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Modern Money Mechanics

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A Workbook on Bank Reserves and Deposit Expansion.

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Modern MoneyMechanics AWorkbook on Bank Reserves and Deposit Expansion Federal Reserve Bank of Chicago
Modern Money Mechanics Thepurpose ofthisbookletis to desmmbethe basic process ofmoneycreation in a ~actionalreserve"bank- ingsystem. l7zeapproachtaken illustratesthe changes in bank balancesheets that occurwhen depositsin banks changeasa result ofmonetaryactionby theFederal Reserve System-the centralbank ofthe UnitedStates. Therelationshipsshown are based onsimplil5ring assumptions. For thesake ofsimplicity,the relationships areshown as iftheywere mechanical,but theyare not, as isdescribed laterin the booklet. Thus,theyshould not be intwreted to implya closeandpredictable relation- ship betweena specificcentral bank transactionand the quantityofmoney. Theintroductorypages containa briefgeneral desm'ptionofthe characte*ics ofmoneyand how the US. moneysystem works. m e illustrationsin thefbl- lowingtwosections describe twoprocesses: fijirst, how bank akposits expand orcontractin responsetochanges in theamountofreservessupplied by thecentml bank; and second, how thosereservesareafected by both FederalReserve actionsand otherjizctm. Afinal sec- tion deals withsome ofthe elementsthat modifi,at least i~theshort Tun,thesimple mechanical relationship between bank reservesand depositmoney. Moneyis sucha routinepart of everydaylivingthat itsexistenceand acceptanceordinarilyare taken forgrant- ed. A user may sensethat money must comeinto being either automaticallyasa resultof economicactivityor as an outgrowth of somegovernmentoperation. Butjust how this happens alltoo often remainsa mystery. What Is Money? If moneyisviewed simplyasa tool used to facilitate transactions,onlythose media that are readily acceptedin exchangeforgoods,services,and otherassetsneed to be considered. Manythings-from stonesto baseballcards -have servedthis monetaryfunctionthrough the ages. Today,in the United States,money used in transactionsis mainly of threekinds-currency (papermoney and coins in the pocketsand purses of the public);demand deposits (non-interest-bearingcheckingaccountsinbanks);and othercheckabledeposits,such asnegotiableorderof withdrawal (NOW)accounts,atalldepositoryinstitutions, includingcommercialand savingsbanks, savingsandloan associations,andcreditunions. Travelerschecksalso are included in the definition of transactionsmoney. Since$1 in currencyand $1in checkabledeposits arefreelycon- vertible intoeach otherand both canbe used directlyfor expenditures,they are moneyin equaldegree. However, onlythe cash and balances held by the nonbank public are countedin the money supply. Depositsof the U.S. Trea- sury,depositoryinstitutions,foreignbanksand official institutions,aswell asvault cash in depositoryinstitutions areexcluded. Thistransactionsconceptof money is the onedesig- nated asM1in the FederalReserve's money stock statis- tics. Broaderconceptsof money (M2 and M3) includeM1 aswell ascertainotherhancial assets (such assavings and time depositsatdepositoryinstitutionsand sharesin moneymarket mutual funds) which are relativelyliquid but believed to representprincipallyinvestmentsto their holdersrather than mediaof exchange. While fundscan be shiftedfairlyeasilybetween transaction balances and these otherliquid assets,the moneycreationprocesstakes placeprincipallythrough transaction accounts. In the remainderof thisbooklet, "money"meansMI. The distributionbetween the currencyand deposit componentsof money dependslargelyonthe preferences of the public. When a depositorcashesa checkor makes a cashwithdrawal through an automaticteller machine,he or shereducesthe amountof depositsand increasesthe amountof currencyheld by the public. Conversely,when people have morecurrencythan is needed, someisre- turned to banks in exchangefor deposits. While currencyisused for a greatvariety of small transactions,most of the dollaramount of moneypay- mentsin our economyare made by checkorby electronic
transferbetween depositaccounts. Moreover,currency is a relatively smallpart of the moneystock. About 69 percent,or$623biion, of the $898 biion totalmoney stockin December 1991,wasin the formof transaction deposits,of which$290billion were demand and $333 billion were other checkabledeposits. What Makes MoneyValuable? In the United Statesneitherpaper currencynor depositshavevalue ascommodities. Intrinsically,a dollar bii isjust a pieceof paper, depositsmerelybook entries. Coinsdo have someintrinsicvalue asmetal,but generally farlessthan their facevalue. What,then,makesthese instruments-checks, paper money,and coins-acceptableatfacevalue in payment of alldebtsandfor othermonetary uses? Mainly, itisthe confidencepeoplehave that theywillbe ableto exchangesuchmoneyfor otherfinancialassets and for real goodsand serviceswhenever theychooseto do so. Money,like anythingelse,derivesitsvaluefrom its scarcity in relation to itsusefulness. Commoditiesor ser- vices aremore orlessvaluablebecause there are more or lessof them relative to the amountspeoplewant. Money's usefulnessisitsunique abilityto commandothergoods and servicesandto permit aholder to be constantlyready to do so. How much money is demanded dependson severalfactors,suchasthe totalvolumeof transactions in the economyat anygiven time,the paymentshabits of the society,the amount of moneythat individualsand businesseswantto keep on hand to take care of unexpect- ed transactions, and the foregoneearningsof holding tinancialassetsin the form of moneyrather than some other asset. Control of the quantity of moneyisessentialif its valueis to be kept stable. Money's real value canbe mea- sured onlyin termsof what itwillbuy. Therefore,itsvalue variesinverselywith the generallevelof prices. Assuming a constant rate of use,if the volume of money growsmore rapidlythan the rate atwhich the outputof realgoodsand servicesincreases,priceswill rise. Thiswill happen b e causetherewill be more money than therewillbe goods and servicesto spend it on at prevailingprices. But if, on the otherhand, growthin the supplyof money does not keeppacewith the economy'scurrentproduction,then priceswillfall,the nation's laborforce,factories,and other production facilitieswillnot be fully employed,or both. Just how largethe stockof moneyneeds to be in ordertohandlethe transactionsof the economywithout exertingundueiduence on the price level dependson how intensivelymoney isb e i iused. Everytransaction depositbalanceand everydollarbill isa part of some- body's spendablefundsat anygiventime, ready to move to otherownersastransactionstake place. Someholders spend money quicklyaftertheyget it, makingthese funds availablefor otheruses. Others,however,hold moneyfor longerperiods. Obviously,when somemoney remains idle,a largertotalis needed to accomplish anygiven volume of transactions. Who Creates Money? Changesin the quantityof money may originatewith actionsof the FederalReserve System (thecentralbank), depositoryinstitutions (principallycommercialbanks),or the public. The majorcontrol,however,rests with the centralbank. The actualprocessof money creation takesplace primarilyin banks.' As noted earlier,checkableliabilities of banksare money. These liabilitiesare customers'ac- counts. Theyincreasewhen customersdepositcurrency and checksandwhen the proceedsof loansmade by the banksarecreditedtoborrowers' accounts. In the absenceof legalreserve requirements,banks canbuild up depositsby increasingloansand investments solongastheykeepenoughcurrencyon hand to redeem whatever amountsthe holders of depositswantto convert intocurrency. Thisunique attributeof the bankingbusi- nesswas discoveredmany centuriesago. It startedwith goldsmiths. As earlybankers,they initiallyprovided safekeepingservices,makinga profit from vaultstoragefeesforgold and coinsdepositedwith them. Peoplewould redeemtheir "depositreceipts"whenever they needed gold orcoinsto purchase something,and physicallytake the gold or coinsto the sellerwho,in turn, would depositthem for safekeeping,oftenwith the same banker. Everyone soonfoundthat itwasa loteasier simply to use the deposit receiptsdirectlyasa meansof payment. These receipts,which became known asnotes,were ac- ceptableasmoney sincewhoeverheld them couldgo to the banker and exchangethem for metallicmoney. Then,bankers discoveredthat they could make loans merelyby giving their promisesto pay, orbank notes, to borrowers. In thisway,banksbegan to create money. More notes couldbe issuedthan the gold and coinon hand because only a portionof the notesoutstandingwould be presented forpaymentat anyonetime. Enough metallic moneyhad to be kept on hand, of course,to redeemwhat- evervolumeof noteswas presented for payment. Transactiondepositsare the modem counterpartof bank notes. Itwas a small stepfromprintingnotesto mak- ingbook entriescreditingdepositsof borrowers,which the borrowersin turncould "spend"by writingchecks,thereby "printing"their own money. Inordertodescribethemoneycreationprocessassimplyaspossible,the term Bank"used in this bookletshouldbe understoodto encompassall depositoryinstitutions. SincetheDepositoryInstitutionsDeregulationand MonetaryControlActof 1980,alldepositoryinstitutionshavebeenpermit- ted to offer interest-bearing transaction accounts to certain customers. Transaction accounts (interest-bearing as well as demand deposits on which payment of interest is still legally prohibited) at all depository institutions are subject to the reserve requirements set by the Federal Reserve. Thus an such institutions, notjust commercialbanks,havethe potential for creatingmoney.
What Iimits the Amount of Money Banks Can Create? If depositmoney canbe createdsoeasily,what isto preventbanksfrommaking too much -more than sufti- cient to keep the nation's productiveresourcesfullyem- ployedwithoutprice inflation? Likeitspredecessor,the modem bank must keep available,to makepayment on demand,a considerableamountof currency andfundson depositwith the centralbank. Thebank mustbe prepared to convertdepositmoneyintocurrencyforthose deposi- torswho requestcurrency. It must make remittanceon checkswritten by depositorsand presented for payment by otherbanks (settleadverseclearings). Finally,it must maintain legallyrequired reserves,in theformof vaultcash and/or balances atitsFederal ReserveBank,equalto a prescribedpercentage of itsdeposits. Thepublic's demandfor currencyvariesgreatly,but generallyfollowsa seasonalpattern that isquitepredict- able. Theeffectsonbank fundsof thesevariations in the amountof currencyheld by the public usuallyareoffsetby the centralbank, which replacesthe reservesabsorbedby currencywithdrawalsfrombanks. Ousthowthisisdone willbe explainedlater.) For allbankstaken together,there isno net drainof fundsthroughclearings. Acheckdrawn on onebank normallywillbe depositedto the creditof anotheraccount,if not in the samebank, then in some otherbank. Theseoperatingneeds influencethe minimum amountof reservesan individualbankwillhold voluntarily. However, aslongasthis minimum amountislessthan what islegallyrequired, operatingneeds areof relatively minor importanceasa restrainton aggregatedepositex- pansion in thebankingsystem. Such expansioncannot continuebeyond the pointwherethe amountof reserves that allbankshave isjust sufficientto satisfylegal require- ments under our"fractionalreserve" system. For example, if reservesof 20 percentwere required, depositscould expand onlyuntiltheywere fivetimes aslargeasreserves. Reservesof $10million could supportdepositsof $50mil- lion. Thelowerthe percentage requirement,the greater the depositexpansionthatcanbe supportedby eachaddi- tional reserve dollar. Thus,thelegalreserveratiotogether with the dollaramountof bank reservesarethefactorsthat setthe upper limitto money creation. What Are Bank Reserves? Currencyheld in bank vaults may be countedas legalreservesaswell as deposits (reservebalances) atthe FederalReserveBanks. Both areequallyacceptablein satisfactionof reserverequirements. Abank canalways obtain reserve balancesby sendingcurrencyto itsReserve Bank and canobtaincurrencyby drawingon itsreserve balance. Because eithercanbe used to supporta much largervolumeof depositliabilitiesof banks, currencyin circulationand reservebalancestogetherare oftenrefer- red to as"high-poweredmoney"orthe "monetarybase." Reservebalancesandvault cash in banks, however,arenot counted aspart of the money stockheld by thepublic. 4 Modem Money Mechanics For individualbanks, reserveaccountsalso serveas workingbalances? Banksmay increase the balancesin their reserveaccountsby depositingchecksand proceeds fromelectronicfundstransfersaswell ascurrency. Or they may drawdown these balancesby writingcheckson them orby authorizinga debitto them in paymentfor currency,customers' checks,or otherfundstransfers. Although reserveaccountsareused asworking balances,eachbank must maintain,on the averageforthe relevantreservemaintenanceperiod, reservebalancesat the ReserveBank andvaultcashwhich together areequal to itsrequired reserves,asdeterminedby the amountof itsdepositsin the reservecomputationperiod. Where Do Bank Reserves Come From? Increasesor decreasesin bank reservescanresult froma number of factorsdiscussed later in thisbooklet. From the standpointof moneycreation,however,the essentialpoint isthat the reserves of banksare,forthe most part, Wities of the Federal ReserveBanks,and net changesin them arelargelydeterminedby actionsof the Federal ReserveSystem. Thus,the FederalReserve, through itsabiityto varyboth the totalvolume of reserves and the required ratio of reservesto depositliabilities, influencesbanks' decisionswith respectto their assetsand deposits. One of the major responsibilitiesof the Federal ReserveSystemisto providethe total amountof reserves consistentwith the monetaryneeds of the economyat reasonablystableprices. Suchactionstake intoconsider- ation,of course,anychangesin the pace atwhich money isbeingused and changesin the public's demandsfor cash balances. The reader shouldbe mindfulthat depositsand reserves tend to expand simultaneouslyand thatthe Fed- eral Reserve's controloften is exertedthroughthe market- place asindividualbanksfind it eithercheaperor more expensiveto obtaintheir required reserves,dependingon the willingnessof the Fed to supportthe currentrate of creditand depositexpansion. While an individualbank can obtain reservesby biddingthem awayfromotherbanks, this cannotbe done by the banking systemasawhole. Exceptfor reserves borrowed temporarily from the Federal Reserve's discount window, asis shownlater,the supplyof reservesin the banking systemiscontrolledby the Federal Reserve. Moreover,a givenincreasein bank reservesisnot necessarilyaccompaniedby an expansionin money equal to the theoreticalpotential based on the required ratio of reservesto deposits. Whathappensto the quantityof ZPartof an individual bank's reserve account may representits reserve balanceused to meetits reserverequirementswhile anotherpart may be its requiredclearingbalance on which earningscredits are generated to pay for Federal Reserve Bank services.
money willvary, dependingupon thereactionsof the banks andthe public. A numberof slippagesmay occur. Whatamountof resmeswillbe drainedintothe public's currencyholdings? Towhatextentwill the increase in totalreservesremain unused asexcessreserves? How much will be absorbedby depositsor otherliabiitiesnot definedasmoneybut againstwhichbanksmight alsohave to hold reserves? How sensitivearethe banksto policy actionsof thecentralbank? The significanceof these questionswillbe discussedlater in thisbooklet. The an- swersindicatewhy changesinthe money supplymay be differentthan expectedormay respond to policyaction onlyafterconsidembletimehas elapsed. In the succeedingpages,the effectsof varioustrans- actionsonthe quantityof money aredescribed and illus- trated. Thebasic workingtool isthe Taccount, which providesa simplemeans of tracing,stepby step,the effects of these transactionson both the asset and liabity sidesof bankbalance sheets. Changesin asset itemsareentered on thelefthalf of the Tand changesin liabiitiesonthe righthalf. For anyonetransaction,of course,there must be atleasttwo entriesin orderto maintainthe equalityof assetsandliabiities. Introduction 5
Bank Deposits-How l%ey Expand or Contract Let us assumethat expansionin the money stockis desiredby the FederalReserveto achieveitspolicy objec- tives. Oneway the centralbank can initiate suchan expan- sionisthrough purchasesof securitiesin the open market Paymentforthe securitiesaddstobank reserves. Such purchases (and sales) arecalled"open market operations." How doopen market purchasesadd to bank reserves and deposits? Supposethe Federal ReserveSystem, through itstrading desk at the FederalReserveBank of New York,buys$10,000of Treasurybillsfroma dealerin U.S. governmentsecuritie~.~In today's world of computer- ized financialtransactions,the FederalReserveBank pays forthe securitieswith an "electronic"checkdrawn on itself! Via its"Fedwire" transfer network, the Federal Reserve notifiesthe dealer's designatedbank (BankA) that payment for the securitiesshouldbe credited to (de- posited in) the dealer'saccountat BankA At the same time, BankA's reserveaccountatthe FederalReserve iscreditedforthe amountof the securitiespurchase. The FederalReserve Systemhas added $10,000of securi- ties to itsassets,which ithas paid for,in effect, by creating aliabilityonitself in the formof bank reservebalances. These reserveson BankA's books arematchedby $10,000of the dealer's depositsthat did not existbefore. See illustration 1. How the Multiple Expansion ProcessWorks If the processendedhere,therewould be no "multi- ple" expansion,i.e., depositsandbank reserveswould havechangedby the sameamount However,banksare requiredto maintainreservesequalto onlya fraction of their deposits. Reservesin excessof this amountmaybe used to increase earningassets-loansand investments. Unused orexcessreservesearnno interest Undercurrent regulations,the reserverequirementagainstmost transac- tion accountsis 10percent5 Assuming,for simplicity,a uniform 10percent reserverequirementagainstalltransac- tion deposits,andfurther assumingthat allbanksattempt to remain fullyinvested,we cannowtracethe processof expansionin depositswhich can take place on the basisof the additionalreservesprovided by the Federal Reserve System's purchaseof U.S. governmentsecurities. Theexpansionprocessmay ormay not begin with BankA, dependingonwhat the dealerdoeswith the mon- eyreceivedfromthe saleof securities. If the dealerimme- diatelywriteschecksfor$10,000and allof them are depositedin otherbanks, BankAlosesboth depositsand reservesand showsno net changeasa result of the Sys- tem's openmarketpurchase. However,otherbankshave receivedthem. Mostlikely,a part of the initialdepositwill remain with BankA, and a partwillbe shifted to other banks asthe dealer'schecksclear. 6 Modem Money Mechanics It doesnot reallymatterwherethismoney is atany giventime. The importantfactisthat thesedeposits do not disappear. Theyarein somedepositaccountsatalltimes. All bankstogether have $10,000of depositsand reserves thatthey did nothave before. However,they arenot requiredto keep $10,000of reservesagainstthe $10,000 of deposits. All they need to retain,under a 10percent resenrerequirement, is$1,000. The remaining$9,000is "excessreserves." Thisamountcan be loaned or invested. See illustration 2. If businessisactive,the bankswith excessreserves probablywillhave opportunitiesto loan the $9,000. Of course,they donot reallypay outloansfromthe money theyreceiveasdeposits. If they did this,no additional moneywould be created. Whatthey dowhen they make loansisto acceptpromissorynotesin exchangeforcredits to the borrowers' transactionaccounts. Loans (assets) anddeposits (liabilities) both riseby $9,000. Reservesare unchanged by the loan transactions. Butthe depositcred- itsconstitutenewadditionsto the totaldepositsof the banking system. See illustration 3. 3Dollaramountsused in the variousillustrationsdo not necessarilybear any resemblancetoactualtransactions. Forexample,openmarketopera- tions typically are conductedwith many dealers and in amountstotaling severalbillion dollars. 'Indeed, manytransactionstodayareaccomplishedthroughanelectronic transferoffundsbetweenaccountsratherthanthroughissuanceofapaper check. Apart from the timing of posting, the accounting entries are the samewhetheratransferismadewith apapercheckorelectronically. The term "check,"therefore,is usedfor both typesof transfers. SForeachbank, the reserverequirementis 3 percent on a specifiedbase amountof transactionaccountsand 10percent on the amountabovethis base. Initially,theMonetaryControlActsetthisbaseamount-calledthe "low reserve tranche"-at $25 million, and provided for it to change annuallyinlinewiththegrowthintransactiondepositsnationally.Thelow reserve tranchewas $41.1million in 1991and $42.2millionin 1992. The Garn-St Germain Act of 1982 further modiied these requirements by exemptingthefirst$2millionofreservableliabilitiesfromreserverequire ments. Likethelowreservetranche,theexemptlevelisadjustedeachyear toreflectgrowthinreservableliabilities.Theexemptlevelwas$3.4million in 1991and $3.6millionin 1992.
DepositEzpansion 1 Thecustomerdepositat Bank A likely will be transfeerred,in part, to otherbanks and quickly loses its identity amid the huge interbankflow ofdeposits. When the FederalReserveBankpurchasesgovernmentsecurities,bank reservesincrease. Thishappens becausethe sellerof the securitiesreceivespaymentthrough a creditto a designateddeposit account ata bank (BankA) which the FederalReserveeffectsby creditingthe reserve account of BankA Assets Liabilities Assets Liabilities U.S.government securities + 10,000 Expansion takesplace onlyif the banksthat hold these excessreserves (Stage1banks) increase 2 I their loansorinvestments. Loansaremade by Assets Liabilities Reserve accounts: Reserveswith Bank A + 10,000 W F.R. Banks + 10,000 ASa result, allbankstaken togethernow have Total reservesgainedfrom new deposits ..................... 10.000 "excess"reservesonwhich depositexpansion less: Requiredagainstnew deposits can take place. (at 10 percent)........................................ 1,000 equals Excessreserves ................................................ 9,000 crediting the borrower's deposit account, i.e., by creatingadditionaldeposit money. Customer deposit + 10,000 Deposit Expansion and Contraction 1 7 Loans + 9,000 ~~p Borrower deposits + 9,000
ntisisthe beginningof the dejPosit expansionpmcess. In thefirst stageof the process, totalloansand depositsof the banksrise by an amountequalto the excessreserves existingbefore anyloanswere made (90percent of the initialdepositincrease). At the end of Stage 1,deposits have risen a total of $19,000 (theinitial$10,000provided by the FederalReserve's action plus the $9,000in deposits createdby Stage1banks). See illustration 4. However, only$900 (10percent of $9,OOO) of excessreserveshave been absorbedby the additionaldepositgrowth at Stage 1 banks. See illustration 5. Thelendingbanks,however, donot expectto retain the depositstheycreatethrough theirloan operations. Borrowerswrite checksthatprobablywillbe depositedin otherbanks. As thesechecksmovethroughthe collection process,the FederalReserveBanks debitthe reserve accountsof thepayingbanks (Stage 1banks) and credit those of the receivingbanks. See illustration 6. Whether Stage1banks actually dolosethe deposits to otherbanks orwhetheranyor allof theborrowers' checksareredepositedin thesesame banksmakesno differencein the expansionprocess. If thelendingbanks expect to losethese deposits-and an equalamountof reserves-asthe borrowers' checksarepaid,theywill not lend more than theirexcessreserves. Likethe original $10,000deposit,the loanaeated depositsmaybetrans ferred to otherbanks, but they remain somewherein the banking system. Whicheverbanksreceivethem also acquireequalamountsof reserves,of which allbut 10 percentwillbe "excess." Assuming thatthe banksholdingthe $9,000of d e posits created in Stage1in turn makeloansequalto their excessreserves,then loansand depositswill rise by a further$8,100in the secondstage of expansion. This processcan continueuntil depositshave risen to the point whereallthe reservesprovided by the initialpurchaseof governmentsecuritiesby the Federal ReserveSystemare just sufficientto satisfyreserverequirementsagainstthe newly created deposits. (Seepages 10and 1I.) Theindividualbank, of course,isnot concerned as to the stagesof expansionin which itmay be participating. Mows and outflowsof depositsoccurcontinuously. Any depositreceived isnew money,regardlessof itsultimate source. Butif bank policyisto makeloansand invest- ments equaltowhatever reservesarein excessof legal requirements,the expansionprocesswill be carriedon. How Much Can Deposits Expand in the Banking System? Thetotalamountof expansionthat cantakeplace is illustrated onpage 11. Carriedthrough to theoretical limits,the initial$10,000of reserves distributedwithinthe banking systemgivesrise to an expansion of $90,000in bank credit (loans and investments) and supportsa total of $100,000in new depositsunder a 10percent reserver e quirement. The depositexpansionfactorfor a given 8 Modern Monqr Mechanics amountof new reservesisthus the reciprocal of the r e quiredreservepercentage (1/.10 = 10). Loan expansion willbe lessby the amountof the initialinjection. Themulti- ple expansionispossible becausethe banksasa group arelike onelargebank inwhich checks drawnagainst borrowers' depositsresult in creditsto accountsof other depositors,with no net changein total reserves. Expansion through Bank Investments Depositexpansioncanproceed ii-ominvestments aswell asloans. Supposethatthe demandforloansat someStage 1banks isslack Thesebankswould then probablypurchasesecurities. If the sellersof the securities were customers,the bankswould makepaymentby credit- ingthe customers'transaction accounts;depositliabiities would risejust asif loanshad been made. Morelikely, thesebankswould purchasethe securitiesthrough deal- ers,paying forthem with checkson themselvesor ontheir reserveaccounts. Thesecheckswould be depositedin the sellers'banks. In eithercase,the net effectsonthe banking systemareidenticalwith those resultingfrom loan operations.
