its reserveaccount at the Federal Reserve Bank. Repayment of borrow-ing, therefore, reduces b oth reserves and "borrowings fromFede ral Reserve Banks." S ~ Piiustmtzon29Unlike loans made under th e seasonal and extended

credit programs, adjustment credit loans to banks generally

Extended credit

must be repaid within a shor t time since such loans are madeprimarily to cover ne eds created by temp orary fluctuations indeposits and loans relative to usu al patterns. Adjustments,such a s sales of securities, made by some banks to "get outof th e window" tend to transfer reserve sho rtages to otherbanks and may force these other b anks to b orrow, especiallyin periods of heavy credit demands. Even at times when thetotal volume of adjustment credit borrowing is rising, someindividual banks are repaying loans while other s are borrow-ing. In the aggregate, adjustm ent credit borrowing usuallyincrea ses in periods of rising bu siness activity when th epublic's d eman ds for credit are rising mor e rapidly thannonbo rrowed reserves are being provided by System openmarket operations.

Although reserve expansion through borrowing is initi-ated by banks, the am ount of reserves th at banks can acquirein this way ordinarily is limited by the Federal Reserve's ad-ministration of the d iscount window and by its control of therate charged b anks for adjustment credit loans- he discountrate.17 Loans are made only for approved purposes, and otherreason ably available sou rces of fund s must have been fullyused. Moreo ver, banks are discou raged from borrowing ad-justment cred it too frequently or for extended time periods.Raising the discount rate tends to restrain borrowing byincreasing its cost relative to th e cost of alternative sourcesof reserves.Discount window administration is an im portant adjunctto th e oth er Fed eral Reserve tools of m onetary policy. Whilethe privilege of borrowing offers a "safety valve" to temporarilyrelieve severe strains on th e reserve positions of individualbanks, the re is generally a stro ng incentive for a bank to repayborrowing before adding further to its loans and investments.- -- - - -.- - --

'fiAdjustment redit is short-term credit available to meet temporary needsfor funds. Season al credit is available for longer periods to smaller institu-tions having regular seasonal needs for funds. Extended credit may be m adeavailable to an in stitution or group of institutions experienc ing sustainedliquidity pressures. T he re serves provided through extended credit borrow-ing typically are offset by open market operations.';Flexible dis count rates related to rates on mo ney market source s of fundscurrently arecharged for seasonalcredit and for extended credit outstandingmore than 30days.

24 1 Modem Money Mechanrcs


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3 26 I A bank may incur a reserve deficiency if it makesloans when it has no excess reserves.Assets LiabilitiesLoans

no change

I ~ss ets Liabilities

1Assets Liabilities

27 Borrowing from a Federal Reserve Bank to cover such a deficit is accompanied by a direct credit to thebank's reserve account.

1 N ofi rhe r expansion can take phce on the new reserves because thy a n ll needed against the deposits created in (26).Loans to depository

+ 10

Assets LiabilitiesSecurities - 10

Reserve accounts: Reserves with Borrowings fromBank A + 10-F.R Banks F.R. Banks + 10+ lo 1

Reserves withF.R Banks

Assets

29

Liabilities Assets

Repayment of borrowings from the Federal Reserve Bank reduces reserves.

Loans to depositoryinstitutions:BankA - 10Reserve accounts: Reserves withBankA - 10-F.R.Banks - 10

LiabilitiesBorrowings from

FactorsmetingEank Resewes 25


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Changes in Resave Req zkm entsThus far we have described transactions that affect thevolume of bank reserves and the impact the se transactionshave upon the capacity of the banks to expand their assetsand deposits. It is also possible to id ue nc e deposit expan-sion or contraction by chang ing the required minimum ratioof reserves to deposits.The authority to vary required reserve percentages forbanks that were mem bers of the Federal Reserve System(member banks) was first granted by Congress to the Fed-eral Reserve Board of G overnors in 1933. The ranges withinwhich this authority can be exercised have been changedseveral times, most recently in the Monetary ControlAct of1980, which provided for the establishment of reserve r equirem ents that apply uniformly to all depository institutions.?he 1980 statute established the following limits:On transadon accounts