As a result of theprocess sofar, totalassetsand totalliabiitiesof allbankstogetherhave risen Assets Reserveswith F.R. Banks + 10,000 Loans + 9,000 Total + 19.000 Liabilities Deposits: Initial + 10,000 Stage I + 19,000 Excessreserveshave been reduced by the Total reservesgainedfrom initialdeposii............................ 10,000 .............amountrequiredagainstthe depositscreated less: Requiredagainstinitialdeposits 1,000 ............ ......by the loansmade in Stage 1. lets: RequiredagainstStage I deposits 900 1,900 eq& Excess reserves........................................................ 8,100 Whydothesebankssmincreasingtheirloans and depositswhentheystill have excessreserves? ...becauseborrowerswrite checksontheir accountsatthe lendingbanks. As these checks I I are depositedin thepayees' banksand cleared, Assets Liabilities the depositscreatedby Stage 1loansand an Reservesv equalamountof reservesmay be transferred rF.R. Banks to otherbanks. vith - 9,000 Deposit expansion hasjust begun! Borrower deposits - 9,000 Assets Liabilities Assets Liabilities J Deposit Erpansionand Contmctwn 9 Reserveaccounts: Reserveswith Stage I banks - 9,000 2 F . R . Banks + 9,000 Other banks + 9,000 Deposits + 9,000
7 8 to Stage 3 banks Expansioncontinuesasthebanksthathave excessreservesincreasetheirloansby that amount, creditingborrowers' depositaccounts Assets Liabilities in the process, thus creatingstillmore money. 9 Loans + 8,100 NOWthe bankingsystem'sassetsandliabilities have risen by 27,100. Assets Liabilities ..........................Butthere arestill7,290of excessreservesin the Total reservesgainedfrom initialdeposits 10,000 ............bankingsystem. less: Requiredagainst initialdeposits 1,000 less: Requiredagainst Stage I deposii............ 900 less: Requiredagainst Stage2 deposits ............ 810.... a It should be understood that thestages ofexpansionoccurneithersimultaneously nor in thesequence demibed above. Some banks use theirresmes incompletelyor only aftera considerable time lag, whileothersexpand assetson the basis of expected resemegrowth. m eprocess is, infact,continuousand may neverreach its theoretical limits. Borrower deposits + 8,100 Reserveswith F.R Banks + 10,000 Loans: Stage I + 9,000 Stage 2 + 8,100 Total + 27,100 ......................................................eq& Excessreserves 7,290 10 10 1 Modem M m q Mahatub Deposits: Initial + 10,000 Stage I + 9,000 Stage 2 + 8,100 Total + 27,100 As borrowersmake payments,these reserveswill be furtherdispersed,andthe processcan continuethrough manymore stages,in progressivelysmallerincrements,until the entire 10,000of reserveshave been absorbed by depositgrowth. Asisapparentfromthe summarytableonpage 11,more than tw&hiidsof the deposit expansionpotential isreached afterthe firstten stages.
Assets Reserves Total [Required] [Excess] Initial reserves provided ................... 10*000 1.000 9.000 Expansion- Stage l ..................... 10.000 1,900 8.100 Stage 2 ..................... 10.000 2.710 7.290 Stage3 ..................... 10.000 3.439 6,561 Stage 4 ..................... 10.000 4,095 5.905 Stage 5 ..................... lO.Oo0 4.686 5.3 14 Stage 6 ..................... 10,000 5,2 17 4.783 Stage 7 ..................... 10,000 5,695 4.305 Stage 8 ..................... 10,000 6. 126 3.874 Stage 9 ..................... lo,000 6.513 3.487 Stage I 0 ................... lo.000 6.862 3.I38 Stage 20 ................... 10.000 8.906 1.094 Final stage................ 10,000 / 0.000 0 Loans and Investments Liabilities Deposits 10.000 Deposit wowtar a& Corfmctiopz
How Open Market Sales Reduce Bank Reserves and Deposits Now supposesomereductionin the amountof money isdesired. Nonnally thiswould reflecttemporary or seasonalreductionsin activityto be hawed since,on ayear-to-yearbasis, agrowing economyneeds atleast somemonetary expansion. Just aspurchasesof govern- ment securitiesby the pederal ReserveSystemcan pre vide thebasisfor depositexpansionby addingto bank reserves, salesof securitiesby the Federal ReserveSystem reduce the money stockby absorbingbank reserves. The processisessentiallythe reverseof the expansionsteps just described. Supposethe FederalReserveSystemsells$10,000of Treasuryb i s to a U.S. governmentsecuritiesdealerand receivesinpaymentan "electronic"checkdrawnonBank A Asthispaymentismade,BankA's reserveaccountat a FederalReserveBank isreduced by $10,000. As a result, the FederalReserveSystem's holdingsof securitiesand the reserve accountsof banks areboth reduced $10,000. The$10,000reductionin BankA's depositliabilitiesconsti- tutes a declinein the money stock. Seeillustration 11. Contraction Also Is a Cumulative Process While BankA mayhave regainedpart of the initial reduction in depositsfromotherbanksasa result of inter- bank depositflows,allbankstaken togetherhave $10,000 lessin both depositsand reservesthan they had before the FederalReserve's salesof securities. The amountof reservesfreed by the declinein deposits,however,isonly $1,000(10percent of $10,000). Unless thebanksthatlose the reservesand depositshad excessreserves,they are leftwith a reserve deficiencyof $9,000. See illustration 12. Although they mayborrow fromthe Federal Reserve Banksto coverthis deficiencytemporarily,soonerorlater the bankswill have to obtainthe necessary reservesin someotherway or reducetheir needsfor reserves. Oneway for a bank to obtainthe reservesit needs isby sellingsecurities. But, asthe buyersof the securities pay forthemwith fundsin their depositaccountsin the sameor otherbanks, the net result isa $9,000declinein securitiesand depositsat allbanks. See illustration 13. At the end of Stage 1of the contractionprocess, deposits have been reduced by a totalof $19,000 (theinitial $10,000 resultingfrom the Federal Reserve's action plus the $9,000 in depositsextinguishedby securitiessalesof Stage 1 banks). See illustration 14. However,thereisnowa reservedeficiencyof $8,100 atbankswhose depositorsdrewdown their accountsto purchasethe securitiesfrom Stage 1banks. Asthe new groupof reservedeficientbanks,in turn,makesup this deficiencyby sellingsecuritiesor reducingloans,further depositcontractiontakesplace. Thus,contractionproceedsthrough reductionsin depositsandloansor investmentsin one stageafteranoth- er until total depositshave been reduced to the point 12 / Modem MoneyMnhanics wherethe smallervolume of reserves isadequateto sup port them. The contractionmultipleisthe sameasthat which appliesin the caseof expansion. Under a 10percent reserverequirement,a $10,000reductionin reserveswould ultimatelyentailreductions of $100,000in depositsand $90,000inloansandinvestments. As in the caseof depositexpansion,contractionof bank depositsmay take place as a result of eithersalesof securitiesorreductions of loans. While someadjustments of both kinds undoubtedlywould be made,the initialim- pactprobablywould be reflectedin salesof government securities. Mosttypes of outstandingloanscannotbe calledforpayment prior to their due dates. Butthe bank may ceaseto make newloansor refuse to renewoutstand- ingonesto replacethosecurrentlymaturing. Thus,depos itsbuilt up by borrowersfor the purposeof loan retirement would be extinguished asloanswere repaid. There is oneimportantdifferencebetween the expan- sion and contractionprocesses. Whenthe FederalReserve Systemaddsto bank reserves,expansionof creditand depositsmay take place up to the limitspermittedby the minimum reserveratio that banksarerequired to maintain. Butwhen the Systemactsto reducethe amountof bank reserves,contractionof creditand depositsmust takeplace (exceptto the extentthat existingexcessreserve balances and/or surplusvaultcash areutilized) to the pointwhere the required ratio of reserves to depositsisrestored. But the signi6canceof this difference shouldnot be overempha- sized. Becauseexcessreservebalancesdonot earninter- est, there isa strongincentiveto convertthem into earning assets (loansand investments).
Assets Liabilities Liabilities 11 U.S. government Reserve accounts: Reserveswith 1Customer securities -10,000 BankA - 10,000 W F . R Banks - 10,000 deposit - 10,000 When the Federal Reserve Bank sellsgovernment securities,bank reservesdecline. This happens because the buyer of the securitiesmakespayment through a debitto a designated depositaccountat a bank (BankA),with the transferof fundsbeing effectedby a debitto BankA's reserveaccountat the Federal Reserve Bank. lXisreduction in the customerdepositat Bank A may be spread among a numberof banks throughhtedank depositflows Contraction-Stage 1 I The bankswith the reservedeficiencies (Stage 1 banks) cansellgovernmentsecuritiesto acauire 12 1 I reserves,but thiscauses a declinein the debsits &sets Liabilities The loss of reservesmeansthat allbanks taken Total reserveslostfrom deposawithdrawal...................... 10,000 together now have a reservedeficiency. less Reservesfreed bydeposiidecline (at 10 percent) ..................................................... 1,000 equals Mciency in reservesagainst remainingdepostts. 9,000 and reservesof the buyers' banks. U.S. government securities - 9,000 Reserveswith + 9,000 As a resultof the processsofar, assets and total depositsof allbankstogether havedeclined 19,000. Assets Liabilities Assets Liabilities J Stage 1contractionhas freed 900of reserves,but Liabilities there is stilla reservedeficiencyof 8,100. Reserveswith Deposits: F.R. Banks US.government Stage I securities 9,000 Total - 19.000 Reserve accounts: Reserveswith Stage I banks + 9,000 9 F . R . Banks - 9,000 Other banks - 9,000 I Futthncontractionmust take#lace! Deposits - 9,000 Deposit E*palrtion and Contraction 13
Bank Reserves-How l%eyChange Moneyhas been detined asthe sum of transaction accountsin depositoryinstitutions,and currencyandtrav- elerschecksin the hands of the public. Currencyis some thingalmosteveryoneuses everyday. Therefore,when mostpeoplet h i i of money,theythink of currency. Con- traryto this popular impression,however,tmtlsactiolr depositsarethe most signiscantpart of the moneystock Peoplekeep enoughcurrencyon hand to effect smallface teface transactions,but theywrite checksto covermost largeexpenditures. Most businessesprobablyhold even smalleramountsof currencyin relationto theirtotaltrans actionsthan do individuals. Sincethe mostimportantcomponentof moneyis transactiondeposits,and sincethese depositsmustbe sup ported by reserves,the centralbank's influenceovermon- eyhingeson itscontroloverthe totalamountof reserves and the conditionsunderwhich bankscan obtain them. The preceding illustrationsof the expansionand contractionprocesseshave demonstratedhow the central bank, by purchasing and sellinggovernmentsecurities, can deliberatelychangeaggregatebank reservesin order to affectdeposits. But open market operationsare only one of a number of kinds of transactionsor developments that causechangesin reserves. Somechangesoriginate from actionstakenby the public,by theTreasuryDepart- ment, by the banks, orby foreign andinternationalinstitu- tions. Otherchangesarisefromthe servicefunctionsand operatingneedsof the Reserve Banksthemselves. Thevariousfactorsthat provide and absorbbank reserve balances,togetherwith symbolsindicatingthe effectsof these developments,arelistedonthe opposite page. Thistabulation alsoindicatesthe nature of the bal- ancingentriesonthe Federal Reserve's books. Co the extentthat the impactisabsorbedby changesinbanks' vaultcash,the Federal Reserve's books are unaffected.) Independent FadorsVersus PolicyAction It isapparentthat bank reservesare affectedin sev- eralways thatare independentof the controlof the central bank. Most of these "independent?elementsare changing more orlesscontinually. Sometimestheir effectsmay last only a day or twobeforebeiig reversed automatically. Thishappens,forinstance,when bad weatherslowsup the checkcollectionprocess,givingrise to an automaticin- creasein Federal Reserve creditin the form of "float." Otherinfluences,suchaschangesin the public's currency holdings,may persistforlongerperiodsof time. Stillothervariationsin bank reservesresult solely from the mechanicsof institutionalarrangementsamong theTreasury,the FederalReserveBanks,and the deposi- tory institutions. TheTreasury,for example,keepspart of itsoperatingcash balanceon depositwith banks. But virtually all disbursementsare made from itsbalancein I4 I Modern Money Mechanics the ReserveBanks. As is shownlater, anybuildupin bal- ancesatthe ReserveBanksprior to expenditureby the Treasurycausesa dollar-fordollardrainon bank reserves. In contrastto these independentelementsthat affect reservesare the policy actionstaken by the Federal Re serveSystem. Theway Systemopen market purchases and salesof securitiesaffectreserveshas alreadybeen d e scribed. In addition,there are two otherwaysin which the Systemcanaffectbank reservesand potentialdepositvol- ume directly:first,through loansto depositoryinstitutions; and second,through changesin reserve requirementper- centages. A changein the required reserveratio,of course, doesnot alterthe dollarvolume of reserves directlybut doeschangethe amount of depositsthat a givenamount of reservescan support. Any changein reserves,regardlessof itsorigin,has the samepotentialto affect deposits. Therefore,in orderto achievethe net reserve effectsconsistentwith itsmonetary policy objectives,the FederalReserveSystemcontinuously must take accountof what the independentfactorsare doingto reservesand then,using itspolicytools,offsetor supplementthem asthe situationmay require. By farthe largestnumber and amount of the Sys tern's gross open markettransactionsare undertaken to offset drainsfrom or additionsto bank reservesfrom non- FederalReservesourcesthat mightotherwisecauseabrupt changesin creditavailabiity. In addition,Federal Reserve purchasesand/or salesof securitiesare madeto provide the reservesneeded to supportthe rate of moneygrowth consistentwith monetary policy objectives. In this section of the booklet, severalkindsof trans- actionsthat canhave importantweek-to-weekeffectson bank reservesare traced in detail. Other factorsthat nor- mallyhave onlya smallinfluenceare describedbrieflyon page 35.
Facton ChangingReserve Balances-lndefiendent and Assets Liabilities Public actions ....................................................................lncrease in currency holdings ..................................................................Decrease in currency holdings Treasury, bank, and foreign actions Increase in Treasury deposits in F.R. Banks ........................................... Decrease in Treasury deposits in F.R. Banks ......................................... Gold purchases (inflow) o r increase in official valuation* ................... Gold sales (outflow)* .................................................................................. Increase in SDR certificates issued* ......................................................... Decrease in SDR certificates issued* ...................................................... Increase in Treasury currency outstanding* .......................................... Decrease in Treasury currency outstanding* ........................................ Increase in Treasury cash holdings* ......................................................... Decrease in Treasury cash holdings* ...................................................... increase in service-related balancesladjustments.................................. Decrease in service-related balancesladjustments ............................... Increase in foreign and other deposits in F.R. Banks ........................... Decrease in foreign and other deposits in F.R. Banks ......................... Federal Reserve actions ...................................................... ...................................................... ................................................... Increase in Federal Reserve float ............................................................. Decrease in Federal Reserve float ........................................................... ..........................lncrease in assets denominated in foreign currencies .......................Decrease in assets denominated in foreign currencies increase in other assets** .......................................................................... ........................................................................Decrease in other assets** Increase in other liabilities** ..................................................................... ...................................................................Decrease in other liabilities** Increase in capital accounts** ................................................................... .................................................................Decrease in capital accounts** * These factors represent assets and liabilities of the Treasury. Changes in them typically affect reserve balancesthrough a related change in the Federal Reserve Banks' liability "Treasury deposits." ** Included in "Other Federal Reserve accounts" as described on page 35. *** Effect on excess reserves. Total reserves are unchanged. Note: To the extent that reserve changes are in the form of vault cash, Federal Reserve accounts are not affected. Facton flfectitzg Balk Reserves 15
Changesin theAmount of CuvmcyHeld by thePublic Changesin the amountof currencyheld by the public typicallyfollowa fairlyregularintramonthlypattern. Majorchangesalsooccur overholidayperiods and during the Christmasshoppingseason-timeswhen peoplefind itconvenientto keep more pocketmoney onhand. (See chart.) Thepublic acquirescurrencyfrombanksby cash- ingchecks6 When deposits,which arefractionalreserve money,areexchangedfor currency,which is 100percent reserve money,thebanking systemexperiencesa net reserve drain. Under the assumed 10percent reserve requirement,agivenamountof bank reservescan support depositsten times asgreat,but when drawnupon to meet currencydemand,the exchangeisoneto one. A $1in- creasein currencyusesup $1of reserves. Supposea bank customercashed a $100checkto obtaincurrencyneeded for aweekend holiday. Bank depositsdecline$100becausethe customerpaysfor the currencywith a checkonhis orher transactiondeposit; and thebank'scurrency (vaultcash reserves) isalso r e duced $100. See illustration 15. Now the bank has lesscurrency. It may replenish itsvaultcashby orderingcurrencyfromitsFederalRe serveBank -makingpaymentby authorizinga charge to itsreserve account. Onthe ReserveBank's books,the chargeagainstthe bank'sreserveaccountisoffsetby an increasein theliabilityitem "FederalReservenotes." See illustration 16. The ReserveBank shipmentto thebank mightconsist,atleastin part, of US. coinsratherthan FederalReserve notes. All coins,aswell asa smallamount of paper currencystilloutstandingbut no longerissued, are obligationsof theTreasury. Tothe extentthat ship ments of cash to banksarein the formof coin,the offset- ting entryon the ReserveBank's books isa declinein its assetitem "coin." Thepublic nowhas the samevolumeof money as before,exceptthat more isin the formof currency and lessis in the form of transactiondeposits. Under a 10 percent reserve requirement,the amountof reservesre- quired againstthe $100of depositswas only$10,while a full$100of reserveshave been drainedawayby the dis bursement of $100in currency. Thus,if the bank had no excessreserves,the $100withdrawalin currencycausesa reserve deficiencyof $90. Unlessnewreservesarepro- videdfrom someother source,bank assetsand deposits will haveto be reduced (accordingto the contractionpro- cessdescribedon pages 12and 13)by an additional$900. At thatpoint, the reservedeficiencycaused by the cash withdrawalwould be eliminated. When CurrencyReturns to Banks, Reserves Rise Afterholidayperiods,currencyreturnsto the banks. Thecustomerwho casheda checkto coveranticipated cashexpendituresmaylaterredepositanycurrency still held thafs beyond normal pocketmoney needs. Most of it 16 / Modern Money Mechanb Currency heldby the public weekly averages, billions of dollars, not seasonally adjusted probablywill have changedhands, and itwill be deposited by operatorsof motels,gasoline stations,restaurants,and retail stores. Thisprocessisexactlythe reverseof the currencydrain,exceptthatthe bankstowhichcurrency isreturned may not be the samebanks thatpaid itout. But in the aggregate,the banksgain reservesas 100 percentreserve money isconvertedback intofractional reservemoney. When $100of currencyisreturned to the banks, depositsandvaultcash are increased. See illustration 1Z Thebanks cankeep the currencyasvaultcash,which also countsasreserves. Morelikely,the currencywill be shippedto the ReserveBanks. The ReserveBankscredit bank reserve accountsand reduce Federal Reservenote liabiities. See illustration 18. Sice only$10must be held againstthe new$100in deposits,$90isexcessreserves and cangiverise to $900of additionaldeposits. To avoidmultiplecontractionor expansionof deposit money merely becausethe public wishesto changethe compositionofitsmoneyholdings,the effectsof changes in the public's currencyholdings on bank reservesnor- mally areoffsetby System open marketoperations. 6Thesame balance sheet entries applywhether the individualphysically cashesapapercheckorobtainscurrencybywithdrawingcashthrough an- - automati; tkllermachine. - - 'Under current reserve accounting regulations,vault cash reserves are used tosatisfyreserverequirements inafuturemaintenanceperiodwhile reserve balances sati* requirements in the currentperiod. As a result, theimpactonabank's currentreservepositionmaydifferfromthat shown unless the bank restores its vault cash position in the current period via changes in its reserve balance.
15! When a depositorcashesa check,both depositsandvaultcash reserves decline. I Assets Liabilities Vault cash reserves Deposits -100 Assets Liabilities Assets Liabilities Reserve accounts: Vault cash +I00 Bank A Reserveswith F.R. notes +I00 F.R. Banks - 100 16 When currencycomesback to the banks, both depositsandvaultcash reservesrise. If the bank replenishesitsvaultcash,itsaccountat the ReserveBank is drawn downin exchangefornotes issued by the Federal Reserve. Assets Vault cash reserves +I00 Liabilities If the currencyisreturned to the Federal Reserve,reserveaccountsarecredited and Federal Reserve notes aretaken outof circulation. Assets Liabilities Assets Vault cash - 100 Reserveswith FA. notes F.R. Banks +I00 Liabilities I FactorsAfecting Bark Reserues 17
Changesin US. Treasury Depositsin Federal Bank Reserveaccountsof depositoryinstitutionsconsti- tutethe bulk of the depositliabilitiesof the FederalRe- serveSystem. Otherinstitutions,however,alsom & ~ n balancesin the Federal ReserveBanks-mainly the U.S. Treasury,foreigncentralbanks, and internationalhancial institutions. In general,when these balances rise, bank reserves fall,and viceversa. 'I'his occursbecausethe fundsu se agenciesto build up their depositsin the Res s ultimatelycomefrom depositsin banks. Gonvemly,recipientsof paymentsfrom these agenciesnormallydepositthe fundsin banks. the collectionprocessthese banks receivecre reserve accounts. rtant nonbank depositoristhe US. Treasury. Partof theTreasury's ope iskeptin the Federal ReserveBanks, depositoryinstitutionsalloverthe counm,in d l e d 'Treasury tax andloan" m&L) note accounts. a&) Disbursementsby theTreasury,h madeagainstitsbalances atthe Federal Reserve. Thus, transfersfrombanks to Federal ReserveBanks are made throughregularlyscheduled"calls"on TT&Lbalancesto assurethat sufficientfundsare availableto coverTreasury checksasthey arepresented for payment8 CallsonTT&Lnoteaccountsdrainreservesfrorn the banksby the fullamountofthe transferasfundsmove frorntheTT&Lbalances (Via chargesto bank reserve accounts)toTreasurybalances at the ReserveBanks. Becausereservesare not required againstTT&Lnote accounts,these transfers do not reducerequired reserves? SupposeaTreasurycallpayableby BankA amounts to $1,000. The Federal Reserve Banksare authorized to transfer the amountof theTreasurycallfromBankA's reserve accountatthe FederalReserve to the account of the U.S. Treasuryatthe FederalReseme. As a result of the transfer,both reservesandTT&Lnotebalancesof the bank arereduced. On the books of the ReserveBank, bank reserves declineandTreasurydepositsrise. Thiswithdrawalof Treasuryfundswill causea reserve deficiencyof $1,000sinceno resemes are releasedby the declineinlT&Lnote accountsatdeposi- tory institutions. As theTreasurymakes expenditures,checksh w n on itsbalancesin the ReserveBanksare paid tothe public, andthese fundsiindtheirway back to banksin the form of deposits. The banks receive reserve creditequalbthe full amountof these depositsalthoughthe corresponding increasein theirrequired reservesis only 10percent of thisamount. Modem MoneyMechanics -- ---- -- - -- -- Operatingcash balanceof the US. Treasury weekly averages, billions of dollars, not seasonally adjusted Supposea governmentemployeedepositsa $1,000 checkin Bankk The bank sendsthe checkto itsFederalReserveBankfor collection. The Reserve Bank then creditsBankATsreserve accountand chargesthe Treasury's account. As a result, thebank gainsboth re- servesand deposits. Whilethere is no changein the as- setsortotalliabilitiesof the Reserve Banks,the funds drawn awayfrom theTreasury's balances havebeen shift- ed to bank reserve accounts. One of the objectivesof theTT&Lnoteprogram, which requiresdepositoryinstitutionsthatwant to hold Treasuryfundsfor more than onedayto pay intereston them,isto allowtheTreasuryto hold itsbalanceatthe ReserveBanksto the minimum consistentwith current paymentneeds. By mainMng a fairlyconsmt balance, largedrainsfrom oradditionsto bank reservesfromwide swingsin theTreasury's balancethat would requireexten- siveoffsettingopenmarket operationscan be avoided. Nevertheless,there are stillperiodswhen these fluctua- tionshave large reserveeffects. In 1991,forexample, week-to-weekchangesinTreasurydepositsatthe Reserve Banks averaged only$56million,but ranged from"$4.15 biion to +$8.57billion. When theTreasurykbalanceattheFederalReserverisesaboveexpected payment needs, the Treasury m y place the excess funds in lT&L note accountslfirough a "direct investment." The accountingentries are the same, but of opposite signs,as those shown when funds are transferred from'lT&L note accountstoTreasurydeposits atthe Fed. *TmpaymenbreceivedbyinstitutionsdesignatedasFederaltaxdepositar- ies initially are credited to reservable demand deposits due to the U.S. govement. Becausesuch tax paymentstypicallycomefrom reservable transactionaccounts,required reservesarenot materiallyaffectedon this day, Onthenextbusinessday,however,whenthesefundsareplacedeither in a nonreservable note account or remitted to the Federal Reserve for creditto theTreasury'sbalanceatthe Fed, required reservesdecline.