first $25million 3%above $25 million 8% o 14%

On nonpmonal time deposits 0%o 9%The 1980 law initially se t the requirem ent against transactionaccounts over $25 million at 12 percent and that againstnonpersonal time deposits at 3perc ent Th e initial $25miklion "low reserve tranche" was indexed to change each yearin line with 80 percent of the growth in transaction accountsat all depository institutions. (For example, the low reservetranche was increased from $41.1 million for 1991 o $42.2million for 1992.) In addition, reserve requirem ents can beimposed on certain nondeposit sources of funds, such asEurocurrency iabiitie~?~Initially the Board set a 3percentrequirement on Eurocurrency liabiitiea)

Th e Garn-StGermainAct of 1982 modiied these provi-sions somewhat by exempting from reserve requirementsthe first $2 million of total rese m bl e liabiities at each dep ository institution. Similar to the low reserve tranche adjust-ment for transaction accounts, the $2 million " re se m bl eliabiities exemption amount" was indexed to 80 percent ofannual increases in total re se m bl e liabiities. (For example,the exemption amount was increased from $3.4 million for1991 to $3.6 million for 1992.)Th e Federal Reserve Board is authorized to change, atits discretion, the percentage requirements on transaction

accounts above the low reserve tranche and on nonpersonaltime depositswithii he ranges indicated above. In addition,the Board may impose differing reserve requirements onnonpersonal time deposits based on the maturity of the de-posit. m e Board initially imposed th e 3percent nonper-sonal time deposit requirem ent only on such deposits withoriginal maturities of under four years.)During the ph ase in period, which ended in 1984 formost mem ber banks and in 1987 for most nonm ember insti-tutions, requirements changed according to a predeterminedschedule, without any action by the Federal Reserve Board.Apart from these legally prescribed changes, once the Mone-tary ControlAct provisions were implemented in late 1980,

the Board did not change any reserve requirement ratios untillate 1990. m e riginal maturity break for requirements onnonpersonal time deposits was shortened several times, oncein 1982 and twice in 1983, in connection with actions taken toderegu late rates paid on deposits.) In December 1990, theBoard reduced reserve requirements against nonpersonaltime deposits and Eurocurrency liabilities from 3percent tozero. Effective in April 1992, the reserve requirem ent ontransaction accounts above the low reserve tranche was low-ered from 12 percent to 10 percent.

When reserve requirem ents are lowered, a portion ofbanks' existing holdings of required reserves becomes excessreserves and may be loaned or invested. For example,with arequirem ent of 10 percent, $10 of reserves would be requiredto support $100 of deposits. See illustration30. But a reduc-tion in the legal requirement to 8 percent would tie up only$8,f r e e i i $2 out of each $10 of re serves for use in creating addi-tional bank credit and deposits. See illustration 31.

An increase in reserve requirem ents, on the other hand,absorbs additional reserve funds, and banks which have noexcess reserves must acquire reserves or reduce loans orinvestments toavoid a reserve deficiency. Th us an increasein the requirem ent from 10 percent to 12 percent would boostrequired rese rves to $12 for each $100 of deposits. Assumingbanks have no excess reserves , this would force them toliquidate asse tsuntil the reserve deficiencywas eliminated,at which point deposits would be on esixth less than before.See illustration 32.Reserve Requirements and Monetary Policy

The power to change reserve requirements, like pur-chases and sale s of securities by th e Federal Reserve, is aninstrum ent of monetary policy. Even a small change in r equirements- ay, oneha lf of one percentage point- anhave a large and widespread impact. Other instruments ofmonetary policy have sometimes been used to cushion theinitial impact of a reserve requirement change. Thus , theSystem may sell securities (or purchase less than otherwisewould be appropriate) to absorb part of the reserves releasedby a cut in requirements.