Assets 19 Liabilities Assets Liabilities When theTreasurybuildsupitsdepositsat the Federal Reservethrough"calls"on?T&L notebalances, reserveaccountsarereduced. Reserve accounts: Reserveswith Bank A - 1.000 f---,F.R Banks U.S.Treasury deposits +1,000 Treasury tax and loan note account - 1,000 Liabilities Assets Liabilities 20 Reserve accounts: Reserveswith Bank A +1.000UF.R. Banks U.S.Treasury deposits - 1.000 Checkswrittenon theTreasury's accountatthe Federal ReserveBank aredepositedin banks. As these are collected,banksreceivecreditto theirreserveaccountsatthe Federal ReserveBanks. Privatedeposits +1.000 FactonMeetingBank RCSCNCS 19
Changesilz Federal Reseme Float Alargeproportionof checksdrawnonbanks and depositedin otherbanksiscleared (collected)through the Federal ReserveBanks. Someof thesechecksarecredit- ed immediatelytotheresem accountsof the depositing b& and arecollectedthe samedayby debitingthe reserve accountsof the banksonwhichthe checksare drawn. All checksarecreditedto theaccountsof the depositingbanksaccordingtoavailabilityschedules relatedtothe timeitnormallytakesthe FederalReserveto collectthe checks,but rarelymore thantwobusiness days aftertheyarereceived atthe ReserveBanks,eventhough they may notyethavebeen collected dueto processing, mspomtion, or otherdelays. Thereservecreditgivenforchecksnotyetcollected isincludedin FederalResenre Onthe booksof the FederalReserveBanks,balance sheetfloat, orstate- mentfloatasitissometimescalled,isthe differencebe- tweenthe asset account"itemsin processof collection," andthe liabiityaccount"deferredcredititems." State- mentfloatisusuallypositive sinceitismore oftenthecase thatreserve creditisgivenbeforethe checksareactually collectedthan the otherwayaround. Publisheddataon FederalReservefloatarebased on a"reserves-fadof' frameworkratherthan abalance sheetaccountingkamework. Aspublished,Federal Re- servefloatincludesstatementfloat,asdehned above,as wellasfloat-related"as-of' adjustments." Theseadjust- mentsrepresentcorrectionsforerrorsthatarisein pro- cessingtransactionsrelated to Federal Reservepriced services. As-ofadjustmentsdonot changethebalance sheetsof eitherthe Federal ReserveBanksoran individ- ualbank. Rather they arecorrectionstothe bank'sreserve position,thereby affectingthe calculationof whether or notthebank meetsitsreserverequirements. An Increase in Federal Reserve kink Reserves Asfloatrises, totalbank reservesrise by the same amount. For example,supposeBankAreceiveschecks totaling$100drawnon BanksB, C,and D, allin distant cities. BankAincreasesthe accountsof itsdepositors $100,and sendsthe itemsto aFederalReserveBankfor collection. Upon receipt of the checks,the ReserveBank increasesitsownassetaccount"itemsin processof collec- tion,"andincreasesitsliabilityaccount"deferredcredit items" (checksand other itemsnotyet creditedta the sendingbanks' reserveaccounts). Aslongasthesetwo accountsmove together,there isno changein floator in totalreservesfromthis source. See illustmtiotz21. On the next businessday (assumingBanksB, C, and D are oneday deferred availabilitypoints), the Re- serveBankpaysBankA. The ReserreBank's "deferred credititems"accountisreduced,and BankA's reserve accountisincreased $100. If theseitemsactuallytake morethan onebusinessdayto collectsothat "items in 10 / Modem Momy Mechanics FederalReservefloat (includingas-of adjustments) annual averages, billions of dollars 81 processof collection*arenot reducedthat day,the credit to BankA representsan addition to totalbank reserves sincethe reserveaccountsof BanksB, C,and Dwillnot havebeen commensmtelyreduced.= See iEZusl.ration22. A Decline in Fed Reserve Float Reduces Bamk Remrves Onlywhen the checksareactuallycollectedfrom BanksB, C,and D doesthe floatinvolvedin the aboveex- ampledisappear-"items in processof collectioni'of the Reserve Bank declineasthe reserveaccountsof BanksB, C,and D are reduced. See illustration23. On anannualaveragebasis,FederalReservefloat declineddramaticallyfrom 1979through 1984,in part reflectingactionstaken to implementprovisionsof the MonetaryControlAct that directedthe Federal Reserveto reduce andpricefloat. (Set: chant.) Since1984,Federal Reservefloathas been fairlystableon anannualaverage basis,but oftenfluctuatessharplyover shortperiods. From the standpointof the effectonbank reserves,the significantaspectof floatisnotthatitexistsbutthatits volumechangesin a difticdt-to-predictway. Floatcan increaseunexpectedly,forexample,if weatherconditions groundplanestransportingchecksto payingbanksfor collection. However,suchperiodstypicallyarefollowed by oneswhere actualcollectionsexceed newitemsbeing received for collection. Thus,reservesgainedfromfloat expansionusuallyare quitetemporary. '"Federal Reserve float also arises from other funds transfer sentices provided by the Fed, such as wire transfers, securities transfers, and automaticclearinghousetransfers. "As-ofadjustmentsalsoareusedasonemeansofpricingfloat,asdiscussed on page22,andfornonfloat-relatedcorrections,asdiscussedonpage35. I2If thechecksreceivedfromBankAhadbeenerroneouslyassignedatwo- day deferred availability,then neitherstatementfloatnor reserveswould increase,although both should. BankA's reservepositionandpublished FederalReservefloatdataarecorrectedforthisandsimilarerrorsthrough asof adjustments.
Assets 21 Items in process of collection +I00 When a bank receives depositsin the formof checksdrawn onotherbanks, itcan send them to the Federal ReserveBank for collection. (Required reserves arenot affected immediatelybecauserequirementsapplyto net transactionaccounts,i.e., total transactionaccountsminus both cash itemsin processof collectionand depositsduefrom domesticdepositoryinstitutions.) Liabilities Assets Liabilities Assets Deferred Cash items in credit items +I00 process of collection +I00 22 Liabilities Assets Deferred Cash items in credit items -100 processof Reserve accounts: collection - 100 Bank A Reserves with F.R. Banks +I00 Deposits +I00 Ifthe reserveaccountofthe payee bank iscreditedbeforethe reserveaccountsof the payingbanksaredebited, total reservesincrease. Liabilities Assets 23 Items in process of collection - 100 But upon actualcollectionof the items,accountsof the payingbanks arecharged,andtotalreservesdecline. Liabilities Assets Liabilities Reserveaccounts: Bank B -100 Bank D Facton qdFectingBank R-LS 21
Changesin Service-RelatedBalances andA&&ments In orderto fostera safeand efficientpaymentssystem, the Federal Reserve offersbanksavarietyof paymentsser- vices, Priorto passage of the Monetary ControlAct in 1980, the Federal Reserve offeredits servicesfree,but onlyto banksthat were membersof the Federal ReserveSystem. TheMonetaryControlAct directed the Federal Reserveto offeritsservicesto alldepositoryinstitutions,to chargefor these services,and to reduceandprice FederalReserve float.13 Except forfloat,allservicescovered by theActwere pricedby the end of 1982. Implementationof floatpricing essentiallywascompleted in 1983. Theadvent of FederalReservepriced servicesled to severalchangesthat affectthe use of fundsin banks' re- serveaccounts. As a result,onlypart of the totalbalancesin bank reserve accountsisidentifiedas"reservebalances" availableto meet reserverequirements. Otherbalancesheld in reserveaccountsrepresent "service-relatedbalancesand adjustments (tocompensateforfloat)." Service-relatedbal- ancesare"requiredclearingbalances"held by banksthat use FederalReserve serviceswhile"adjustments"representbal- ancesheld by banksthatpay for floatwith as-of adjustments. An Increase in Required Clearing B b c e s Reduces Reserve Balances Proceduresfor establishingand maintainingclearing balances were approvedby the Board of Governorsof the FederalReserve Systemin February 1981. Abank may be requiredto hold a clearingbalanceif ithas no required re- servebalance or if itsrequired reservebalance (held to satis- fy reserverequirements) isnotlargeenoughto handle its volumeof clearings. Tmicallya bank holdsboth reservebal- ancesandrequired clearingbalancesin the samereserve account. Thus,asrequired clearingbalancesareestablished or increased,theamountof fundsin reserveaccountsidenti- fiedasreserve balancesdeclines. SupposeBankAwants to use FederalReserve services but has a reserve balance requirementthatislessthan its expected operatingneeds. With itsReserveBank,it isdeter- mined that Bank Amust maintain a required clearingbalance of $1,000. If BankA has no excessreservebalance, itwill have to obtainfundsfrom someother source. Bank Acould sell$1,000of securities,but thiswill reducethe amountof totalbank reservebalancesand deposits. See illrkstration24. Banksarebilled eachmonthfor the Federal Reserve servicesthey have used with paymentcollected ona speci- fieddaythe followingmonth. All requiredclearingbalances held generate"earningscredits"which canbe used onlyto offsetchargesfor FederalReserve services.14Alternatively, bankscanpay for servicesthrough a directchargeto their reserve accounts. If accrued earningscreditsare used to pay for services,then reservebalancesareunaffected. On the otherhand,if paymentfor servicestakesthe form of a direct chargeto thebank's reserveaccount,then reservebalances decline. See illustrafian25. 22 Mudai Money M~ckanlo Service-relatedbalances and adjustments weekly averages, billions of dollars, not seasonally adjusted -Of Adjushents Reduce In 1983,the Federal Reservebegan pricing explicitly forfloat,15specifically"interterritory"checkfloat,i.e., float generated by checksdepositedby a bank servedby oneRe- serveBank but h w n ona bank servedby anotherReserve Bank. The depositingbank has three optionsin payingfor interterritorycheckfloatitgenerates. It can use itsearnings credits,authorizea direct charge to itsreserveaccount,or payfor the floatwith an as-of adjustment. If eitherof the first two optionsischosen,the accountingentriesarethe sameas payingfor otherpriced services. If the as-of adjustmento p tion ischosen,however,the balance sheetsof the Reserve Banksand the bank arenot directlyaffected. In effectwhat happensisthatpart of the total balancesheld in thebank's reserveaccountisidentifiedasbeing held to compensatethe Federal Reserveforfloat. Thispart, then,cannotbe used to satisfyeitherreserverequirementsor clearingbalancere- quirements. Floatpricingas-ofadjustmentsareapplied two weeks afterthe related floatisgenerated. Thus, an individual bank has sufticienttime to obtain fundsfrom other sourcesin orderto avoid anyreserve deficienciesthatmightresult from floatpricingas-of adjustments, If allbankstogetherhave no excessreserves,however,thefloatpricing as-of adjustments lead to a declinein totalbank reservebalances. Week-to-weekchangesin service-relatedbalancesand adjustmentscan bevolatile,primarily reflecting adjustments to compensateforfloat. (See cilart,) Sincethese changes areknown in advance,anyundesired impacton reserve bal- ancescanbe offseteasilythrough open market operations, 'The Act specified that fee schedules cover services such as check clearing and collection, wire transfer, automated clearinghouse, settle- ment, securitiessafekeeping, noncash collection, Federal Reserve float, and any new servicesoffered. M"Eamingscreditsn are calculated by multiplying the actual average c l e a ~ gbalanceheld overamaintenanceperiod,upto that requiredplus theclearingbalanceband,timesaratebasedonthe averagefederalfunds rate. The clearing balance band is 2 percent of the required clearing balanceor$25,000,whichever amountis larger. *Whilesometypes of floatarepriceddirectly,the FederalReserveprices othertypesoffloatindirectly,forexample,by includingthecostoffloatin the per-itemfeesforthe priced service.
When BankA establishesa requiredclearing balanceata FederalReserveBank by selling - balance +1.000 Assets securities,the reserve balances and depositsof Assets otherbanksdecline. U.S. government securities - 1,000 Reserveaccount with F.R. Banks: Requiredclearing Liabilities Reserveaccounts: Requiredclearing balances: Bank A +1,000 4- Reserve balances: Liabilities Liabilities Reserveaccounts with F.R Banks: Other banks - 1,000 Deposits .. -1,000 When BankA isVied monthly for FederalReserveservicesused, itcan pay for these servicesby having earningscreditsapplied and/or by authorizinga directchargeto itsreserve account SupposeBankA has accrued earningscreditsof $100but incursfeesof $125.Then both methodswould be used. On the Federal Reserve Bank's books,the liabiityaccount "earningscreditsdueto depositoryinstitutions"declinesby$100 and BankA's reserve account isreduced by $25. Offsettingthese entriesisa reduction in the Fed's (other) assetaccount "accrued serviceincome." On BankA'sbooks, the accountingentriesmight be a $100reduc- tion to itsassetaccount "earningscreditduefrom FederalReserveBanks "and a $25reduction in itsreserve account, which are offsetby a $125declinein itsliabiity 'accounts payable." Whilean individualbank may use differentaccountingentries,the net effectonreservesisa reduction of $25,the amountof billed feesthat were paid through a directchargeto BankA's reserve account Assets Accrued service income - 125 Liabilities Assets Earnings credits Earnings credits due to depository due from institutions F.R Banks -100 Reserveaccounts: Reserveswith - 25 H F . R Banks - 25 Liabilities Accounts payable -125 FacfonmetingBark R m e s 23 I
ChangesinLoans to Depository Institutions Loans to depository institutions monthly averages, billions of dollars, not seasonally adjusted Prior to passage of the Monetary ControlAct of 1980, onlybanks that were members of the Federal Reserve Sys- tem had regular accessto the Fed's "discountwindow." Sincethen, all institutionshaving depositsreservableunder theAct alsohave been ableto borrow fromthe Fed. Under conditionssetby the Federal Reserve,loansare available under three credit programs: adjustment, seasonal,and ex- tended credit.16 The averageamountof each type of discount windowcredit provided variesover time. (See rlrn~-fi When a bank borrowsfroma FederalReserve Bank, it borrows reserves. The acquisitionof reserves in this manner diem in an importantway from the cases already illustrated. Banksnormally borrow adjustmentcredit onlyto avoid re- servedeficienciesor overdrafts,not to obtain excessre- serves. Adjustmentcreditborrowings,therefore, are reserves on which expansion has already taken place. How can this happen? In their effortsto accommodatecustomersas well as to keepfullyinvested,banks frequentlymake loansin anticipa- tion of inflowsof loanablefundsfromdepositsor money market sources. Loans add to bank depositsbut not to bank reserves. Unless excessreserves can be tapped, banks will not have enough reserves to meet the reserve requirements againstthe new deposits. Likewise,individualbanks may incur deficienciesthrough unexpected depositoutflowsand correspondinglosses of reserves through clearings. Other banks receivethese depositsand can increase their loans accordingly,but the banks that lost them may not be ableto reduce outstandingloansor investmentsin order to restore their reserves to required levelswithin the required time period. In either case, a bank may borrow reserves tempo- rarily fromitsReserve Bank. Supposea customer of Bank Awantsto borrow $100. On the basisof the management'sjudgment that the bank's reserveswillbe sufticientto provide the necessary funds,the customeris accommodated. The loan is madeby increasing "loans"and creditingthe customer's depositaccount. Now BankA's depositshave increased by $100. However, if re- servesare insufticientto supportthe higher deposits,Bank A will have a $10reserve deficiency,assumingrequirements of 10percent. See zllustratlo~z26. Bank Amay temporarily borrowthe $10from its Federal Reserve Bank,which makes a loanby increasingits asset item "loansto depositoryinstitu- tions" and crediting Bank A's reserve account. Bank A gains reserves and a correspondingliability"borrowingsfrom FederalReserveBanks." See tlitutruiito~z27 To repay borrowing, a bank must gain reserves through either depositgrowth or asset liquidation. 3cr ~llrrstrntio~z2% Abank makes payment by authorizinga debitto its reserve account atthe Federal Reserve Bank. Repaymentof borrow- ing,therefore,reduces both reserves and "borrowingsfrom FederalReserveBanks." S ~ Pziiustmtzon 29 Unlike loans made under the seasonaland extended creditprograms,adjustmentcredit loans to banks generally Extended credit must be repaid within a shorttime sincesuch loans are made primarilyto cover needs created by temporaryfluctuationsin deposits and loansrelativeto usual patterns. Adjustments, such as sales of securities,made by some banks to "get out of the window" tend to transfer reserve shortages to other banks and may forcethese other banks to borrow, especially in periods of heavy credit demands. Even at timeswhen the totalvolume of adjustmentcredit borrowing is rising, some individualbanks are repayingloanswhile others are borrow- ing. In the aggregate, adjustmentcredit borrowing usually increases in periods of rising business activitywhen the public's demands for credit are rising more rapidly than nonborrowedreserves are being provided by Systemopen market operations. Although reserve expansionthrough borrowingis initi- ated by banks, the amount of reserves that banks can acquire in thisway ordinarilyislimitedby the Federal Reserve's ad- ministration of the discountwindowand by its controlofthe rate charged banks for adjustmentcredit loans-the discount rate.17 Loansare made onlyfor approved purposes, and other reasonablyavailable sources of funds must have been fully used. Moreover,banks are discouragedfromborrowingad- justment credit too frequentlyor for extended time periods. Raisingthe discountrate tends to restrain borrowingby increasingits cost relativeto the cost of alternativesources of reserves. Discountwindow administrationis an importantadjunct to the other Federal Reservetoolsof monetarypolicy. While the privilege of borrowing offersa "safetyvalve"to temporarily relieve severe strains on the reserve positions of individual banks, there is generallya strong incentivefor a bank to repay borrowing beforeaddingfurther to its loansand investments. - --- --- -. - -- -- 'fiAdjustmentcredit is short-term credit available to meet temporary needs for funds. Seasonalcredit is availablefor longer periods to smallerinstitu- tionshavingregular seasonalneedsforfunds. Extendedcreditmaybemade available to an institution or group of institutions experiencing sustained liquiditypressures. The reservesprovided through extendedcreditborrow- ing typicallyare offset by open market operations. ';Flexible discount rates related to rates on moneymarket sources of funds currentlyarecharged forseasonalcredit andforextendedcreditoutstanding more than 30 days. 24 1 Modem Money Mechanrcs
326 I Abank mayincur a reserve deficiencyif it makes loanswhen ithasno excess reserves. Assets Liabilities Loans no change I ~ssets Liabilities 1 Assets Liabilities 27 Borrowingfrom aFederal Reserve Bank to coversuch adeficitis accompaniedby a directcreditto the bank'sreserve account. 1 Nofirher expansion can takephce on the new reserves because thya nall neededagainst the deposits created in (26). Loansto depository + 10 Assets Liabilities Securities - 10 Reserve accounts: Reserves with Borrowingsfrom Bank A + 10-F.R Banks F.R. Banks + 10 +lo 1 Reserves with F.R Banks Assets 29 Liabilities Assets Repaymentof borrowingsfromthe Federal ReserveBank reducesreserves. Loansto depository institutions: Bank A - 10 Reserveaccounts: Reserves with Bank A - 10-F.R.Banks - 10 Liabilities Borrowingsfrom FactorsmetingEank Resewes 25
ChangesinResave Reqzkments Thusfarwe have describedtransactionsthat affectthe volume of bank reservesand the impactthesetransactions haveupon the capacityof the banksto expandtheirassets and deposits. It isalsopossible toiduence depositexpan- sionorcontractionby changingthe required minimumratio of reservesto deposits. Theauthoritytovary required reserve percentagesfor banksthatwere membersof the FederalReserve System (memberbanks) was firstgranted by Congresstothe Fed- eralReserve Board of Governorsin 1933. The rangeswithin which this authoritycanbe exercisedhavebeen changed severaltimes,mostrecentlyin the MonetaryControlAct of 1980,which providedforthe establishmentof reserve r e quirementsthatapplyuniformlyto alldepositoryinstitutions. ?he 1980statuteestablishedthe followinglimits: On transadon accounts first$25 million 3% above $25 million 8%to 14% On nonpmonal time deposits 0%to 9% The 1980lawinitiallysetthe requirementagainsttransaction accountsover$25million at 12percent andthat against nonpersonaltime depositsat3percent Theinitial$25mik lion "lowreservetranche"wasindexed to changeeachyear in linewith 80percent of thegrowth in transactionaccounts atalldepositoryinstitutions. (For example,thelowreserve tranchewas increased from$41.1millionfor 1991to $42.2 million for 1992.) In addition,reserve requirementscan be imposedon certainnondepositsourcesof funds,suchas Eurocurrencyliabiitie~?~(Initiallythe Board seta 3percent requirementon Eurocurrencyliabiitiea) The Garn-StGermainAct of 1982modiied these provi- sionssomewhatby exemptingfromreserve requirements thefirst$2million of totalresemble liabiitiesateachdepos itoryinstitution. Similarto the lowreserve trancheadjust- mentfortransaction accounts,the $2million "resemble liabiitiesexemptionamount"was indexedto 80percent of annualincreasesin totalresembleliabiities. (For example, the exemption amountwas increased from $3.4 millionfor 1991to $3.6millionfor 1992.) TheFederalReserve Board isauthorized to change,at itsdiscretion,the percentagerequirementsontransaction accountsabovethelow reserve trancheand on nonpersonal time depositswithiithe rangesindicatedabove. In addition, the Board may impose differingreserve requirementson nonpersonaltime depositsbased on the maturityofthe de- posit. m e Board initiallyimposedthe 3percent nonper- sonaltime depositrequirement only on such depositswith originalmaturitiesof underfouryears.) Duringthe phasein period,which ended in 1984for mostmember banksand in 1987for most nonmemberinsti- tutions,requirementschanged accordingto a predetermined schedule,withoutanyactionby the FederalReserveBoard. Apart fromthese legallyprescribedchanges,oncethe Mone- tary ControlAct provisionswere implementedin late 1980, the Board did not changeanyreserve requirement ratiosuntil late 1990. m e originalmaturitybreak for requirementson nonpersonaltime depositswas shortened severaltimes, once in 1982andtwice in 1983,in connectionwith actionstakento deregulate ratespaid on deposits.) In December 1990,the Board reduced reserve requirements againstnonpersonal time depositsand Eurocurrencyliabilitiesfrom 3percentto zero. EffectiveinApril 1992,the reserve requirementon transactionaccountsabovethe low reservetranchewaslow- eredfrom 12percentto 10percent. When reserve requirementsarelowered,a portion of banks' existingholdingsof required reservesbecomesexcess reservesand may be loaned or invested. For example,with a requirement of 10percent, $10of reserveswould be required to support$100of deposits. See illustration30. Buta reduc- tion in the legalrequirementto 8percentwould tieup only$8, freeii$2outof each $10of reservesfor use in creatingaddi- tionalbank creditand deposits. See illustration 31. An increasein reserverequirements,on the otherhand, absorbsadditionalreserve funds,andbankswhich haveno excessreservesmust acquirereservesorreduce loansor investmentsto avoid a reserve deficiency. Thusan increase in the requirementfrom 10percentto 12percentwould boost required reservesto $12foreach $100of deposits. Assuming bankshave no excessreserves,thiswould forcethemto liquidateassetsuntilthe reserve deficiencywas eliminated, atwhich pointdepositswould be onesixthlessthan before. See illustration 32. Reserve Requirements and Monetary Policy The powerto changereserve requirements,likepur- chasesand salesof securitiesby the FederalReserve,isan instrumentof monetarypolicy. Even a smallchangein r e quirements-say,onehalf of onepercentagepoint-can have a largeandwidespread impact. Otherinstrumentsof monetarypolicy have sometimesbeen used to cushionthe initialimpactof a reserverequirement change. Thus,the Systemmay sellsecurities(or purchase lessthan otherwise would be appropriate) to absorbpartof the reservesreleased by a cutin requirements. It shouldbe noted that in additionto their initialimpact onexcessreserves,changesin requirements alterthe expan- sionpower of everyreserve dollar. Thus,suchchangesaffect the leverageof allsubsequentincreasesor decreasesin re- servesfrom anysource. For this reason,changesin thetotal volume of bank reservesactuallyheld between pointsin time when requirementsdiier do not provide an accurateindica- tion of the FederalReserve'spolicy actions. Both reserve balancesandvaultcash areeligibleto satisfyreserverequirements. To the extentsomeinstitutions normally hold vaultcashto meet operatingneedsin amounts exceedingtheir required reserves,they areunlikelytobe affected by anychange in requirements. I8The1980statutealsoprovidesthat"underextraordinarycircumstances" reserve requirements can be imposed at any level on any liability of depositoryinstitutionsfor as long as six months;and,if essentialfor the conductofmonetarypolicy,supplementalrequirementsupto4 percentof transactionaccountscan be imposed.