It should be noted that in addition to their initial impacton excess reserves, changes in requirements alter the expan-sion power of every reserve dollar. Th us, such chang es affectthe leverage of all subsequent increases or decreases in re-serves from any source. For this reason, chang es in the totalvolume of bank rese rves actually held between points in timewhen requirements dii er do not provide an accurate indica-tion of the Federal Reserve's policy actions.

Both reserve balances and vault cash are eligible tosatisfy reserve requirements. To the extent some institutionsnormally hold vault cash to m eet operating needs in amountsexceeding their required reserves, they a re unlikely to beaffected by any change in requirements.I8The1980statute also provides that "underextraordinarycircumstances"reserve requirements can be imposed at any level on any liability ofdepository institutions for as long a s six months; and, if essential for theconduct of m onetary policy, supplemental requirements up to4 percent oftransaction accountscanbe imposed.


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Under a 10 percent reserve requirement,$10 of reserves are needed to support each$100 of deposits. Assets LiabilitiesLoans and

Reserves

With a reduction in requirements from 10percent to 8percent, fewer reserves arerequired against the same volume of deposits Assetsso that excess reserves are created. These can Loans andbe loaned or invested. investments 90Reserves 10

Assets LiabilitiesI

NO CHANGETLiabilitiesDeposits 100

There is no change in the total amount of bank reserves.

With an increase in requirements from 10percent to 12 percent, more reserves arerequired against the same volume of deposits. AssetsThe resulting deficiencies must be coveredbyliquidation of loans or investments. . Loans andinvestments 90Reserves 10'3

Assets LiabilitiesI

LiabilitiesDeposits

.. because the total amount of bank reserves remainsunchanged.

FactorsmctrrgBank Resemes 27


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The Federal Reserve has engaged in foreign currencyoperations for its own account since 1962. In addition,it acts as the agent for foreign currency transactions of theU.S. Treasury, and since the 1950s has executed transac-tions for customers such as foreign central banks. Perhapsthe most publicized type of foreign currency transactionundertaken by the Federal Reserve is intervention in theforeign exchange markets. Intervention, however, is onlyone of several foreign-related transactions that have thepotential for increasing or decreasing reserves of banks,thereby affecting money and credit growth.

Several foreign-related transactions and their effectson U.S. bank reserves are described in the next few pages.Includedaresome but not all of the types of transactionsused. The key point to remember, however, is that theFederal Reserve routinely offsets any undesired change inU.S bank reserves resulting from foreign-related transac-tions. Asa result, such transactions do notaffectmoneyand credit growth in the United States.Foreign Exchange Intervention for the FederalReserve's OwnAccountWhen the Federal Reserve intervenes in foreignexchange markets to sell dollars for its own itacquires foreign currency assets and reserves of U.S. banksinitially rise. In contrast, when the Fed intervenes to buydollars for its own account, it uses foreign currencyassekto pay for the dollars purchased and reserves of US. banksinitially fall.

Consider the example where the Federal Reserveintervenes in the foreign exchange markets to sell$100 ofU.S. dollars for its own account. In this transaction, theFederal Reserve buys a foreignarrencydenominateddeposit of a U.S. bank held at a foreign commercial barkz0and pays for this foreign currency deposit by crediting $100to the U.S. bank's reserve account at the Fed. The FederalReserve deposits the foreign currency proceeds in its ac-count at a Foreign Central Bank, and as this transactionclears, the foreign bank's reserves at the Foreign CentralBank decline. See illustration33 on pages 3 03 1 . Initially,then, the Fed's intervention sale of dollars in this exampleleads to an increase in Federal Reserve Bank assetsdenom-inated in foreign currencies and an increase in reserves ofU.S. banks.

Suppose instead that the Federal Reserve intervenesin the foreign exchange markets to buy $100 of US. dollars,again for its own account. The Federal Reserve purchases adollardenominated deposit of a foreign bank held at a US.bank, and pays for this dollar deposit by drawing on itsforeign currency deposit at a Foreign Central Bank. m eFederal Reserve might have to sell some of its foreign cur-rency investments to build up its deposits at

48608300 modern money mechanics meccaniche monetarie moderne

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