Under a 10percent reserve requirement, $10of reservesareneeded to supporteach $100of deposits. Assets Liabilities Loansand Reserves With a reductionin requirementsfrom 10 percent to 8percent,fewerreservesare required againstthe samevolumeof deposits Assets sothat excessreservesarecreated. These can Loansand be loaned or invested. investments 90 Reserves 10 Assets Liabilities I NO CHANGE T Liabilities Deposits 100 Thereis no changein the totalamount of bank reserves. With an increase in requirementsfrom 10 percent to 12percent,more reservesare required againstthe samevolumeof deposits. Assets Theresultingdeficienciesmust be coveredby liquidationof loansorinvestments. .. Loans and investments 90 Reserves 10 '3 Assets Liabilities I Liabilities Deposits ...becausethetotal amountof bank reservesremains unchanged. FactorsmctirrgBank Resemes 27
The FederalReservehas engaged in foreign currency operationsforitsown accountsince 1962. In addition, itactsasthe agentforforeign currency transactions of the U.S. Treasury,and sincethe 1950shas executedtransac- tionsforcustomerssuch asforeigncentralbanks. Perhaps the mostpublicized type of foreign currency transaction undertakenby the FederalReserveisinterventionin the foreignexchangemarkets. Intervention,however,isonly oneof severalforeign-relatedtransactionsthathave the potentialforincreasingor decreasingreserves of banks, thereby affectingmoney and creditgrowth. Severalforeign-relatedtransactionsand their effects on U.S. bank reservesare describedin the next fewpages. Includedaresomebut not all of thetypes of transactions used. Thekeypointto remember,however,isthatthe FederalReserveroutinely offsetsanyundesired changein U.S bank reservesresultingfromforeign-relatedtransac- tions. As a result, suchtransactionsdonot affectmoney and creditgrowthin the United States. Foreign Exchange Intervention for the Federal Reserve's OwnAccount When the Federal Reserveintervenesin foreign exchangemarketsto selldollarsforitsown it acquiresforeigncurrencyassetsand reservesof U.S. banks initiallyrise. In contrast,when the Fed intervenestobuy dollarsfor itsown account, it usesforeigncurrencyassek to pay forthe dollarspurchased and reservesof US. banks initiallyfall. Considerthe examplewhere the FederalReserve intervenesin theforeign exchangemarketsto sell$100of U.S. dollarsfor itsown account. In thistransaction,the Federal Reservebuys a foreignarrencydenominated depositof a U.S. bank held at a foreign commercialbarkz0 andpays for thisforeigncurrencydepositby crediting$100 totheU.S. bank's reserveaccountattheFed. TheFederal Reserve depositsthe foreigncurrencyproceedsin itsac- countata Foreign CentralBank,and asthistransaction clears,the foreignbank's reservesatthe ForeignCentral Bank decline. See illustration33onpages 3031. Initially, then,the Fed's interventionsaleof dollarsin thisexample leadsto an increase in Federal ReserveBank assetsdenom- inated in foreigncurrenciesand an increase in reservesof U.S. banks. Supposeinstead thatthe FederalReserveintervenes in theforeignexchangemarketsto buy $100of US. dollars, againforitsown account. The FederalReservepurchasesa dollardenominateddepositof a foreignbank held at a US. bank,andpays for this dollar depositby drawingonits foreigncurrency depositat a Foreign CentralBank. m e FederalReservemighthave to sellsomeof itsforeign cur- rency investmentsto build up itsdepositsatthe Foreign CentralBank,but thiswould not affectU.S. bank reserves.) As the FederalReserve's accountatthe ForeignCentral Bank ischarged,theforeignbank's reservesatthe Foreign CentralBankincrease. In turn,the dollardepositof the foreignbank atthe U.S. bank declinesasthe U.S. bank transfers ownershipof those dollarsto the Federal Reserve 28 M& Money Mechanics Federal ReserveBank assets denominated inforeign currencies end of month, billionsof dollars, not seasonally adjusted via a $100chargeto itsreserveaccountatthe FederalRe serve. See illustration 34 on pages 3031. Initially,then,the Fed's interventionpurchaseof dollarsin thisexampleleads to a decreasein Federal Reserve Bank assetsdenominatedin foreign currenciesand adecreasein reservesof U.S. banks. Asnoted earlier,the Federal Reserveoffsetsor "ster- ilizes" anyundesired changein U.S. bank reservesstemming fromforeign exchangeinterventionsalesorpurchasesof dollars. For example,Federal ReserveBank assetsdenomi- nated inforeigncurrenciesrose dramaticallyin 1989,in part dueto significantU.S. interventionsalesofdollars. (See chart on thispage.) Totalreserves of U.S. banks, however,declined slightlyin 1989asopen market operationswereused to "ster- ilize" the initialintervention-inducedincrease in reserves. Monthly Revaluation of Foreign Currency Assets Anothersetof accountingtransactionsthataffects Federal Reserve Bank assetsdenominated in foreigncurren- ciesisthe monthly revaluationof such assets. Twobusiness daysprior to the end of the month,the Fed's foreigncurrency assetsareincreased if their marketvaluehasappreciated or decreasedif their valuehas depreciated. The offsettine;ac- countingentryonthe Fed's balance sheetisto the "exchange translationaccount"included in "otherF.R liabiities." These changesin the Fed's balance sheetdonot alterbank reserves directly. However, sincethe FederalReserveturnsoverits net earningsto theTreasuryeachweek,the revaluationaf- fectsthe amountof the Fed's paymentto theTreasury,which in turn iniluencesthe sizeof 'IT&Lcallsandbank reserves. (Seeexplanationonpages 18and 19.) 'gOverallresponsibiityfor U.S.interventioninforeignexchangemarkets rests with the U.S. Treasury. Foreign exchange transactions for the Federal Reserve'saccountare carriedout under directivesissued by the FederalReserve'sOpenMarketCommitteewithiithegeneralframework of exchange rate policy establishedby the US. Treasury in consultation withthe Fed. Theyareimplementedatthe FederalReserve Bankof New York,typicallyatthe same timethat similartransactionsareexecutedfor theTreasurylsExchange StabilizationFund. 2oAmericanstravelingto foreign countries engagein "foreignexchange" transactionswhenever they obtain foreign coins and paper currency in exchangefor U.S.coinsand currency. However,mostforeignexchange transactionsdo not involve the physicalexchangeof coinsand currency. Rather, most of these transactions represent the buying and selling of foreign currenciesby exchangingone bank depositdenominated in one currencyforanotherbank depositdenominatedin anothercurrency. For easeofexposition,theexamplesassumethatUS.banksandforeignbanks arethemarketparticipantsintheinterventiontransactions,buttheimpact onreserveswouldbe the same if the U.S.orforeignpublicwere involved.
Foreign-RelatedTransactions for the Treasury U.S. interventionin foreign exchangemarketsby the FederalReserve usually is dividedbetween itsown account and theTreasury'sExchangeStabilizationFund (ESF')ac- count. The impacton U.S. bank reservesfromthe interven- tion transactionisthe sameforboth -salesof dollarsadd to reserveswhilepurchasesof dollarsdrainreserves. See illustration 35 on pages 3@31. Dependingupon how the Treasurypaysfor,orhances,itspart of the intervention, however,the FederalReservemay not need to conduct offsettingopenmarket operations. TheTreasurytypicallykeeps onlyminimalbalances in the ESFs accountatthe Federal Reserve. Therefore, theTreasurygenerally has to convertsomeESFassetsinto dollaror foreigncurrencydepositsin order to payfor itspart of an intervention transaction. Likewise,the dollar or for- eign currency depositsacquiredby the ESFin the interven- tion typicallyare drawndownwhen the ESFinveststhe proceeds in earningassets. For example,to hance an interventionsaleof dollars (such asthat shownin illustration 35),theTreasurymight redeem someof the U.S. governmentsecuritiesissuedto the ESF,resulting in a transferof fundsfromtheTreasury's (generalaccount)balancesatthe Federal Reserveto the ESFsaccountatthe Fed. (Onthe Federal Reserve's bal- ancesheet, the ESFs accountisincluded in the liability category"other deposits.") TheTreasury,however,would need to replenish itsFed balancesto desiredlevels,perhaps by increasingthe size of ?T&L calls-a transactionthat drainsU.S. bank reserves. The interventionandfinancing transactionsessentiallyoccur simultaneously. As a result, U.S. bank reservesadded in the interventionsaleof dollars areoffsetby the drainin U.S. bank reservesfromthe?T&L call. See illustrations35 and 36 on pages 3@31. Thus,no FederalReserveoffsettingactionswould be needed if the Treasuryh c e d the interventionsaleof dollarsthrough a?T&L callonbanks. Offsettingactionsby the Federal Reservewould be needed,however,if theTreasuryrestored depositsaffected by foreign-relatedtransactionsthrough a number of transac- tions involvingthe FederalReserve. These includethe Treasury's issuanceof SDRorgold certificatesto the Feder- al Reserve and the "warehousing"of foreign currenciesby the FederalReserve. SDR certtj5cate.s. OccasionallytheTreasuryacquires dollardepositsfor the ESFs accountby issuingcertificates to the FederalReserve againstallocationsof SpecialDraw- ingRights (SDRs) received fromthe InternationalMonetary Fund.21For example,$3.5biion of SDRcertificateswere issued in 1989,and another$1.5billion in 1990. This"mone- tization"of SDRsisreflected onthe Federal Reserve's bal- ancesheetasanincreasein itsasset"SDRcertificate account"and an increasein itsliability"other deposits (ESFaccount)." If the ESFusesthese dollar depositsdirectlyin an intervention saleof dollars,then the intervention-induced increase in U.S. bank reservesisnot altered. See illustra- tions 35 and 370n pages 3@31. If not needed immediately for an intervention transaction,the ESFmightuse the dollar depositsfrom issuanceof SDRcertificatesto buy securities USgold stock, gold certificates and SDR certificates end of year, billions of dollars ""certificates from theTreasury,resulting in a transferof fundsfrom the ESFs accountatthe FederalReservetotheTreasury'sac- countat the Fed. U.S. bank reserveswould then increaseas theTreasuryspentthe fundsor transferred them to banks through a d i iinvestmentto ?T&L note accounts. Goldstock andgold certtj5cates. Changesin the U.S. monetarygold stockused to be an importantfactor affecting bank reserves. However,the gold stockandgoldcertificates issued to the FederalReservein "monetizing"gold,have not changedsignificantlysincethe early 1970s. (See chart on thispage.) Priorto August 1971,theTreasurybought and sold goldfor a fixedpricein termsof U.S. dollars,mainly atthe initiativeof foreigncentralbanks and governments. Gold purchasesby theTreasurywere added to the U.S. monetary gold stock,and paid forfromitsaccountatthe Federal Reserve. Asthe sellersdepositedtheTreasury's checksin banks, reservesincreased. To replenish itsbalance atthe Fed,theTreasuryissued gold certificatesto the Federal Reserveand received a creditto itsdepositbalance. Treasurysalesof gold have the oppositeeffect Buy- ers' checksarecredited to theTreasury'saccountand re- servesdecline. Because the officialU.S. gold stockis now fully"monetized,"theTreasurycurrentlyhas to use its depositsto retiregold certificatesissued to the Federal Reservewhenevergold issold. However,thevalueof gold certificatesretired,aswell asthe net contractionin bank reserves,isbased onthe officialgold price. Proceedsfrom agold saleatthe marketpriceto meet demandsof domestic buyerslikelywould be greater. The differencerepresents theTreasury's profit,which,when spent,restores deposits and bank reservesby a likeamount. WhiletheTreasuryno longer purchasesgold and salesof gold have been limited,increasesin the officialprice of gold have added to thevalue of the gold stock. W e officialgold pricewaslastraised,from$38.00 to $42.22 per troy ounce,in 1973.) Warehousing. TheTreasurysometimesacquiresdol- lar depositsatthe Federal Reserveby "warehousing"foreign currencieswith the Fed. (Forexample,$7billion of foreign 21SDRswere createdin 1970for use by governmentsin officialbalanceof payments transactions.
When the Federal Reserve intervenesto selldollarsfor itsown account, it pays for a foreignarrencydenominateddepositof a U.S. bank at a foreigncommercialbank by creditingthe reserveaccountof Liabilities the U.S. bank,and acquiresa foreigncurrencyassetin the form of a Depositsat Reserves: depositat a ForeignCentralBank. The Federal Reserve,however,will ForeignCentral US.bank + 100-offset the increase in U.S. bank reservesif it isinconsistentwith domesticpolicyobjectives. When the Federal Reserveintervenestobuy dollarsforitsown account, it drawsdown itsforeign currencydepositsata Foreign CentralBankto pay fora dollardenominated depositof a foreignbank Liabilities at a U.S. bank,whichleadsto a contractionin reservesof the US. Depositsat Reserves: bank. Thisreductionin reserveswillbe offsetby the Federal Reserve ForeignCentral U.S. bank - 100 -if itisinconsistentwith domesticpolicy objectives. In aninterventionsaleof dollarsforthe U.S. Treasury,depositsof the ESF atthe FederalReserve areused to pay fora foreigncurrencydepositof a US. bank ata foreignbank, and the foreign currencyproceedsare deposited in an accountat a Foreign CentralBank. U.S. bank reservesincreaseasa result of thisinterventiontransaction. Assets Liabilities Assets Liabilities Assets Liabilities Depositsat Other deposits: Foreign Central Concurrently,theTreasurymusth c e the interventiontransactionin (35). ?he Treasurymightbuild up depositsin the ESFsaccountatthe Federal Reserveby redeemingsecuritiesissuedto the ESF, and replenish itsown (general account) depositsatthe Federal Reserveto desiredlevelsby issuinga callon?T&L note accounts. Thissetof transac- tions drainsreserves of U.S. banksby the sameamountasthe interventionin (35) added to U.S. bank reserves. Assets US. govt Depositsat F.R. Banks Liabilities Assets Liabilities Assets Liabilities Treas. deps.: net 0 Other deposits: + 100 Alternatively,theTreasurymighth n c e the interventionin (35) by issuing SDRcertificatesto the Federal Reserve,a transactionthatwould not disturbthe additionof US. bank reserves in intervention(35). The Federal Reserve,however,would offset anyundesired changein U.S. bank reserves. 30 1 Modem Monq Mechanics I Assets Liabilities Assets Liabilities Deposits at FA. Banks + 100 SDR certificates SDR certificate Other deposits: issuedto account + I00 ESF + 100
Assets Liabilities Assets Uabiliti~ Assets Liabilities Depositsat Reservesof foreign bank - 100 foreign bank - 100 Assets Liabilities Assets Liabilities Assets Liabilities ,-b F.R. Banks foreign bank - 100 Reserveswith Reservesof ForeignCentral foreign bank + 100 + 100 Assets Liabilities Assets Liabilities Assets Liabilities ForeignCentral Depositsat Reserves of foreign bank - 100 foreign bank - 100 Assets Liabilities Reserveswith TT&Laccts. - I00 -F.R. Banks - 1007 Assets Liabilities I NO CHANGE I FactotsMxfingBank Rcsmes 31
currencieswerewarehoused in 1989.) TheTreasuryor ESFacquiresforeigncurrencyassetsasa result of transac- tionssuch asinterventionsalesof dollarsor salesof U.S. governmentsecuritiesdenominated in foreigncurrencies. When the FederalReservewarehousesforeign currencies fortheTrea~ury,~"FederalReserveBank assetsdenomi- nated in foreigncurrencies"increase asdoTreasurydepos- itsatthe Fed. As these depositsare spent, reservesof U.S. banks rise. In contrast,theTreasurylikelywill have to increasethe sizeof lT&Lcalls-a transactionthat drains reserves-when it repurchaseswarehousedforeigncur- renciesfrom the FederalReserve. (In1991,$2.5billion of warehoused foreigncurrencieswere repurchased.) The repurchasetransactionisreflected onthe Fed's balance sheetasdeclinesin bothTreasurydepositsatthe Federal Reserve and FederalReserveBank assetsdenominatedin foreigncurrencies. Transactionsfor Foreign Customers Manyforeigncentralbanksand governmentsmain- tain depositsat the Federal Reserveto facilitatedollar- denominatedtransactions. These"foreign deposits"on the liabilityside of the Fed's balance sheettypicallyareheld at minimallevelsthatvary littlefromweek to week. For ex- ample,foreign depositsatthe FederalReserveaveraged only$237million in 1991,rangingfrom$178million to $319 millionon aweekly averagebasis. Changesin foreign depositsare smallbecause foreigncustomers"manage" their FederalReservebalancesto desired levelsdailyby buying and sellingU.S. governmentsecurities. The extent of these foreigncustomer"cash management"transactions isreflected,in part, by largeand frequentchangesin mar- ketableU.S. governmentsecuritiesheld in custodyby the Federal Reserveforforeigncustomers. (Seechart.) The net effectof foreign customers'cash managementtransac- tionsusuallyisto leaveU.S. bank reservesunchanged. Managingfbreign depositsthroughsales ofsecurities. Foreigncustomersof the FederalReservemake dollar- denominatedpayments,includingthosefor intervention salesof dollarsby foreign centralbanks,by drawingdown their depositsatthe Federal Reserve. As these fundsare deposited in U.S. banks and cleared,reserves of U.S. banks rise. See illustration38. However,if paymentsfromtheir accountsatthe FederalReservelowerbalancesto below desiredlevels,foreigncustomerswill replenish their Feder- al Reserve depositsby sellingU.S. governmentsecurities. Actingastheir agent,the Federal Reserveusuallyexecutes foreigncustomers' sellordersin the market. As buyerspay for the securitiesby drawingdown depositsat U.S. banks, reservesof U.S. banksfalland offset the increasein re- servesfromthe disbursementtransactions. Thenet effect isto leave U.S. bank reservesunchanged when U.S. govern- ment securitiesof foreign customersare sold in the mar- ket. See illustrations38 and 39. Occasionally,however,the FederalReserve executesforeigncustomers' sellorders withthe System's account. When thisis done,the risein reservesfromthe foreign customers' disbursementof funds remainsin place. See illustratiolzs 38 and 40. The Federal Reservemightchooseto executesellorderswith the Sys- tem's accountif an increase in reservesisdesiredfor do- mesticpolicyreasons. MarketableUSgovernmentsecurities held in custodyfor foreign customers during 1991 Wednesday outsmndings,billions of dollars 235 ~ ~ ' ' ' 1 ' ' ' ~ ' ' ' ~ ' ' ' ' ~ ' ' ' ~ ' ' ' ' ~ ' ' ' ~ ' ' ' 1 ' ' ' ' 1 ' ' ' 1 ' ' ' i Feb. Apr. June Aug. Oct. Dec. Managragrngfbreign deposits throughpurchases ofsecuri- ties. Foreigncustomersof the FederalReservealsoreceive a variety of dollardenominatedpayments, includingpro- ceedsfrominterventionpurchasesof dollarsby foreign centralbanks, that are drawn on U.S. banks. As thesefunds arecreditedto foreign depositsatthe FederalReserve,r e servesof U.S. banks decline. Butif receiptsof dollardenom- hated paymentsraisetheir depositsatthe FederalReserve to levelshigherthan desired,foreigncustomerswillbuy U.S. governmentsecurities. The net effedtgenerally istoleave U.S. bank reserves unchanged when the U.S. government securitiesare purchased in the market. Usingthe swap network. Occasionally,foreigncentral banksacquiredollar depositsby activatingthe "swap"net- work,which consistsof reciprocalshort-termcreditarrange- mentsbetweenthe Federal Reserveand certainforeign centralbanks. When a foreigncentralbank drawson its swapline atthe Federal Reserve,itimmediatelyobtainsa dollar depositatthe Fed in exchangeforforeigncurrencies, and agreesto reversethe exchange sometimein thefuture. Onthe FederalReserve's balance sheet,activationof the swapnetworkisreflected asan increase in FederalReserve Bank assetsdenominatedin foreigncurrenciesand an in- creasein the liabiitycategoryYoreign deposits." Whenthe swaplineisrepaid,both of these accountsdecline. Reserves of U.S. bankswill risewhen the foreigncentralbank spends itsdollarproceedsfromthe swapdrawing. See illustration 41. In contrast, reservesof U.S. bankswillfall asthe foreign centralbank rebuilds its depositsatthe Federal Reserve in orderto repaya swapdrawing. The accountingentriesand impacton U.S. bank r e servesarethe same if the FederalReserveuses the swap networkto borrowand repayforeign currencies. However, the Federal Reservehas not activatedthe swapnetwork in recent years. nTechnically, warehousing consists of two parts: the Federal Reserve's agreementtopurchaseforeigncurrencyassetsfromtheTreaswyorESF for dollardepositsnow, and the Treasury's agreementto repurchasethe foreigncurrenciessometimein the future.
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Modern Money Mechanics

  • 1. Modern MoneyMechanics AWorkbook on Bank Reserves and Deposit Expansion Federal Reserve Bank of Chicago
  • 2. Modern Money Mechanics Thepurpose ofthisbookletis to desmmbethe basic process ofmoneycreation in a ~actionalreserve"bank- ingsystem. l7zeapproachtaken illustratesthe changes in bank balancesheets that occurwhen depositsin banks changeasa result ofmonetaryactionby theFederal Reserve System-the centralbank ofthe UnitedStates. Therelationshipsshown are based onsimplil5ring assumptions. For thesake ofsimplicity,the relationships areshown as iftheywere mechanical,but theyare not, as isdescribed laterin the booklet. Thus,theyshould not be intwreted to implya closeandpredictable relation- ship betweena specificcentral bank transactionand the quantityofmoney. Theintroductorypages containa briefgeneral desm'ptionofthe characte*ics ofmoneyand how the US. moneysystem works. m e illustrationsin thefbl- lowingtwosections describe twoprocesses: fijirst, how bank akposits expand orcontractin responsetochanges in theamountofreservessupplied by thecentml bank; and second, how thosereservesareafected by both FederalReserve actionsand otherjizctm. Afinal sec- tion deals withsome ofthe elementsthat modifi,at least i~theshort Tun,thesimple mechanical relationship between bank reservesand depositmoney. Moneyis sucha routinepart of everydaylivingthat itsexistenceand acceptanceordinarilyare taken forgrant- ed. A user may sensethat money must comeinto being either automaticallyasa resultof economicactivityor as an outgrowth of somegovernmentoperation. Butjust how this happens alltoo often remainsa mystery. What Is Money? If moneyisviewed simplyasa tool used to facilitate transactions,onlythose media that are readily acceptedin exchangeforgoods,services,and otherassetsneed to be considered. Manythings-from stonesto baseballcards -have servedthis monetaryfunctionthrough the ages. Today,in the United States,money used in transactionsis mainly of threekinds-currency (papermoney and coins in the pocketsand purses of the public);demand deposits (non-interest-bearingcheckingaccountsinbanks);and othercheckabledeposits,such asnegotiableorderof withdrawal (NOW)accounts,atalldepositoryinstitutions, includingcommercialand savingsbanks, savingsandloan associations,andcreditunions. Travelerschecksalso are included in the definition of transactionsmoney. Since$1 in currencyand $1in checkabledeposits arefreelycon- vertible intoeach otherand both canbe used directlyfor expenditures,they are moneyin equaldegree. However, onlythe cash and balances held by the nonbank public are countedin the money supply. Depositsof the U.S. Trea- sury,depositoryinstitutions,foreignbanksand official institutions,aswell asvault cash in depositoryinstitutions areexcluded. Thistransactionsconceptof money is the onedesig- nated asM1in the FederalReserve's money stock statis- tics. Broaderconceptsof money (M2 and M3) includeM1 aswell ascertainotherhancial assets (such assavings and time depositsatdepositoryinstitutionsand sharesin moneymarket mutual funds) which are relativelyliquid but believed to representprincipallyinvestmentsto their holdersrather than mediaof exchange. While fundscan be shiftedfairlyeasilybetween transaction balances and these otherliquid assets,the moneycreationprocesstakes placeprincipallythrough transaction accounts. In the remainderof thisbooklet, "money"meansMI. The distributionbetween the currencyand deposit componentsof money dependslargelyonthe preferences of the public. When a depositorcashesa checkor makes a cashwithdrawal through an automaticteller machine,he or shereducesthe amountof depositsand increasesthe amountof currencyheld by the public. Conversely,when people have morecurrencythan is needed, someisre- turned to banks in exchangefor deposits. While currencyisused for a greatvariety of small transactions,most of the dollaramount of moneypay- mentsin our economyare made by checkorby electronic
  • 3. transferbetween depositaccounts. Moreover,currency is a relatively smallpart of the moneystock. About 69 percent,or$623biion, of the $898 biion totalmoney stockin December 1991,wasin the formof transaction deposits,of which$290billion were demand and $333 billion were other checkabledeposits. What Makes MoneyValuable? In the United Statesneitherpaper currencynor depositshavevalue ascommodities. Intrinsically,a dollar bii isjust a pieceof paper, depositsmerelybook entries. Coinsdo have someintrinsicvalue asmetal,but generally farlessthan their facevalue. What,then,makesthese instruments-checks, paper money,and coins-acceptableatfacevalue in payment of alldebtsandfor othermonetary uses? Mainly, itisthe confidencepeoplehave that theywillbe ableto exchangesuchmoneyfor otherfinancialassets and for real goodsand serviceswhenever theychooseto do so. Money,like anythingelse,derivesitsvaluefrom its scarcity in relation to itsusefulness. Commoditiesor ser- vices aremore orlessvaluablebecause there are more or lessof them relative to the amountspeoplewant. Money's usefulnessisitsunique abilityto commandothergoods and servicesandto permit aholder to be constantlyready to do so. How much money is demanded dependson severalfactors,suchasthe totalvolumeof transactions in the economyat anygiven time,the paymentshabits of the society,the amount of moneythat individualsand businesseswantto keep on hand to take care of unexpect- ed transactions, and the foregoneearningsof holding tinancialassetsin the form of moneyrather than some other asset. Control of the quantity of moneyisessentialif its valueis to be kept stable. Money's real value canbe mea- sured onlyin termsof what itwillbuy. Therefore,itsvalue variesinverselywith the generallevelof prices. Assuming a constant rate of use,if the volume of money growsmore rapidlythan the rate atwhich the outputof realgoodsand servicesincreases,priceswill rise. Thiswill happen b e causetherewill be more money than therewillbe goods and servicesto spend it on at prevailingprices. But if, on the otherhand, growthin the supplyof money does not keeppacewith the economy'scurrentproduction,then priceswillfall,the nation's laborforce,factories,and other production facilitieswillnot be fully employed,or both. Just how largethe stockof moneyneeds to be in ordertohandlethe transactionsof the economywithout exertingundueiduence on the price level dependson how intensivelymoney isb e i iused. Everytransaction depositbalanceand everydollarbill isa part of some- body's spendablefundsat anygiventime, ready to move to otherownersastransactionstake place. Someholders spend money quicklyaftertheyget it, makingthese funds availablefor otheruses. Others,however,hold moneyfor longerperiods. Obviously,when somemoney remains idle,a largertotalis needed to accomplish anygiven volume of transactions. Who Creates Money? Changesin the quantityof money may originatewith actionsof the FederalReserve System (thecentralbank), depositoryinstitutions (principallycommercialbanks),or the public. The majorcontrol,however,rests with the centralbank. The actualprocessof money creation takesplace primarilyin banks.' As noted earlier,checkableliabilities of banksare money. These liabilitiesare customers'ac- counts. Theyincreasewhen customersdepositcurrency and checksandwhen the proceedsof loansmade by the banksarecreditedtoborrowers' accounts. In the absenceof legalreserve requirements,banks canbuild up depositsby increasingloansand investments solongastheykeepenoughcurrencyon hand to redeem whatever amountsthe holders of depositswantto convert intocurrency. Thisunique attributeof the bankingbusi- nesswas discoveredmany centuriesago. It startedwith goldsmiths. As earlybankers,they initiallyprovided safekeepingservices,makinga profit from vaultstoragefeesforgold and coinsdepositedwith them. Peoplewould redeemtheir "depositreceipts"whenever they needed gold orcoinsto purchase something,and physicallytake the gold or coinsto the sellerwho,in turn, would depositthem for safekeeping,oftenwith the same banker. Everyone soonfoundthat itwasa loteasier simply to use the deposit receiptsdirectlyasa meansof payment. These receipts,which became known asnotes,were ac- ceptableasmoney sincewhoeverheld them couldgo to the banker and exchangethem for metallicmoney. Then,bankers discoveredthat they could make loans merelyby giving their promisesto pay, orbank notes, to borrowers. In thisway,banksbegan to create money. More notes couldbe issuedthan the gold and coinon hand because only a portionof the notesoutstandingwould be presented forpaymentat anyonetime. Enough metallic moneyhad to be kept on hand, of course,to redeemwhat- evervolumeof noteswas presented for payment. Transactiondepositsare the modem counterpartof bank notes. Itwas a small stepfromprintingnotesto mak- ingbook entriescreditingdepositsof borrowers,which the borrowersin turncould "spend"by writingchecks,thereby "printing"their own money. Inordertodescribethemoneycreationprocessassimplyaspossible,the term Bank"used in this bookletshouldbe understoodto encompassall depositoryinstitutions. SincetheDepositoryInstitutionsDeregulationand MonetaryControlActof 1980,alldepositoryinstitutionshavebeenpermit- ted to offer interest-bearing transaction accounts to certain customers. Transaction accounts (interest-bearing as well as demand deposits on which payment of interest is still legally prohibited) at all depository institutions are subject to the reserve requirements set by the Federal Reserve. Thus an such institutions, notjust commercialbanks,havethe potential for creatingmoney.
  • 4. What Iimits the Amount of Money Banks Can Create? If depositmoney canbe createdsoeasily,what isto preventbanksfrommaking too much -more than sufti- cient to keep the nation's productiveresourcesfullyem- ployedwithoutprice inflation? Likeitspredecessor,the modem bank must keep available,to makepayment on demand,a considerableamountof currency andfundson depositwith the centralbank. Thebank mustbe prepared to convertdepositmoneyintocurrencyforthose deposi- torswho requestcurrency. It must make remittanceon checkswritten by depositorsand presented for payment by otherbanks (settleadverseclearings). Finally,it must maintain legallyrequired reserves,in theformof vaultcash and/or balances atitsFederal ReserveBank,equalto a prescribedpercentage of itsdeposits. Thepublic's demandfor currencyvariesgreatly,but generallyfollowsa seasonalpattern that isquitepredict- able. Theeffectsonbank fundsof thesevariations in the amountof currencyheld by the public usuallyareoffsetby the centralbank, which replacesthe reservesabsorbedby currencywithdrawalsfrombanks. Ousthowthisisdone willbe explainedlater.) For allbankstaken together,there isno net drainof fundsthroughclearings. Acheckdrawn on onebank normallywillbe depositedto the creditof anotheraccount,if not in the samebank, then in some otherbank. Theseoperatingneeds influencethe minimum amountof reservesan individualbankwillhold voluntarily. However, aslongasthis minimum amountislessthan what islegallyrequired, operatingneeds areof relatively minor importanceasa restrainton aggregatedepositex- pansion in thebankingsystem. Such expansioncannot continuebeyond the pointwherethe amountof reserves that allbankshave isjust sufficientto satisfylegal require- ments under our"fractionalreserve" system. For example, if reservesof 20 percentwere required, depositscould expand onlyuntiltheywere fivetimes aslargeasreserves. Reservesof $10million could supportdepositsof $50mil- lion. Thelowerthe percentage requirement,the greater the depositexpansionthatcanbe supportedby eachaddi- tional reserve dollar. Thus,thelegalreserveratiotogether with the dollaramountof bank reservesarethefactorsthat setthe upper limitto money creation. What Are Bank Reserves? Currencyheld in bank vaults may be countedas legalreservesaswell as deposits (reservebalances) atthe FederalReserveBanks. Both areequallyacceptablein satisfactionof reserverequirements. Abank canalways obtain reserve balancesby sendingcurrencyto itsReserve Bank and canobtaincurrencyby drawingon itsreserve balance. Because eithercanbe used to supporta much largervolumeof depositliabilitiesof banks, currencyin circulationand reservebalancestogetherare oftenrefer- red to as"high-poweredmoney"orthe "monetarybase." Reservebalancesandvault cash in banks, however,arenot counted aspart of the money stockheld by thepublic. 4 Modem Money Mechanics For individualbanks, reserveaccountsalso serveas workingbalances? Banksmay increase the balancesin their reserveaccountsby depositingchecksand proceeds fromelectronicfundstransfersaswell ascurrency. Or they may drawdown these balancesby writingcheckson them orby authorizinga debitto them in paymentfor currency,customers' checks,or otherfundstransfers. Although reserveaccountsareused asworking balances,eachbank must maintain,on the averageforthe relevantreservemaintenanceperiod, reservebalancesat the ReserveBank andvaultcashwhich together areequal to itsrequired reserves,asdeterminedby the amountof itsdepositsin the reservecomputationperiod. Where Do Bank Reserves Come From? Increasesor decreasesin bank reservescanresult froma number of factorsdiscussed later in thisbooklet. From the standpointof moneycreation,however,the essentialpoint isthat the reserves of banksare,forthe most part, Wities of the Federal ReserveBanks,and net changesin them arelargelydeterminedby actionsof the Federal ReserveSystem. Thus,the FederalReserve, through itsabiityto varyboth the totalvolume of reserves and the required ratio of reservesto depositliabilities, influencesbanks' decisionswith respectto their assetsand deposits. One of the major responsibilitiesof the Federal ReserveSystemisto providethe total amountof reserves consistentwith the monetaryneeds of the economyat reasonablystableprices. Suchactionstake intoconsider- ation,of course,anychangesin the pace atwhich money isbeingused and changesin the public's demandsfor cash balances. The reader shouldbe mindfulthat depositsand reserves tend to expand simultaneouslyand thatthe Fed- eral Reserve's controloften is exertedthroughthe market- place asindividualbanksfind it eithercheaperor more expensiveto obtaintheir required reserves,dependingon the willingnessof the Fed to supportthe currentrate of creditand depositexpansion. While an individualbank can obtain reservesby biddingthem awayfromotherbanks, this cannotbe done by the banking systemasawhole. Exceptfor reserves borrowed temporarily from the Federal Reserve's discount window, asis shownlater,the supplyof reservesin the banking systemiscontrolledby the Federal Reserve. Moreover,a givenincreasein bank reservesisnot necessarilyaccompaniedby an expansionin money equal to the theoreticalpotential based on the required ratio of reservesto deposits. Whathappensto the quantityof ZPartof an individual bank's reserve account may representits reserve balanceused to meetits reserverequirementswhile anotherpart may be its requiredclearingbalance on which earningscredits are generated to pay for Federal Reserve Bank services.
  • 5. money willvary, dependingupon thereactionsof the banks andthe public. A numberof slippagesmay occur. Whatamountof resmeswillbe drainedintothe public's currencyholdings? Towhatextentwill the increase in totalreservesremain unused asexcessreserves? How much will be absorbedby depositsor otherliabiitiesnot definedasmoneybut againstwhichbanksmight alsohave to hold reserves? How sensitivearethe banksto policy actionsof thecentralbank? The significanceof these questionswillbe discussedlater in thisbooklet. The an- swersindicatewhy changesinthe money supplymay be differentthan expectedormay respond to policyaction onlyafterconsidembletimehas elapsed. In the succeedingpages,the effectsof varioustrans- actionsonthe quantityof money aredescribed and illus- trated. Thebasic workingtool isthe Taccount, which providesa simplemeans of tracing,stepby step,the effects of these transactionson both the asset and liabity sidesof bankbalance sheets. Changesin asset itemsareentered on thelefthalf of the Tand changesin liabiitiesonthe righthalf. For anyonetransaction,of course,there must be atleasttwo entriesin orderto maintainthe equalityof assetsandliabiities. Introduction 5
  • 6. Bank Deposits-How l%ey Expand or Contract Let us assumethat expansionin the money stockis desiredby the FederalReserveto achieveitspolicy objec- tives. Oneway the centralbank can initiate suchan expan- sionisthrough purchasesof securitiesin the open market Paymentforthe securitiesaddstobank reserves. Such purchases (and sales) arecalled"open market operations." How doopen market purchasesadd to bank reserves and deposits? Supposethe Federal ReserveSystem, through itstrading desk at the FederalReserveBank of New York,buys$10,000of Treasurybillsfroma dealerin U.S. governmentsecuritie~.~In today's world of computer- ized financialtransactions,the FederalReserveBank pays forthe securitieswith an "electronic"checkdrawn on itself! Via its"Fedwire" transfer network, the Federal Reserve notifiesthe dealer's designatedbank (BankA) that payment for the securitiesshouldbe credited to (de- posited in) the dealer'saccountat BankA At the same time, BankA's reserveaccountatthe FederalReserve iscreditedforthe amountof the securitiespurchase. The FederalReserve Systemhas added $10,000of securi- ties to itsassets,which ithas paid for,in effect, by creating aliabilityonitself in the formof bank reservebalances. These reserveson BankA's books arematchedby $10,000of the dealer's depositsthat did not existbefore. See illustration 1. How the Multiple Expansion ProcessWorks If the processendedhere,therewould be no "multi- ple" expansion,i.e., depositsandbank reserveswould havechangedby the sameamount However,banksare requiredto maintainreservesequalto onlya fraction of their deposits. Reservesin excessof this amountmaybe used to increase earningassets-loansand investments. Unused orexcessreservesearnno interest Undercurrent regulations,the reserverequirementagainstmost transac- tion accountsis 10percent5 Assuming,for simplicity,a uniform 10percent reserverequirementagainstalltransac- tion deposits,andfurther assumingthat allbanksattempt to remain fullyinvested,we cannowtracethe processof expansionin depositswhich can take place on the basisof the additionalreservesprovided by the Federal Reserve System's purchaseof U.S. governmentsecurities. Theexpansionprocessmay ormay not begin with BankA, dependingonwhat the dealerdoeswith the mon- eyreceivedfromthe saleof securities. If the dealerimme- diatelywriteschecksfor$10,000and allof them are depositedin otherbanks, BankAlosesboth depositsand reservesand showsno net changeasa result of the Sys- tem's openmarketpurchase. However,otherbankshave receivedthem. Mostlikely,a part of the initialdepositwill remain with BankA, and a partwillbe shifted to other banks asthe dealer'schecksclear. 6 Modem Money Mechanics It doesnot reallymatterwherethismoney is atany giventime. The importantfactisthat thesedeposits do not disappear. Theyarein somedepositaccountsatalltimes. All bankstogether have $10,000of depositsand reserves thatthey did nothave before. However,they arenot requiredto keep $10,000of reservesagainstthe $10,000 of deposits. All they need to retain,under a 10percent resenrerequirement, is$1,000. The remaining$9,000is "excessreserves." Thisamountcan be loaned or invested. See illustration 2. If businessisactive,the bankswith excessreserves probablywillhave opportunitiesto loan the $9,000. Of course,they donot reallypay outloansfromthe money theyreceiveasdeposits. If they did this,no additional moneywould be created. Whatthey dowhen they make loansisto acceptpromissorynotesin exchangeforcredits to the borrowers' transactionaccounts. Loans (assets) anddeposits (liabilities) both riseby $9,000. Reservesare unchanged by the loan transactions. Butthe depositcred- itsconstitutenewadditionsto the totaldepositsof the banking system. See illustration 3. 3Dollaramountsused in the variousillustrationsdo not necessarilybear any resemblancetoactualtransactions. Forexample,openmarketopera- tions typically are conductedwith many dealers and in amountstotaling severalbillion dollars. 'Indeed, manytransactionstodayareaccomplishedthroughanelectronic transferoffundsbetweenaccountsratherthanthroughissuanceofapaper check. Apart from the timing of posting, the accounting entries are the samewhetheratransferismadewith apapercheckorelectronically. The term "check,"therefore,is usedfor both typesof transfers. SForeachbank, the reserverequirementis 3 percent on a specifiedbase amountof transactionaccountsand 10percent on the amountabovethis base. Initially,theMonetaryControlActsetthisbaseamount-calledthe "low reserve tranche"-at $25 million, and provided for it to change annuallyinlinewiththegrowthintransactiondepositsnationally.Thelow reserve tranchewas $41.1million in 1991and $42.2millionin 1992. The Garn-St Germain Act of 1982 further modiied these requirements by exemptingthefirst$2millionofreservableliabilitiesfromreserverequire ments. Likethelowreservetranche,theexemptlevelisadjustedeachyear toreflectgrowthinreservableliabilities.Theexemptlevelwas$3.4million in 1991and $3.6millionin 1992.
  • 7. DepositEzpansion 1 Thecustomerdepositat Bank A likely will be transfeerred,in part, to otherbanks and quickly loses its identity amid the huge interbankflow ofdeposits. When the FederalReserveBankpurchasesgovernmentsecurities,bank reservesincrease. Thishappens becausethe sellerof the securitiesreceivespaymentthrough a creditto a designateddeposit account ata bank (BankA) which the FederalReserveeffectsby creditingthe reserve account of BankA Assets Liabilities Assets Liabilities U.S.government securities + 10,000 Expansion takesplace onlyif the banksthat hold these excessreserves (Stage1banks) increase 2 I their loansorinvestments. Loansaremade by Assets Liabilities Reserve accounts: Reserveswith Bank A + 10,000 W F.R. Banks + 10,000 ASa result, allbankstaken togethernow have Total reservesgainedfrom new deposits ..................... 10.000 "excess"reservesonwhich depositexpansion less: Requiredagainstnew deposits can take place. (at 10 percent)........................................ 1,000 equals Excessreserves ................................................ 9,000 crediting the borrower's deposit account, i.e., by creatingadditionaldeposit money. Customer deposit + 10,000 Deposit Expansion and Contraction 1 7 Loans + 9,000 ~~p Borrower deposits + 9,000
  • 8. ntisisthe beginningof the dejPosit expansionpmcess. In thefirst stageof the process, totalloansand depositsof the banksrise by an amountequalto the excessreserves existingbefore anyloanswere made (90percent of the initialdepositincrease). At the end of Stage 1,deposits have risen a total of $19,000 (theinitial$10,000provided by the FederalReserve's action plus the $9,000in deposits createdby Stage1banks). See illustration 4. However, only$900 (10percent of $9,OOO) of excessreserveshave been absorbedby the additionaldepositgrowth at Stage 1 banks. See illustration 5. Thelendingbanks,however, donot expectto retain the depositstheycreatethrough theirloan operations. Borrowerswrite checksthatprobablywillbe depositedin otherbanks. As thesechecksmovethroughthe collection process,the FederalReserveBanks debitthe reserve accountsof thepayingbanks (Stage 1banks) and credit those of the receivingbanks. See illustration 6. Whether Stage1banks actually dolosethe deposits to otherbanks orwhetheranyor allof theborrowers' checksareredepositedin thesesame banksmakesno differencein the expansionprocess. If thelendingbanks expect to losethese deposits-and an equalamountof reserves-asthe borrowers' checksarepaid,theywill not lend more than theirexcessreserves. Likethe original $10,000deposit,the loanaeated depositsmaybetrans ferred to otherbanks, but they remain somewherein the banking system. Whicheverbanksreceivethem also acquireequalamountsof reserves,of which allbut 10 percentwillbe "excess." Assuming thatthe banksholdingthe $9,000of d e posits created in Stage1in turn makeloansequalto their excessreserves,then loansand depositswill rise by a further$8,100in the secondstage of expansion. This processcan continueuntil depositshave risen to the point whereallthe reservesprovided by the initialpurchaseof governmentsecuritiesby the Federal ReserveSystemare just sufficientto satisfyreserverequirementsagainstthe newly created deposits. (Seepages 10and 1I.) Theindividualbank, of course,isnot concerned as to the stagesof expansionin which itmay be participating. Mows and outflowsof depositsoccurcontinuously. Any depositreceived isnew money,regardlessof itsultimate source. Butif bank policyisto makeloansand invest- ments equaltowhatever reservesarein excessof legal requirements,the expansionprocesswill be carriedon. How Much Can Deposits Expand in the Banking System? Thetotalamountof expansionthat cantakeplace is illustrated onpage 11. Carriedthrough to theoretical limits,the initial$10,000of reserves distributedwithinthe banking systemgivesrise to an expansion of $90,000in bank credit (loans and investments) and supportsa total of $100,000in new depositsunder a 10percent reserver e quirement. The depositexpansionfactorfor a given 8 Modern Monqr Mechanics amountof new reservesisthus the reciprocal of the r e quiredreservepercentage (1/.10 = 10). Loan expansion willbe lessby the amountof the initialinjection. Themulti- ple expansionispossible becausethe banksasa group arelike onelargebank inwhich checks drawnagainst borrowers' depositsresult in creditsto accountsof other depositors,with no net changein total reserves. Expansion through Bank Investments Depositexpansioncanproceed ii-ominvestments aswell asloans. Supposethatthe demandforloansat someStage 1banks isslack Thesebankswould then probablypurchasesecurities. If the sellersof the securities were customers,the bankswould makepaymentby credit- ingthe customers'transaction accounts;depositliabiities would risejust asif loanshad been made. Morelikely, thesebankswould purchasethe securitiesthrough deal- ers,paying forthem with checkson themselvesor ontheir reserveaccounts. Thesecheckswould be depositedin the sellers'banks. In eithercase,the net effectsonthe banking systemareidenticalwith those resultingfrom loan operations.
  • 9. As a result of theprocess sofar, totalassetsand totalliabiitiesof allbankstogetherhave risen Assets Reserveswith F.R. Banks + 10,000 Loans + 9,000 Total + 19.000 Liabilities Deposits: Initial + 10,000 Stage I + 19,000 Excessreserveshave been reduced by the Total reservesgainedfrom initialdeposii............................ 10,000 .............amountrequiredagainstthe depositscreated less: Requiredagainstinitialdeposits 1,000 ............ ......by the loansmade in Stage 1. lets: RequiredagainstStage I deposits 900 1,900 eq& Excess reserves........................................................ 8,100 Whydothesebankssmincreasingtheirloans and depositswhentheystill have excessreserves? ...becauseborrowerswrite checksontheir accountsatthe lendingbanks. As these checks I I are depositedin thepayees' banksand cleared, Assets Liabilities the depositscreatedby Stage 1loansand an Reservesv equalamountof reservesmay be transferred rF.R. Banks to otherbanks. vith - 9,000 Deposit expansion hasjust begun! Borrower deposits - 9,000 Assets Liabilities Assets Liabilities J Deposit Erpansionand Contmctwn 9 Reserveaccounts: Reserveswith Stage I banks - 9,000 2 F . R . Banks + 9,000 Other banks + 9,000 Deposits + 9,000
  • 10. 7 8 to Stage 3 banks Expansioncontinuesasthebanksthathave excessreservesincreasetheirloansby that amount, creditingborrowers' depositaccounts Assets Liabilities in the process, thus creatingstillmore money. 9 Loans + 8,100 NOWthe bankingsystem'sassetsandliabilities have risen by 27,100. Assets Liabilities ..........................Butthere arestill7,290of excessreservesin the Total reservesgainedfrom initialdeposits 10,000 ............bankingsystem. less: Requiredagainst initialdeposits 1,000 less: Requiredagainst Stage I deposii............ 900 less: Requiredagainst Stage2 deposits ............ 810.... a It should be understood that thestages ofexpansionoccurneithersimultaneously nor in thesequence demibed above. Some banks use theirresmes incompletelyor only aftera considerable time lag, whileothersexpand assetson the basis of expected resemegrowth. m eprocess is, infact,continuousand may neverreach its theoretical limits. Borrower deposits + 8,100 Reserveswith F.R Banks + 10,000 Loans: Stage I + 9,000 Stage 2 + 8,100 Total + 27,100 ......................................................eq& Excessreserves 7,290 10 10 1 Modem M m q Mahatub Deposits: Initial + 10,000 Stage I + 9,000 Stage 2 + 8,100 Total + 27,100 As borrowersmake payments,these reserveswill be furtherdispersed,andthe processcan continuethrough manymore stages,in progressivelysmallerincrements,until the entire 10,000of reserveshave been absorbed by depositgrowth. Asisapparentfromthe summarytableonpage 11,more than tw&hiidsof the deposit expansionpotential isreached afterthe firstten stages.
  • 11. Assets Reserves Total [Required] [Excess] Initial reserves provided ................... 10*000 1.000 9.000 Expansion- Stage l ..................... 10.000 1,900 8.100 Stage 2 ..................... 10.000 2.710 7.290 Stage3 ..................... 10.000 3.439 6,561 Stage 4 ..................... 10.000 4,095 5.905 Stage 5 ..................... lO.Oo0 4.686 5.3 14 Stage 6 ..................... 10,000 5,2 17 4.783 Stage 7 ..................... 10,000 5,695 4.305 Stage 8 ..................... 10,000 6. 126 3.874 Stage 9 ..................... lo,000 6.513 3.487 Stage I 0 ................... lo.000 6.862 3.I38 Stage 20 ................... 10.000 8.906 1.094 Final stage................ 10,000 / 0.000 0 Loans and Investments Liabilities Deposits 10.000 Deposit wowtar a& Corfmctiopz
  • 12. How Open Market Sales Reduce Bank Reserves and Deposits Now supposesomereductionin the amountof money isdesired. Nonnally thiswould reflecttemporary or seasonalreductionsin activityto be hawed since,on ayear-to-yearbasis, agrowing economyneeds atleast somemonetary expansion. Just aspurchasesof govern- ment securitiesby the pederal ReserveSystemcan pre vide thebasisfor depositexpansionby addingto bank reserves, salesof securitiesby the Federal ReserveSystem reduce the money stockby absorbingbank reserves. The processisessentiallythe reverseof the expansionsteps just described. Supposethe FederalReserveSystemsells$10,000of Treasuryb i s to a U.S. governmentsecuritiesdealerand receivesinpaymentan "electronic"checkdrawnonBank A Asthispaymentismade,BankA's reserveaccountat a FederalReserveBank isreduced by $10,000. As a result, the FederalReserveSystem's holdingsof securitiesand the reserve accountsof banks areboth reduced $10,000. The$10,000reductionin BankA's depositliabilitiesconsti- tutes a declinein the money stock. Seeillustration 11. Contraction Also Is a Cumulative Process While BankA mayhave regainedpart of the initial reduction in depositsfromotherbanksasa result of inter- bank depositflows,allbankstaken togetherhave $10,000 lessin both depositsand reservesthan they had before the FederalReserve's salesof securities. The amountof reservesfreed by the declinein deposits,however,isonly $1,000(10percent of $10,000). Unless thebanksthatlose the reservesand depositshad excessreserves,they are leftwith a reserve deficiencyof $9,000. See illustration 12. Although they mayborrow fromthe Federal Reserve Banksto coverthis deficiencytemporarily,soonerorlater the bankswill have to obtainthe necessary reservesin someotherway or reducetheir needsfor reserves. Oneway for a bank to obtainthe reservesit needs isby sellingsecurities. But, asthe buyersof the securities pay forthemwith fundsin their depositaccountsin the sameor otherbanks, the net result isa $9,000declinein securitiesand depositsat allbanks. See illustration 13. At the end of Stage 1of the contractionprocess, deposits have been reduced by a totalof $19,000 (theinitial $10,000 resultingfrom the Federal Reserve's action plus the $9,000 in depositsextinguishedby securitiessalesof Stage 1 banks). See illustration 14. However,thereisnowa reservedeficiencyof $8,100 atbankswhose depositorsdrewdown their accountsto purchasethe securitiesfrom Stage 1banks. Asthe new groupof reservedeficientbanks,in turn,makesup this deficiencyby sellingsecuritiesor reducingloans,further depositcontractiontakesplace. Thus,contractionproceedsthrough reductionsin depositsandloansor investmentsin one stageafteranoth- er until total depositshave been reduced to the point 12 / Modem MoneyMnhanics wherethe smallervolume of reserves isadequateto sup port them. The contractionmultipleisthe sameasthat which appliesin the caseof expansion. Under a 10percent reserverequirement,a $10,000reductionin reserveswould ultimatelyentailreductions of $100,000in depositsand $90,000inloansandinvestments. As in the caseof depositexpansion,contractionof bank depositsmay take place as a result of eithersalesof securitiesorreductions of loans. While someadjustments of both kinds undoubtedlywould be made,the initialim- pactprobablywould be reflectedin salesof government securities. Mosttypes of outstandingloanscannotbe calledforpayment prior to their due dates. Butthe bank may ceaseto make newloansor refuse to renewoutstand- ingonesto replacethosecurrentlymaturing. Thus,depos itsbuilt up by borrowersfor the purposeof loan retirement would be extinguished asloanswere repaid. There is oneimportantdifferencebetween the expan- sion and contractionprocesses. Whenthe FederalReserve Systemaddsto bank reserves,expansionof creditand depositsmay take place up to the limitspermittedby the minimum reserveratio that banksarerequired to maintain. Butwhen the Systemactsto reducethe amountof bank reserves,contractionof creditand depositsmust takeplace (exceptto the extentthat existingexcessreserve balances and/or surplusvaultcash areutilized) to the pointwhere the required ratio of reserves to depositsisrestored. But the signi6canceof this difference shouldnot be overempha- sized. Becauseexcessreservebalancesdonot earninter- est, there isa strongincentiveto convertthem into earning assets (loansand investments).
  • 13. Assets Liabilities Liabilities 11 U.S. government Reserve accounts: Reserveswith 1Customer securities -10,000 BankA - 10,000 W F . R Banks - 10,000 deposit - 10,000 When the Federal Reserve Bank sellsgovernment securities,bank reservesdecline. This happens because the buyer of the securitiesmakespayment through a debitto a designated depositaccountat a bank (BankA),with the transferof fundsbeing effectedby a debitto BankA's reserveaccountat the Federal Reserve Bank. lXisreduction in the customerdepositat Bank A may be spread among a numberof banks throughhtedank depositflows Contraction-Stage 1 I The bankswith the reservedeficiencies (Stage 1 banks) cansellgovernmentsecuritiesto acauire 12 1 I reserves,but thiscauses a declinein the debsits &sets Liabilities The loss of reservesmeansthat allbanks taken Total reserveslostfrom deposawithdrawal...................... 10,000 together now have a reservedeficiency. less Reservesfreed bydeposiidecline (at 10 percent) ..................................................... 1,000 equals Mciency in reservesagainst remainingdepostts. 9,000 and reservesof the buyers' banks. U.S. government securities - 9,000 Reserveswith + 9,000 As a resultof the processsofar, assets and total depositsof allbankstogether havedeclined 19,000. Assets Liabilities Assets Liabilities J Stage 1contractionhas freed 900of reserves,but Liabilities there is stilla reservedeficiencyof 8,100. Reserveswith Deposits: F.R. Banks US.government Stage I securities 9,000 Total - 19.000 Reserve accounts: Reserveswith Stage I banks + 9,000 9 F . R . Banks - 9,000 Other banks - 9,000 I Futthncontractionmust take#lace! Deposits - 9,000 Deposit E*palrtion and Contraction 13
  • 14. Bank Reserves-How l%eyChange Moneyhas been detined asthe sum of transaction accountsin depositoryinstitutions,and currencyandtrav- elerschecksin the hands of the public. Currencyis some thingalmosteveryoneuses everyday. Therefore,when mostpeoplet h i i of money,theythink of currency. Con- traryto this popular impression,however,tmtlsactiolr depositsarethe most signiscantpart of the moneystock Peoplekeep enoughcurrencyon hand to effect smallface teface transactions,but theywrite checksto covermost largeexpenditures. Most businessesprobablyhold even smalleramountsof currencyin relationto theirtotaltrans actionsthan do individuals. Sincethe mostimportantcomponentof moneyis transactiondeposits,and sincethese depositsmustbe sup ported by reserves,the centralbank's influenceovermon- eyhingeson itscontroloverthe totalamountof reserves and the conditionsunderwhich bankscan obtain them. The preceding illustrationsof the expansionand contractionprocesseshave demonstratedhow the central bank, by purchasing and sellinggovernmentsecurities, can deliberatelychangeaggregatebank reservesin order to affectdeposits. But open market operationsare only one of a number of kinds of transactionsor developments that causechangesin reserves. Somechangesoriginate from actionstakenby the public,by theTreasuryDepart- ment, by the banks, orby foreign andinternationalinstitu- tions. Otherchangesarisefromthe servicefunctionsand operatingneedsof the Reserve Banksthemselves. Thevariousfactorsthat provide and absorbbank reserve balances,togetherwith symbolsindicatingthe effectsof these developments,arelistedonthe opposite page. Thistabulation alsoindicatesthe nature of the bal- ancingentriesonthe Federal Reserve's books. Co the extentthat the impactisabsorbedby changesinbanks' vaultcash,the Federal Reserve's books are unaffected.) Independent FadorsVersus PolicyAction It isapparentthat bank reservesare affectedin sev- eralways thatare independentof the controlof the central bank. Most of these "independent?elementsare changing more orlesscontinually. Sometimestheir effectsmay last only a day or twobeforebeiig reversed automatically. Thishappens,forinstance,when bad weatherslowsup the checkcollectionprocess,givingrise to an automaticin- creasein Federal Reserve creditin the form of "float." Otherinfluences,suchaschangesin the public's currency holdings,may persistforlongerperiodsof time. Stillothervariationsin bank reservesresult solely from the mechanicsof institutionalarrangementsamong theTreasury,the FederalReserveBanks,and the deposi- tory institutions. TheTreasury,for example,keepspart of itsoperatingcash balanceon depositwith banks. But virtually all disbursementsare made from itsbalancein I4 I Modern Money Mechanics the ReserveBanks. As is shownlater, anybuildupin bal- ancesatthe ReserveBanksprior to expenditureby the Treasurycausesa dollar-fordollardrainon bank reserves. In contrastto these independentelementsthat affect reservesare the policy actionstaken by the Federal Re serveSystem. Theway Systemopen market purchases and salesof securitiesaffectreserveshas alreadybeen d e scribed. In addition,there are two otherwaysin which the Systemcanaffectbank reservesand potentialdepositvol- ume directly:first,through loansto depositoryinstitutions; and second,through changesin reserve requirementper- centages. A changein the required reserveratio,of course, doesnot alterthe dollarvolume of reserves directlybut doeschangethe amount of depositsthat a givenamount of reservescan support. Any changein reserves,regardlessof itsorigin,has the samepotentialto affect deposits. Therefore,in orderto achievethe net reserve effectsconsistentwith itsmonetary policy objectives,the FederalReserveSystemcontinuously must take accountof what the independentfactorsare doingto reservesand then,using itspolicytools,offsetor supplementthem asthe situationmay require. By farthe largestnumber and amount of the Sys tern's gross open markettransactionsare undertaken to offset drainsfrom or additionsto bank reservesfrom non- FederalReservesourcesthat mightotherwisecauseabrupt changesin creditavailabiity. In addition,Federal Reserve purchasesand/or salesof securitiesare madeto provide the reservesneeded to supportthe rate of moneygrowth consistentwith monetary policy objectives. In this section of the booklet, severalkindsof trans- actionsthat canhave importantweek-to-weekeffectson bank reservesare traced in detail. Other factorsthat nor- mallyhave onlya smallinfluenceare describedbrieflyon page 35.
  • 15. Facton ChangingReserve Balances-lndefiendent and Assets Liabilities Public actions ....................................................................lncrease in currency holdings ..................................................................Decrease in currency holdings Treasury, bank, and foreign actions Increase in Treasury deposits in F.R. Banks ........................................... Decrease in Treasury deposits in F.R. Banks ......................................... Gold purchases (inflow) o r increase in official valuation* ................... Gold sales (outflow)* .................................................................................. Increase in SDR certificates issued* ......................................................... Decrease in SDR certificates issued* ...................................................... Increase in Treasury currency outstanding* .......................................... Decrease in Treasury currency outstanding* ........................................ Increase in Treasury cash holdings* ......................................................... Decrease in Treasury cash holdings* ...................................................... increase in service-related balancesladjustments.................................. Decrease in service-related balancesladjustments ............................... Increase in foreign and other deposits in F.R. Banks ........................... Decrease in foreign and other deposits in F.R. Banks ......................... Federal Reserve actions ...................................................... ...................................................... ................................................... Increase in Federal Reserve float ............................................................. Decrease in Federal Reserve float ........................................................... ..........................lncrease in assets denominated in foreign currencies .......................Decrease in assets denominated in foreign currencies increase in other assets** .......................................................................... ........................................................................Decrease in other assets** Increase in other liabilities** ..................................................................... ...................................................................Decrease in other liabilities** Increase in capital accounts** ................................................................... .................................................................Decrease in capital accounts** * These factors represent assets and liabilities of the Treasury. Changes in them typically affect reserve balancesthrough a related change in the Federal Reserve Banks' liability "Treasury deposits." ** Included in "Other Federal Reserve accounts" as described on page 35. *** Effect on excess reserves. Total reserves are unchanged. Note: To the extent that reserve changes are in the form of vault cash, Federal Reserve accounts are not affected. Facton flfectitzg Balk Reserves 15
  • 16. Changesin theAmount of CuvmcyHeld by thePublic Changesin the amountof currencyheld by the public typicallyfollowa fairlyregularintramonthlypattern. Majorchangesalsooccur overholidayperiods and during the Christmasshoppingseason-timeswhen peoplefind itconvenientto keep more pocketmoney onhand. (See chart.) Thepublic acquirescurrencyfrombanksby cash- ingchecks6 When deposits,which arefractionalreserve money,areexchangedfor currency,which is 100percent reserve money,thebanking systemexperiencesa net reserve drain. Under the assumed 10percent reserve requirement,agivenamountof bank reservescan support depositsten times asgreat,but when drawnupon to meet currencydemand,the exchangeisoneto one. A $1in- creasein currencyusesup $1of reserves. Supposea bank customercashed a $100checkto obtaincurrencyneeded for aweekend holiday. Bank depositsdecline$100becausethe customerpaysfor the currencywith a checkonhis orher transactiondeposit; and thebank'scurrency (vaultcash reserves) isalso r e duced $100. See illustration 15. Now the bank has lesscurrency. It may replenish itsvaultcashby orderingcurrencyfromitsFederalRe serveBank -makingpaymentby authorizinga charge to itsreserve account. Onthe ReserveBank's books,the chargeagainstthe bank'sreserveaccountisoffsetby an increasein theliabilityitem "FederalReservenotes." See illustration 16. The ReserveBank shipmentto thebank mightconsist,atleastin part, of US. coinsratherthan FederalReserve notes. All coins,aswell asa smallamount of paper currencystilloutstandingbut no longerissued, are obligationsof theTreasury. Tothe extentthat ship ments of cash to banksarein the formof coin,the offset- ting entryon the ReserveBank's books isa declinein its assetitem "coin." Thepublic nowhas the samevolumeof money as before,exceptthat more isin the formof currency and lessis in the form of transactiondeposits. Under a 10 percent reserve requirement,the amountof reservesre- quired againstthe $100of depositswas only$10,while a full$100of reserveshave been drainedawayby the dis bursement of $100in currency. Thus,if the bank had no excessreserves,the $100withdrawalin currencycausesa reserve deficiencyof $90. Unlessnewreservesarepro- videdfrom someother source,bank assetsand deposits will haveto be reduced (accordingto the contractionpro- cessdescribedon pages 12and 13)by an additional$900. At thatpoint, the reservedeficiencycaused by the cash withdrawalwould be eliminated. When CurrencyReturns to Banks, Reserves Rise Afterholidayperiods,currencyreturnsto the banks. Thecustomerwho casheda checkto coveranticipated cashexpendituresmaylaterredepositanycurrency still held thafs beyond normal pocketmoney needs. Most of it 16 / Modern Money Mechanb Currency heldby the public weekly averages, billions of dollars, not seasonally adjusted probablywill have changedhands, and itwill be deposited by operatorsof motels,gasoline stations,restaurants,and retail stores. Thisprocessisexactlythe reverseof the currencydrain,exceptthatthe bankstowhichcurrency isreturned may not be the samebanks thatpaid itout. But in the aggregate,the banksgain reservesas 100 percentreserve money isconvertedback intofractional reservemoney. When $100of currencyisreturned to the banks, depositsandvaultcash are increased. See illustration 1Z Thebanks cankeep the currencyasvaultcash,which also countsasreserves. Morelikely,the currencywill be shippedto the ReserveBanks. The ReserveBankscredit bank reserve accountsand reduce Federal Reservenote liabiities. See illustration 18. Sice only$10must be held againstthe new$100in deposits,$90isexcessreserves and cangiverise to $900of additionaldeposits. To avoidmultiplecontractionor expansionof deposit money merely becausethe public wishesto changethe compositionofitsmoneyholdings,the effectsof changes in the public's currencyholdings on bank reservesnor- mally areoffsetby System open marketoperations. 6Thesame balance sheet entries applywhether the individualphysically cashesapapercheckorobtainscurrencybywithdrawingcashthrough an- - automati; tkllermachine. - - 'Under current reserve accounting regulations,vault cash reserves are used tosatisfyreserverequirements inafuturemaintenanceperiodwhile reserve balances sati* requirements in the currentperiod. As a result, theimpactonabank's currentreservepositionmaydifferfromthat shown unless the bank restores its vault cash position in the current period via changes in its reserve balance.
  • 17. 15! When a depositorcashesa check,both depositsandvaultcash reserves decline. I Assets Liabilities Vault cash reserves Deposits -100 Assets Liabilities Assets Liabilities Reserve accounts: Vault cash +I00 Bank A Reserveswith F.R. notes +I00 F.R. Banks - 100 16 When currencycomesback to the banks, both depositsandvaultcash reservesrise. If the bank replenishesitsvaultcash,itsaccountat the ReserveBank is drawn downin exchangefornotes issued by the Federal Reserve. Assets Vault cash reserves +I00 Liabilities If the currencyisreturned to the Federal Reserve,reserveaccountsarecredited and Federal Reserve notes aretaken outof circulation. Assets Liabilities Assets Vault cash - 100 Reserveswith FA. notes F.R. Banks +I00 Liabilities I FactorsAfecting Bark Reserues 17
  • 18. Changesin US. Treasury Depositsin Federal Bank Reserveaccountsof depositoryinstitutionsconsti- tutethe bulk of the depositliabilitiesof the FederalRe- serveSystem. Otherinstitutions,however,alsom & ~ n balancesin the Federal ReserveBanks-mainly the U.S. Treasury,foreigncentralbanks, and internationalhancial institutions. In general,when these balances rise, bank reserves fall,and viceversa. 'I'his occursbecausethe fundsu se agenciesto build up their depositsin the Res s ultimatelycomefrom depositsin banks. Gonvemly,recipientsof paymentsfrom these agenciesnormallydepositthe fundsin banks. the collectionprocessthese banks receivecre reserve accounts. rtant nonbank depositoristhe US. Treasury. Partof theTreasury's ope iskeptin the Federal ReserveBanks, depositoryinstitutionsalloverthe counm,in d l e d 'Treasury tax andloan" m&L) note accounts. a&) Disbursementsby theTreasury,h madeagainstitsbalances atthe Federal Reserve. Thus, transfersfrombanks to Federal ReserveBanks are made throughregularlyscheduled"calls"on TT&Lbalancesto assurethat sufficientfundsare availableto coverTreasury checksasthey arepresented for payment8 CallsonTT&Lnoteaccountsdrainreservesfrorn the banksby the fullamountofthe transferasfundsmove frorntheTT&Lbalances (Via chargesto bank reserve accounts)toTreasurybalances at the ReserveBanks. Becausereservesare not required againstTT&Lnote accounts,these transfers do not reducerequired reserves? SupposeaTreasurycallpayableby BankA amounts to $1,000. The Federal Reserve Banksare authorized to transfer the amountof theTreasurycallfromBankA's reserve accountatthe FederalReserve to the account of the U.S. Treasuryatthe FederalReseme. As a result of the transfer,both reservesandTT&Lnotebalancesof the bank arereduced. On the books of the ReserveBank, bank reserves declineandTreasurydepositsrise. Thiswithdrawalof Treasuryfundswill causea reserve deficiencyof $1,000sinceno resemes are releasedby the declineinlT&Lnote accountsatdeposi- tory institutions. As theTreasurymakes expenditures,checksh w n on itsbalancesin the ReserveBanksare paid tothe public, andthese fundsiindtheirway back to banksin the form of deposits. The banks receive reserve creditequalbthe full amountof these depositsalthoughthe corresponding increasein theirrequired reservesis only 10percent of thisamount. Modem MoneyMechanics -- ---- -- - -- -- Operatingcash balanceof the US. Treasury weekly averages, billions of dollars, not seasonally adjusted Supposea governmentemployeedepositsa $1,000 checkin Bankk The bank sendsthe checkto itsFederalReserveBankfor collection. The Reserve Bank then creditsBankATsreserve accountand chargesthe Treasury's account. As a result, thebank gainsboth re- servesand deposits. Whilethere is no changein the as- setsortotalliabilitiesof the Reserve Banks,the funds drawn awayfrom theTreasury's balances havebeen shift- ed to bank reserve accounts. One of the objectivesof theTT&Lnoteprogram, which requiresdepositoryinstitutionsthatwant to hold Treasuryfundsfor more than onedayto pay intereston them,isto allowtheTreasuryto hold itsbalanceatthe ReserveBanksto the minimum consistentwith current paymentneeds. By mainMng a fairlyconsmt balance, largedrainsfrom oradditionsto bank reservesfromwide swingsin theTreasury's balancethat would requireexten- siveoffsettingopenmarket operationscan be avoided. Nevertheless,there are stillperiodswhen these fluctua- tionshave large reserveeffects. In 1991,forexample, week-to-weekchangesinTreasurydepositsatthe Reserve Banks averaged only$56million,but ranged from"$4.15 biion to +$8.57billion. When theTreasurykbalanceattheFederalReserverisesaboveexpected payment needs, the Treasury m y place the excess funds in lT&L note accountslfirough a "direct investment." The accountingentries are the same, but of opposite signs,as those shown when funds are transferred from'lT&L note accountstoTreasurydeposits atthe Fed. *TmpaymenbreceivedbyinstitutionsdesignatedasFederaltaxdepositar- ies initially are credited to reservable demand deposits due to the U.S. govement. Becausesuch tax paymentstypicallycomefrom reservable transactionaccounts,required reservesarenot materiallyaffectedon this day, Onthenextbusinessday,however,whenthesefundsareplacedeither in a nonreservable note account or remitted to the Federal Reserve for creditto theTreasury'sbalanceatthe Fed, required reservesdecline.
  • 19. Assets 19 Liabilities Assets Liabilities When theTreasurybuildsupitsdepositsat the Federal Reservethrough"calls"on?T&L notebalances, reserveaccountsarereduced. Reserve accounts: Reserveswith Bank A - 1.000 f---,F.R Banks U.S.Treasury deposits +1,000 Treasury tax and loan note account - 1,000 Liabilities Assets Liabilities 20 Reserve accounts: Reserveswith Bank A +1.000UF.R. Banks U.S.Treasury deposits - 1.000 Checkswrittenon theTreasury's accountatthe Federal ReserveBank aredepositedin banks. As these are collected,banksreceivecreditto theirreserveaccountsatthe Federal ReserveBanks. Privatedeposits +1.000 FactonMeetingBank RCSCNCS 19
  • 20. Changesilz Federal Reseme Float Alargeproportionof checksdrawnonbanks and depositedin otherbanksiscleared (collected)through the Federal ReserveBanks. Someof thesechecksarecredit- ed immediatelytotheresem accountsof the depositing b& and arecollectedthe samedayby debitingthe reserve accountsof the banksonwhichthe checksare drawn. All checksarecreditedto theaccountsof the depositingbanksaccordingtoavailabilityschedules relatedtothe timeitnormallytakesthe FederalReserveto collectthe checks,but rarelymore thantwobusiness days aftertheyarereceived atthe ReserveBanks,eventhough they may notyethavebeen collected dueto processing, mspomtion, or otherdelays. Thereservecreditgivenforchecksnotyetcollected isincludedin FederalResenre Onthe booksof the FederalReserveBanks,balance sheetfloat, orstate- mentfloatasitissometimescalled,isthe differencebe- tweenthe asset account"itemsin processof collection," andthe liabiityaccount"deferredcredititems." State- mentfloatisusuallypositive sinceitismore oftenthecase thatreserve creditisgivenbeforethe checksareactually collectedthan the otherwayaround. Publisheddataon FederalReservefloatarebased on a"reserves-fadof' frameworkratherthan abalance sheetaccountingkamework. Aspublished,Federal Re- servefloatincludesstatementfloat,asdehned above,as wellasfloat-related"as-of' adjustments." Theseadjust- mentsrepresentcorrectionsforerrorsthatarisein pro- cessingtransactionsrelated to Federal Reservepriced services. As-ofadjustmentsdonot changethebalance sheetsof eitherthe Federal ReserveBanksoran individ- ualbank. Rather they arecorrectionstothe bank'sreserve position,thereby affectingthe calculationof whether or notthebank meetsitsreserverequirements. An Increase in Federal Reserve kink Reserves Asfloatrises, totalbank reservesrise by the same amount. For example,supposeBankAreceiveschecks totaling$100drawnon BanksB, C,and D, allin distant cities. BankAincreasesthe accountsof itsdepositors $100,and sendsthe itemsto aFederalReserveBankfor collection. Upon receipt of the checks,the ReserveBank increasesitsownassetaccount"itemsin processof collec- tion,"andincreasesitsliabilityaccount"deferredcredit items" (checksand other itemsnotyet creditedta the sendingbanks' reserveaccounts). Aslongasthesetwo accountsmove together,there isno changein floator in totalreservesfromthis source. See illustmtiotz21. On the next businessday (assumingBanksB, C, and D are oneday deferred availabilitypoints), the Re- serveBankpaysBankA. The ReserreBank's "deferred credititems"accountisreduced,and BankA's reserve accountisincreased $100. If theseitemsactuallytake morethan onebusinessdayto collectsothat "items in 10 / Modem Momy Mechanics FederalReservefloat (includingas-of adjustments) annual averages, billions of dollars 81 processof collection*arenot reducedthat day,the credit to BankA representsan addition to totalbank reserves sincethe reserveaccountsof BanksB, C,and Dwillnot havebeen commensmtelyreduced.= See iEZusl.ration22. A Decline in Fed Reserve Float Reduces Bamk Remrves Onlywhen the checksareactuallycollectedfrom BanksB, C,and D doesthe floatinvolvedin the aboveex- ampledisappear-"items in processof collectioni'of the Reserve Bank declineasthe reserveaccountsof BanksB, C,and D are reduced. See illustration23. On anannualaveragebasis,FederalReservefloat declineddramaticallyfrom 1979through 1984,in part reflectingactionstaken to implementprovisionsof the MonetaryControlAct that directedthe Federal Reserveto reduce andpricefloat. (Set: chant.) Since1984,Federal Reservefloathas been fairlystableon anannualaverage basis,but oftenfluctuatessharplyover shortperiods. From the standpointof the effectonbank reserves,the significantaspectof floatisnotthatitexistsbutthatits volumechangesin a difticdt-to-predictway. Floatcan increaseunexpectedly,forexample,if weatherconditions groundplanestransportingchecksto payingbanksfor collection. However,suchperiodstypicallyarefollowed by oneswhere actualcollectionsexceed newitemsbeing received for collection. Thus,reservesgainedfromfloat expansionusuallyare quitetemporary. '"Federal Reserve float also arises from other funds transfer sentices provided by the Fed, such as wire transfers, securities transfers, and automaticclearinghousetransfers. "As-ofadjustmentsalsoareusedasonemeansofpricingfloat,asdiscussed on page22,andfornonfloat-relatedcorrections,asdiscussedonpage35. I2If thechecksreceivedfromBankAhadbeenerroneouslyassignedatwo- day deferred availability,then neitherstatementfloatnor reserveswould increase,although both should. BankA's reservepositionandpublished FederalReservefloatdataarecorrectedforthisandsimilarerrorsthrough asof adjustments.
  • 21. Assets 21 Items in process of collection +I00 When a bank receives depositsin the formof checksdrawn onotherbanks, itcan send them to the Federal ReserveBank for collection. (Required reserves arenot affected immediatelybecauserequirementsapplyto net transactionaccounts,i.e., total transactionaccountsminus both cash itemsin processof collectionand depositsduefrom domesticdepositoryinstitutions.) Liabilities Assets Liabilities Assets Deferred Cash items in credit items +I00 process of collection +I00 22 Liabilities Assets Deferred Cash items in credit items -100 processof Reserve accounts: collection - 100 Bank A Reserves with F.R. Banks +I00 Deposits +I00 Ifthe reserveaccountofthe payee bank iscreditedbeforethe reserveaccountsof the payingbanksaredebited, total reservesincrease. Liabilities Assets 23 Items in process of collection - 100 But upon actualcollectionof the items,accountsof the payingbanks arecharged,andtotalreservesdecline. Liabilities Assets Liabilities Reserveaccounts: Bank B -100 Bank D Facton qdFectingBank R-LS 21
  • 22. Changesin Service-RelatedBalances andA&&ments In orderto fostera safeand efficientpaymentssystem, the Federal Reserve offersbanksavarietyof paymentsser- vices, Priorto passage of the Monetary ControlAct in 1980, the Federal Reserve offeredits servicesfree,but onlyto banksthat were membersof the Federal ReserveSystem. TheMonetaryControlAct directed the Federal Reserveto offeritsservicesto alldepositoryinstitutions,to chargefor these services,and to reduceandprice FederalReserve float.13 Except forfloat,allservicescovered by theActwere pricedby the end of 1982. Implementationof floatpricing essentiallywascompleted in 1983. Theadvent of FederalReservepriced servicesled to severalchangesthat affectthe use of fundsin banks' re- serveaccounts. As a result,onlypart of the totalbalancesin bank reserve accountsisidentifiedas"reservebalances" availableto meet reserverequirements. Otherbalancesheld in reserveaccountsrepresent "service-relatedbalancesand adjustments (tocompensateforfloat)." Service-relatedbal- ancesare"requiredclearingbalances"held by banksthat use FederalReserve serviceswhile"adjustments"representbal- ancesheld by banksthatpay for floatwith as-of adjustments. An Increase in Required Clearing B b c e s Reduces Reserve Balances Proceduresfor establishingand maintainingclearing balances were approvedby the Board of Governorsof the FederalReserve Systemin February 1981. Abank may be requiredto hold a clearingbalanceif ithas no required re- servebalance or if itsrequired reservebalance (held to satis- fy reserverequirements) isnotlargeenoughto handle its volumeof clearings. Tmicallya bank holdsboth reservebal- ancesandrequired clearingbalancesin the samereserve account. Thus,asrequired clearingbalancesareestablished or increased,theamountof fundsin reserveaccountsidenti- fiedasreserve balancesdeclines. SupposeBankAwants to use FederalReserve services but has a reserve balance requirementthatislessthan its expected operatingneeds. With itsReserveBank,it isdeter- mined that Bank Amust maintain a required clearingbalance of $1,000. If BankA has no excessreservebalance, itwill have to obtainfundsfrom someother source. Bank Acould sell$1,000of securities,but thiswill reducethe amountof totalbank reservebalancesand deposits. See illrkstration24. Banksarebilled eachmonthfor the Federal Reserve servicesthey have used with paymentcollected ona speci- fieddaythe followingmonth. All requiredclearingbalances held generate"earningscredits"which canbe used onlyto offsetchargesfor FederalReserve services.14Alternatively, bankscanpay for servicesthrough a directchargeto their reserve accounts. If accrued earningscreditsare used to pay for services,then reservebalancesareunaffected. On the otherhand,if paymentfor servicestakesthe form of a direct chargeto thebank's reserveaccount,then reservebalances decline. See illustrafian25. 22 Mudai Money M~ckanlo Service-relatedbalances and adjustments weekly averages, billions of dollars, not seasonally adjusted -Of Adjushents Reduce In 1983,the Federal Reservebegan pricing explicitly forfloat,15specifically"interterritory"checkfloat,i.e., float generated by checksdepositedby a bank servedby oneRe- serveBank but h w n ona bank servedby anotherReserve Bank. The depositingbank has three optionsin payingfor interterritorycheckfloatitgenerates. It can use itsearnings credits,authorizea direct charge to itsreserveaccount,or payfor the floatwith an as-of adjustment. If eitherof the first two optionsischosen,the accountingentriesarethe sameas payingfor otherpriced services. If the as-of adjustmento p tion ischosen,however,the balance sheetsof the Reserve Banksand the bank arenot directlyaffected. In effectwhat happensisthatpart of the total balancesheld in thebank's reserveaccountisidentifiedasbeing held to compensatethe Federal Reserveforfloat. Thispart, then,cannotbe used to satisfyeitherreserverequirementsor clearingbalancere- quirements. Floatpricingas-ofadjustmentsareapplied two weeks afterthe related floatisgenerated. Thus, an individual bank has sufticienttime to obtain fundsfrom other sourcesin orderto avoid anyreserve deficienciesthatmightresult from floatpricingas-of adjustments, If allbankstogetherhave no excessreserves,however,thefloatpricing as-of adjustments lead to a declinein totalbank reservebalances. Week-to-weekchangesin service-relatedbalancesand adjustmentscan bevolatile,primarily reflecting adjustments to compensateforfloat. (See cilart,) Sincethese changes areknown in advance,anyundesired impacton reserve bal- ancescanbe offseteasilythrough open market operations, 'The Act specified that fee schedules cover services such as check clearing and collection, wire transfer, automated clearinghouse, settle- ment, securitiessafekeeping, noncash collection, Federal Reserve float, and any new servicesoffered. M"Eamingscreditsn are calculated by multiplying the actual average c l e a ~ gbalanceheld overamaintenanceperiod,upto that requiredplus theclearingbalanceband,timesaratebasedonthe averagefederalfunds rate. The clearing balance band is 2 percent of the required clearing balanceor$25,000,whichever amountis larger. *Whilesometypes of floatarepriceddirectly,the FederalReserveprices othertypesoffloatindirectly,forexample,by includingthecostoffloatin the per-itemfeesforthe priced service.
  • 23. When BankA establishesa requiredclearing balanceata FederalReserveBank by selling - balance +1.000 Assets securities,the reserve balances and depositsof Assets otherbanksdecline. U.S. government securities - 1,000 Reserveaccount with F.R. Banks: Requiredclearing Liabilities Reserveaccounts: Requiredclearing balances: Bank A +1,000 4- Reserve balances: Liabilities Liabilities Reserveaccounts with F.R Banks: Other banks - 1,000 Deposits .. -1,000 When BankA isVied monthly for FederalReserveservicesused, itcan pay for these servicesby having earningscreditsapplied and/or by authorizinga directchargeto itsreserve account SupposeBankA has accrued earningscreditsof $100but incursfeesof $125.Then both methodswould be used. On the Federal Reserve Bank's books,the liabiityaccount "earningscreditsdueto depositoryinstitutions"declinesby$100 and BankA's reserve account isreduced by $25. Offsettingthese entriesisa reduction in the Fed's (other) assetaccount "accrued serviceincome." On BankA'sbooks, the accountingentriesmight be a $100reduc- tion to itsassetaccount "earningscreditduefrom FederalReserveBanks "and a $25reduction in itsreserve account, which are offsetby a $125declinein itsliabiity 'accounts payable." Whilean individualbank may use differentaccountingentries,the net effectonreservesisa reduction of $25,the amountof billed feesthat were paid through a directchargeto BankA's reserve account Assets Accrued service income - 125 Liabilities Assets Earnings credits Earnings credits due to depository due from institutions F.R Banks -100 Reserveaccounts: Reserveswith - 25 H F . R Banks - 25 Liabilities Accounts payable -125 FacfonmetingBark R m e s 23 I
  • 24. ChangesinLoans to Depository Institutions Loans to depository institutions monthly averages, billions of dollars, not seasonally adjusted Prior to passage of the Monetary ControlAct of 1980, onlybanks that were members of the Federal Reserve Sys- tem had regular accessto the Fed's "discountwindow." Sincethen, all institutionshaving depositsreservableunder theAct alsohave been ableto borrow fromthe Fed. Under conditionssetby the Federal Reserve,loansare available under three credit programs: adjustment, seasonal,and ex- tended credit.16 The averageamountof each type of discount windowcredit provided variesover time. (See rlrn~-fi When a bank borrowsfroma FederalReserve Bank, it borrows reserves. The acquisitionof reserves in this manner diem in an importantway from the cases already illustrated. Banksnormally borrow adjustmentcredit onlyto avoid re- servedeficienciesor overdrafts,not to obtain excessre- serves. Adjustmentcreditborrowings,therefore, are reserves on which expansion has already taken place. How can this happen? In their effortsto accommodatecustomersas well as to keepfullyinvested,banks frequentlymake loansin anticipa- tion of inflowsof loanablefundsfromdepositsor money market sources. Loans add to bank depositsbut not to bank reserves. Unless excessreserves can be tapped, banks will not have enough reserves to meet the reserve requirements againstthe new deposits. Likewise,individualbanks may incur deficienciesthrough unexpected depositoutflowsand correspondinglosses of reserves through clearings. Other banks receivethese depositsand can increase their loans accordingly,but the banks that lost them may not be ableto reduce outstandingloansor investmentsin order to restore their reserves to required levelswithin the required time period. In either case, a bank may borrow reserves tempo- rarily fromitsReserve Bank. Supposea customer of Bank Awantsto borrow $100. On the basisof the management'sjudgment that the bank's reserveswillbe sufticientto provide the necessary funds,the customeris accommodated. The loan is madeby increasing "loans"and creditingthe customer's depositaccount. Now BankA's depositshave increased by $100. However, if re- servesare insufticientto supportthe higher deposits,Bank A will have a $10reserve deficiency,assumingrequirements of 10percent. See zllustratlo~z26. Bank Amay temporarily borrowthe $10from its Federal Reserve Bank,which makes a loanby increasingits asset item "loansto depositoryinstitu- tions" and crediting Bank A's reserve account. Bank A gains reserves and a correspondingliability"borrowingsfrom FederalReserveBanks." See tlitutruiito~z27 To repay borrowing, a bank must gain reserves through either depositgrowth or asset liquidation. 3cr ~llrrstrntio~z2% Abank makes payment by authorizinga debitto its reserve account atthe Federal Reserve Bank. Repaymentof borrow- ing,therefore,reduces both reserves and "borrowingsfrom FederalReserveBanks." S ~ Pziiustmtzon 29 Unlike loans made under the seasonaland extended creditprograms,adjustmentcredit loans to banks generally Extended credit must be repaid within a shorttime sincesuch loans are made primarilyto cover needs created by temporaryfluctuationsin deposits and loansrelativeto usual patterns. Adjustments, such as sales of securities,made by some banks to "get out of the window" tend to transfer reserve shortages to other banks and may forcethese other banks to borrow, especially in periods of heavy credit demands. Even at timeswhen the totalvolume of adjustmentcredit borrowing is rising, some individualbanks are repayingloanswhile others are borrow- ing. In the aggregate, adjustmentcredit borrowing usually increases in periods of rising business activitywhen the public's demands for credit are rising more rapidly than nonborrowedreserves are being provided by Systemopen market operations. Although reserve expansionthrough borrowingis initi- ated by banks, the amount of reserves that banks can acquire in thisway ordinarilyislimitedby the Federal Reserve's ad- ministration of the discountwindowand by its controlofthe rate charged banks for adjustmentcredit loans-the discount rate.17 Loansare made onlyfor approved purposes, and other reasonablyavailable sources of funds must have been fully used. Moreover,banks are discouragedfromborrowingad- justment credit too frequentlyor for extended time periods. Raisingthe discountrate tends to restrain borrowingby increasingits cost relativeto the cost of alternativesources of reserves. Discountwindow administrationis an importantadjunct to the other Federal Reservetoolsof monetarypolicy. While the privilege of borrowing offersa "safetyvalve"to temporarily relieve severe strains on the reserve positions of individual banks, there is generallya strong incentivefor a bank to repay borrowing beforeaddingfurther to its loansand investments. - --- --- -. - -- -- 'fiAdjustmentcredit is short-term credit available to meet temporary needs for funds. Seasonalcredit is availablefor longer periods to smallerinstitu- tionshavingregular seasonalneedsforfunds. Extendedcreditmaybemade available to an institution or group of institutions experiencing sustained liquiditypressures. The reservesprovided through extendedcreditborrow- ing typicallyare offset by open market operations. ';Flexible discount rates related to rates on moneymarket sources of funds currentlyarecharged forseasonalcredit andforextendedcreditoutstanding more than 30 days. 24 1 Modem Money Mechanrcs
  • 25. 326 I Abank mayincur a reserve deficiencyif it makes loanswhen ithasno excess reserves. Assets Liabilities Loans no change I ~ssets Liabilities 1 Assets Liabilities 27 Borrowingfrom aFederal Reserve Bank to coversuch adeficitis accompaniedby a directcreditto the bank'sreserve account. 1 Nofirher expansion can takephce on the new reserves because thya nall neededagainst the deposits created in (26). Loansto depository + 10 Assets Liabilities Securities - 10 Reserve accounts: Reserves with Borrowingsfrom Bank A + 10-F.R Banks F.R. Banks + 10 +lo 1 Reserves with F.R Banks Assets 29 Liabilities Assets Repaymentof borrowingsfromthe Federal ReserveBank reducesreserves. Loansto depository institutions: Bank A - 10 Reserveaccounts: Reserves with Bank A - 10-F.R.Banks - 10 Liabilities Borrowingsfrom FactorsmetingEank Resewes 25
  • 26. ChangesinResave Reqzkments Thusfarwe have describedtransactionsthat affectthe volume of bank reservesand the impactthesetransactions haveupon the capacityof the banksto expandtheirassets and deposits. It isalsopossible toiduence depositexpan- sionorcontractionby changingthe required minimumratio of reservesto deposits. Theauthoritytovary required reserve percentagesfor banksthatwere membersof the FederalReserve System (memberbanks) was firstgranted by Congresstothe Fed- eralReserve Board of Governorsin 1933. The rangeswithin which this authoritycanbe exercisedhavebeen changed severaltimes,mostrecentlyin the MonetaryControlAct of 1980,which providedforthe establishmentof reserve r e quirementsthatapplyuniformlyto alldepositoryinstitutions. ?he 1980statuteestablishedthe followinglimits: On transadon accounts first$25 million 3% above $25 million 8%to 14% On nonpmonal time deposits 0%to 9% The 1980lawinitiallysetthe requirementagainsttransaction accountsover$25million at 12percent andthat against nonpersonaltime depositsat3percent Theinitial$25mik lion "lowreservetranche"wasindexed to changeeachyear in linewith 80percent of thegrowth in transactionaccounts atalldepositoryinstitutions. (For example,thelowreserve tranchewas increased from$41.1millionfor 1991to $42.2 million for 1992.) In addition,reserve requirementscan be imposedon certainnondepositsourcesof funds,suchas Eurocurrencyliabiitie~?~(Initiallythe Board seta 3percent requirementon Eurocurrencyliabiitiea) The Garn-StGermainAct of 1982modiied these provi- sionssomewhatby exemptingfromreserve requirements thefirst$2million of totalresemble liabiitiesateachdepos itoryinstitution. Similarto the lowreserve trancheadjust- mentfortransaction accounts,the $2million "resemble liabiitiesexemptionamount"was indexedto 80percent of annualincreasesin totalresembleliabiities. (For example, the exemption amountwas increased from $3.4 millionfor 1991to $3.6millionfor 1992.) TheFederalReserve Board isauthorized to change,at itsdiscretion,the percentagerequirementsontransaction accountsabovethelow reserve trancheand on nonpersonal time depositswithiithe rangesindicatedabove. In addition, the Board may impose differingreserve requirementson nonpersonaltime depositsbased on the maturityofthe de- posit. m e Board initiallyimposedthe 3percent nonper- sonaltime depositrequirement only on such depositswith originalmaturitiesof underfouryears.) Duringthe phasein period,which ended in 1984for mostmember banksand in 1987for most nonmemberinsti- tutions,requirementschanged accordingto a predetermined schedule,withoutanyactionby the FederalReserveBoard. Apart fromthese legallyprescribedchanges,oncethe Mone- tary ControlAct provisionswere implementedin late 1980, the Board did not changeanyreserve requirement ratiosuntil late 1990. m e originalmaturitybreak for requirementson nonpersonaltime depositswas shortened severaltimes, once in 1982andtwice in 1983,in connectionwith actionstakento deregulate ratespaid on deposits.) In December 1990,the Board reduced reserve requirements againstnonpersonal time depositsand Eurocurrencyliabilitiesfrom 3percentto zero. EffectiveinApril 1992,the reserve requirementon transactionaccountsabovethe low reservetranchewaslow- eredfrom 12percentto 10percent. When reserve requirementsarelowered,a portion of banks' existingholdingsof required reservesbecomesexcess reservesand may be loaned or invested. For example,with a requirement of 10percent, $10of reserveswould be required to support$100of deposits. See illustration30. Buta reduc- tion in the legalrequirementto 8percentwould tieup only$8, freeii$2outof each $10of reservesfor use in creatingaddi- tionalbank creditand deposits. See illustration 31. An increasein reserverequirements,on the otherhand, absorbsadditionalreserve funds,andbankswhich haveno excessreservesmust acquirereservesorreduce loansor investmentsto avoid a reserve deficiency. Thusan increase in the requirementfrom 10percentto 12percentwould boost required reservesto $12foreach $100of deposits. Assuming bankshave no excessreserves,thiswould forcethemto liquidateassetsuntilthe reserve deficiencywas eliminated, atwhich pointdepositswould be onesixthlessthan before. See illustration 32. Reserve Requirements and Monetary Policy The powerto changereserve requirements,likepur- chasesand salesof securitiesby the FederalReserve,isan instrumentof monetarypolicy. Even a smallchangein r e quirements-say,onehalf of onepercentagepoint-can have a largeandwidespread impact. Otherinstrumentsof monetarypolicy have sometimesbeen used to cushionthe initialimpactof a reserverequirement change. Thus,the Systemmay sellsecurities(or purchase lessthan otherwise would be appropriate) to absorbpartof the reservesreleased by a cutin requirements. It shouldbe noted that in additionto their initialimpact onexcessreserves,changesin requirements alterthe expan- sionpower of everyreserve dollar. Thus,suchchangesaffect the leverageof allsubsequentincreasesor decreasesin re- servesfrom anysource. For this reason,changesin thetotal volume of bank reservesactuallyheld between pointsin time when requirementsdiier do not provide an accurateindica- tion of the FederalReserve'spolicy actions. Both reserve balancesandvaultcash areeligibleto satisfyreserverequirements. To the extentsomeinstitutions normally hold vaultcashto meet operatingneedsin amounts exceedingtheir required reserves,they areunlikelytobe affected by anychange in requirements. I8The1980statutealsoprovidesthat"underextraordinarycircumstances" reserve requirements can be imposed at any level on any liability of depositoryinstitutionsfor as long as six months;and,if essentialfor the conductofmonetarypolicy,supplementalrequirementsupto4 percentof transactionaccountscan be imposed.
  • 27. Under a 10percent reserve requirement, $10of reservesareneeded to supporteach $100of deposits. Assets Liabilities Loansand Reserves With a reductionin requirementsfrom 10 percent to 8percent,fewerreservesare required againstthe samevolumeof deposits Assets sothat excessreservesarecreated. These can Loansand be loaned or invested. investments 90 Reserves 10 Assets Liabilities I NO CHANGE T Liabilities Deposits 100 Thereis no changein the totalamount of bank reserves. With an increase in requirementsfrom 10 percent to 12percent,more reservesare required againstthe samevolumeof deposits. Assets Theresultingdeficienciesmust be coveredby liquidationof loansorinvestments. .. Loans and investments 90 Reserves 10 '3 Assets Liabilities I Liabilities Deposits ...becausethetotal amountof bank reservesremains unchanged. FactorsmctirrgBank Resemes 27
  • 28. The FederalReservehas engaged in foreign currency operationsforitsown accountsince 1962. In addition, itactsasthe agentforforeign currency transactions of the U.S. Treasury,and sincethe 1950shas executedtransac- tionsforcustomerssuch asforeigncentralbanks. Perhaps the mostpublicized type of foreign currency transaction undertakenby the FederalReserveisinterventionin the foreignexchangemarkets. Intervention,however,isonly oneof severalforeign-relatedtransactionsthathave the potentialforincreasingor decreasingreserves of banks, thereby affectingmoney and creditgrowth. Severalforeign-relatedtransactionsand their effects on U.S. bank reservesare describedin the next fewpages. Includedaresomebut not all of thetypes of transactions used. Thekeypointto remember,however,isthatthe FederalReserveroutinely offsetsanyundesired changein U.S bank reservesresultingfromforeign-relatedtransac- tions. As a result, suchtransactionsdonot affectmoney and creditgrowthin the United States. Foreign Exchange Intervention for the Federal Reserve's OwnAccount When the Federal Reserveintervenesin foreign exchangemarketsto selldollarsforitsown it acquiresforeigncurrencyassetsand reservesof U.S. banks initiallyrise. In contrast,when the Fed intervenestobuy dollarsfor itsown account, it usesforeigncurrencyassek to pay forthe dollarspurchased and reservesof US. banks initiallyfall. Considerthe examplewhere the FederalReserve intervenesin theforeign exchangemarketsto sell$100of U.S. dollarsfor itsown account. In thistransaction,the Federal Reservebuys a foreignarrencydenominated depositof a U.S. bank held at a foreign commercialbarkz0 andpays for thisforeigncurrencydepositby crediting$100 totheU.S. bank's reserveaccountattheFed. TheFederal Reserve depositsthe foreigncurrencyproceedsin itsac- countata Foreign CentralBank,and asthistransaction clears,the foreignbank's reservesatthe ForeignCentral Bank decline. See illustration33onpages 3031. Initially, then,the Fed's interventionsaleof dollarsin thisexample leadsto an increase in Federal ReserveBank assetsdenom- inated in foreigncurrenciesand an increase in reservesof U.S. banks. Supposeinstead thatthe FederalReserveintervenes in theforeignexchangemarketsto buy $100of US. dollars, againforitsown account. The FederalReservepurchasesa dollardenominateddepositof a foreignbank held at a US. bank,andpays for this dollar depositby drawingonits foreigncurrency depositat a Foreign CentralBank. m e FederalReservemighthave to sellsomeof itsforeign cur- rency investmentsto build up itsdepositsatthe Foreign CentralBank,but thiswould not affectU.S. bank reserves.) As the FederalReserve's accountatthe ForeignCentral Bank ischarged,theforeignbank's reservesatthe Foreign CentralBankincrease. In turn,the dollardepositof the foreignbank atthe U.S. bank declinesasthe U.S. bank transfers ownershipof those dollarsto the Federal Reserve 28 M& Money Mechanics Federal ReserveBank assets denominated inforeign currencies end of month, billionsof dollars, not seasonally adjusted via a $100chargeto itsreserveaccountatthe FederalRe serve. See illustration 34 on pages 3031. Initially,then,the Fed's interventionpurchaseof dollarsin thisexampleleads to a decreasein Federal Reserve Bank assetsdenominatedin foreign currenciesand adecreasein reservesof U.S. banks. Asnoted earlier,the Federal Reserveoffsetsor "ster- ilizes" anyundesired changein U.S. bank reservesstemming fromforeign exchangeinterventionsalesorpurchasesof dollars. For example,Federal ReserveBank assetsdenomi- nated inforeigncurrenciesrose dramaticallyin 1989,in part dueto significantU.S. interventionsalesofdollars. (See chart on thispage.) Totalreserves of U.S. banks, however,declined slightlyin 1989asopen market operationswereused to "ster- ilize" the initialintervention-inducedincrease in reserves. Monthly Revaluation of Foreign Currency Assets Anothersetof accountingtransactionsthataffects Federal Reserve Bank assetsdenominated in foreigncurren- ciesisthe monthly revaluationof such assets. Twobusiness daysprior to the end of the month,the Fed's foreigncurrency assetsareincreased if their marketvaluehasappreciated or decreasedif their valuehas depreciated. The offsettine;ac- countingentryonthe Fed's balance sheetisto the "exchange translationaccount"included in "otherF.R liabiities." These changesin the Fed's balance sheetdonot alterbank reserves directly. However, sincethe FederalReserveturnsoverits net earningsto theTreasuryeachweek,the revaluationaf- fectsthe amountof the Fed's paymentto theTreasury,which in turn iniluencesthe sizeof 'IT&Lcallsandbank reserves. (Seeexplanationonpages 18and 19.) 'gOverallresponsibiityfor U.S.interventioninforeignexchangemarkets rests with the U.S. Treasury. Foreign exchange transactions for the Federal Reserve'saccountare carriedout under directivesissued by the FederalReserve'sOpenMarketCommitteewithiithegeneralframework of exchange rate policy establishedby the US. Treasury in consultation withthe Fed. Theyareimplementedatthe FederalReserve Bankof New York,typicallyatthe same timethat similartransactionsareexecutedfor theTreasurylsExchange StabilizationFund. 2oAmericanstravelingto foreign countries engagein "foreignexchange" transactionswhenever they obtain foreign coins and paper currency in exchangefor U.S.coinsand currency. However,mostforeignexchange transactionsdo not involve the physicalexchangeof coinsand currency. Rather, most of these transactions represent the buying and selling of foreign currenciesby exchangingone bank depositdenominated in one currencyforanotherbank depositdenominatedin anothercurrency. For easeofexposition,theexamplesassumethatUS.banksandforeignbanks arethemarketparticipantsintheinterventiontransactions,buttheimpact onreserveswouldbe the same if the U.S.orforeignpublicwere involved.
  • 29. Foreign-RelatedTransactions for the Treasury U.S. interventionin foreign exchangemarketsby the FederalReserve usually is dividedbetween itsown account and theTreasury'sExchangeStabilizationFund (ESF')ac- count. The impacton U.S. bank reservesfromthe interven- tion transactionisthe sameforboth -salesof dollarsadd to reserveswhilepurchasesof dollarsdrainreserves. See illustration 35 on pages 3@31. Dependingupon how the Treasurypaysfor,orhances,itspart of the intervention, however,the FederalReservemay not need to conduct offsettingopenmarket operations. TheTreasurytypicallykeeps onlyminimalbalances in the ESFs accountatthe Federal Reserve. Therefore, theTreasurygenerally has to convertsomeESFassetsinto dollaror foreigncurrencydepositsin order to payfor itspart of an intervention transaction. Likewise,the dollar or for- eign currency depositsacquiredby the ESFin the interven- tion typicallyare drawndownwhen the ESFinveststhe proceeds in earningassets. For example,to hance an interventionsaleof dollars (such asthat shownin illustration 35),theTreasurymight redeem someof the U.S. governmentsecuritiesissuedto the ESF,resulting in a transferof fundsfromtheTreasury's (generalaccount)balancesatthe Federal Reserveto the ESFsaccountatthe Fed. (Onthe Federal Reserve's bal- ancesheet, the ESFs accountisincluded in the liability category"other deposits.") TheTreasury,however,would need to replenish itsFed balancesto desiredlevels,perhaps by increasingthe size of ?T&L calls-a transactionthat drainsU.S. bank reserves. The interventionandfinancing transactionsessentiallyoccur simultaneously. As a result, U.S. bank reservesadded in the interventionsaleof dollars areoffsetby the drainin U.S. bank reservesfromthe?T&L call. See illustrations35 and 36 on pages 3@31. Thus,no FederalReserveoffsettingactionswould be needed if the Treasuryh c e d the interventionsaleof dollarsthrough a?T&L callonbanks. Offsettingactionsby the Federal Reservewould be needed,however,if theTreasuryrestored depositsaffected by foreign-relatedtransactionsthrough a number of transac- tions involvingthe FederalReserve. These includethe Treasury's issuanceof SDRorgold certificatesto the Feder- al Reserve and the "warehousing"of foreign currenciesby the FederalReserve. SDR certtj5cate.s. OccasionallytheTreasuryacquires dollardepositsfor the ESFs accountby issuingcertificates to the FederalReserve againstallocationsof SpecialDraw- ingRights (SDRs) received fromthe InternationalMonetary Fund.21For example,$3.5biion of SDRcertificateswere issued in 1989,and another$1.5billion in 1990. This"mone- tization"of SDRsisreflected onthe Federal Reserve's bal- ancesheetasanincreasein itsasset"SDRcertificate account"and an increasein itsliability"other deposits (ESFaccount)." If the ESFusesthese dollar depositsdirectlyin an intervention saleof dollars,then the intervention-induced increase in U.S. bank reservesisnot altered. See illustra- tions 35 and 370n pages 3@31. If not needed immediately for an intervention transaction,the ESFmightuse the dollar depositsfrom issuanceof SDRcertificatesto buy securities USgold stock, gold certificates and SDR certificates end of year, billions of dollars ""certificates from theTreasury,resulting in a transferof fundsfrom the ESFs accountatthe FederalReservetotheTreasury'sac- countat the Fed. U.S. bank reserveswould then increaseas theTreasuryspentthe fundsor transferred them to banks through a d i iinvestmentto ?T&L note accounts. Goldstock andgold certtj5cates. Changesin the U.S. monetarygold stockused to be an importantfactor affecting bank reserves. However,the gold stockandgoldcertificates issued to the FederalReservein "monetizing"gold,have not changedsignificantlysincethe early 1970s. (See chart on thispage.) Priorto August 1971,theTreasurybought and sold goldfor a fixedpricein termsof U.S. dollars,mainly atthe initiativeof foreigncentralbanks and governments. Gold purchasesby theTreasurywere added to the U.S. monetary gold stock,and paid forfromitsaccountatthe Federal Reserve. Asthe sellersdepositedtheTreasury's checksin banks, reservesincreased. To replenish itsbalance atthe Fed,theTreasuryissued gold certificatesto the Federal Reserveand received a creditto itsdepositbalance. Treasurysalesof gold have the oppositeeffect Buy- ers' checksarecredited to theTreasury'saccountand re- servesdecline. Because the officialU.S. gold stockis now fully"monetized,"theTreasurycurrentlyhas to use its depositsto retiregold certificatesissued to the Federal Reservewhenevergold issold. However,thevalueof gold certificatesretired,aswell asthe net contractionin bank reserves,isbased onthe officialgold price. Proceedsfrom agold saleatthe marketpriceto meet demandsof domestic buyerslikelywould be greater. The differencerepresents theTreasury's profit,which,when spent,restores deposits and bank reservesby a likeamount. WhiletheTreasuryno longer purchasesgold and salesof gold have been limited,increasesin the officialprice of gold have added to thevalue of the gold stock. W e officialgold pricewaslastraised,from$38.00 to $42.22 per troy ounce,in 1973.) Warehousing. TheTreasurysometimesacquiresdol- lar depositsatthe Federal Reserveby "warehousing"foreign currencieswith the Fed. (Forexample,$7billion of foreign 21SDRswere createdin 1970for use by governmentsin officialbalanceof payments transactions.
  • 30. When the Federal Reserve intervenesto selldollarsfor itsown account, it pays for a foreignarrencydenominateddepositof a U.S. bank at a foreigncommercialbank by creditingthe reserveaccountof Liabilities the U.S. bank,and acquiresa foreigncurrencyassetin the form of a Depositsat Reserves: depositat a ForeignCentralBank. The Federal Reserve,however,will ForeignCentral US.bank + 100-offset the increase in U.S. bank reservesif it isinconsistentwith domesticpolicyobjectives. When the Federal Reserveintervenestobuy dollarsforitsown account, it drawsdown itsforeign currencydepositsata Foreign CentralBankto pay fora dollardenominated depositof a foreignbank Liabilities at a U.S. bank,whichleadsto a contractionin reservesof the US. Depositsat Reserves: bank. Thisreductionin reserveswillbe offsetby the Federal Reserve ForeignCentral U.S. bank - 100 -if itisinconsistentwith domesticpolicy objectives. In aninterventionsaleof dollarsforthe U.S. Treasury,depositsof the ESF atthe FederalReserve areused to pay fora foreigncurrencydepositof a US. bank ata foreignbank, and the foreign currencyproceedsare deposited in an accountat a Foreign CentralBank. U.S. bank reservesincreaseasa result of thisinterventiontransaction. Assets Liabilities Assets Liabilities Assets Liabilities Depositsat Other deposits: Foreign Central Concurrently,theTreasurymusth c e the interventiontransactionin (35). ?he Treasurymightbuild up depositsin the ESFsaccountatthe Federal Reserveby redeemingsecuritiesissuedto the ESF, and replenish itsown (general account) depositsatthe Federal Reserveto desiredlevelsby issuinga callon?T&L note accounts. Thissetof transac- tions drainsreserves of U.S. banksby the sameamountasthe interventionin (35) added to U.S. bank reserves. Assets US. govt Depositsat F.R. Banks Liabilities Assets Liabilities Assets Liabilities Treas. deps.: net 0 Other deposits: + 100 Alternatively,theTreasurymighth n c e the interventionin (35) by issuing SDRcertificatesto the Federal Reserve,a transactionthatwould not disturbthe additionof US. bank reserves in intervention(35). The Federal Reserve,however,would offset anyundesired changein U.S. bank reserves. 30 1 Modem Monq Mechanics I Assets Liabilities Assets Liabilities Deposits at FA. Banks + 100 SDR certificates SDR certificate Other deposits: issuedto account + I00 ESF + 100
  • 31. Assets Liabilities Assets Uabiliti~ Assets Liabilities Depositsat Reservesof foreign bank - 100 foreign bank - 100 Assets Liabilities Assets Liabilities Assets Liabilities ,-b F.R. Banks foreign bank - 100 Reserveswith Reservesof ForeignCentral foreign bank + 100 + 100 Assets Liabilities Assets Liabilities Assets Liabilities ForeignCentral Depositsat Reserves of foreign bank - 100 foreign bank - 100 Assets Liabilities Reserveswith TT&Laccts. - I00 -F.R. Banks - 1007 Assets Liabilities I NO CHANGE I FactotsMxfingBank Rcsmes 31
  • 32. currencieswerewarehoused in 1989.) TheTreasuryor ESFacquiresforeigncurrencyassetsasa result of transac- tionssuch asinterventionsalesof dollarsor salesof U.S. governmentsecuritiesdenominated in foreigncurrencies. When the FederalReservewarehousesforeign currencies fortheTrea~ury,~"FederalReserveBank assetsdenomi- nated in foreigncurrencies"increase asdoTreasurydepos- itsatthe Fed. As these depositsare spent, reservesof U.S. banks rise. In contrast,theTreasurylikelywill have to increasethe sizeof lT&Lcalls-a transactionthat drains reserves-when it repurchaseswarehousedforeigncur- renciesfrom the FederalReserve. (In1991,$2.5billion of warehoused foreigncurrencieswere repurchased.) The repurchasetransactionisreflected onthe Fed's balance sheetasdeclinesin bothTreasurydepositsatthe Federal Reserve and FederalReserveBank assetsdenominatedin foreigncurrencies. Transactionsfor Foreign Customers Manyforeigncentralbanksand governmentsmain- tain depositsat the Federal Reserveto facilitatedollar- denominatedtransactions. These"foreign deposits"on the liabilityside of the Fed's balance sheettypicallyareheld at minimallevelsthatvary littlefromweek to week. For ex- ample,foreign depositsatthe FederalReserveaveraged only$237million in 1991,rangingfrom$178million to $319 millionon aweekly averagebasis. Changesin foreign depositsare smallbecause foreigncustomers"manage" their FederalReservebalancesto desired levelsdailyby buying and sellingU.S. governmentsecurities. The extent of these foreigncustomer"cash management"transactions isreflected,in part, by largeand frequentchangesin mar- ketableU.S. governmentsecuritiesheld in custodyby the Federal Reserveforforeigncustomers. (Seechart.) The net effectof foreign customers'cash managementtransac- tionsusuallyisto leaveU.S. bank reservesunchanged. Managingfbreign depositsthroughsales ofsecurities. Foreigncustomersof the FederalReservemake dollar- denominatedpayments,includingthosefor intervention salesof dollarsby foreign centralbanks,by drawingdown their depositsatthe Federal Reserve. As these fundsare deposited in U.S. banks and cleared,reserves of U.S. banks rise. See illustration38. However,if paymentsfromtheir accountsatthe FederalReservelowerbalancesto below desiredlevels,foreigncustomerswill replenish their Feder- al Reserve depositsby sellingU.S. governmentsecurities. Actingastheir agent,the Federal Reserveusuallyexecutes foreigncustomers' sellordersin the market. As buyerspay for the securitiesby drawingdown depositsat U.S. banks, reservesof U.S. banksfalland offset the increasein re- servesfromthe disbursementtransactions. Thenet effect isto leave U.S. bank reservesunchanged when U.S. govern- ment securitiesof foreign customersare sold in the mar- ket. See illustrations38 and 39. Occasionally,however,the FederalReserve executesforeigncustomers' sellorders withthe System's account. When thisis done,the risein reservesfromthe foreign customers' disbursementof funds remainsin place. See illustratiolzs 38 and 40. The Federal Reservemightchooseto executesellorderswith the Sys- tem's accountif an increase in reservesisdesiredfor do- mesticpolicyreasons. MarketableUSgovernmentsecurities held in custodyfor foreign customers during 1991 Wednesday outsmndings,billions of dollars 235 ~ ~ ' ' ' 1 ' ' ' ~ ' ' ' ~ ' ' ' ' ~ ' ' ' ~ ' ' ' ' ~ ' ' ' ~ ' ' ' 1 ' ' ' ' 1 ' ' ' 1 ' ' ' i Feb. Apr. June Aug. Oct. Dec. Managragrngfbreign deposits throughpurchases ofsecuri- ties. Foreigncustomersof the FederalReservealsoreceive a variety of dollardenominatedpayments, includingpro- ceedsfrominterventionpurchasesof dollarsby foreign centralbanks, that are drawn on U.S. banks. As thesefunds arecreditedto foreign depositsatthe FederalReserve,r e servesof U.S. banks decline. Butif receiptsof dollardenom- hated paymentsraisetheir depositsatthe FederalReserve to levelshigherthan desired,foreigncustomerswillbuy U.S. governmentsecurities. The net effedtgenerally istoleave U.S. bank reserves unchanged when the U.S. government securitiesare purchased in the market. Usingthe swap network. Occasionally,foreigncentral banksacquiredollar depositsby activatingthe "swap"net- work,which consistsof reciprocalshort-termcreditarrange- mentsbetweenthe Federal Reserveand certainforeign centralbanks. When a foreigncentralbank drawson its swapline atthe Federal Reserve,itimmediatelyobtainsa dollar depositatthe Fed in exchangeforforeigncurrencies, and agreesto reversethe exchange sometimein thefuture. Onthe FederalReserve's balance sheet,activationof the swapnetworkisreflected asan increase in FederalReserve Bank assetsdenominatedin foreigncurrenciesand an in- creasein the liabiitycategoryYoreign deposits." Whenthe swaplineisrepaid,both of these accountsdecline. Reserves of U.S. bankswill risewhen the foreigncentralbank spends itsdollarproceedsfromthe swapdrawing. See illustration 41. In contrast, reservesof U.S. bankswillfall asthe foreign centralbank rebuilds its depositsatthe Federal Reserve in orderto repaya swapdrawing. The accountingentriesand impacton U.S. bank r e servesarethe same if the FederalReserveuses the swap networkto borrowand repayforeign currencies. However, the Federal Reservehas not activatedthe swapnetwork in recent years. nTechnically, warehousing consists of two parts: the Federal Reserve's agreementtopurchaseforeigncurrencyassetsfromtheTreaswyorESF for dollardepositsnow, and the Treasury's agreementto repurchasethe foreigncurrenciessometimein the future.