Modern Money Mechanics
A Workbook on Bank Reserves and Deposit Expansion
Federal Reserve Bank of Chicago
Modern Money Mechanics
The purpose of this booklet is to describe the basic
process of money creation in a fractional reserve" bank-
ing system. The approach taken illustrates the changes
in bank balance sheets that occur when deposits in banks
change as a result of monetary action by the Federal
Reserve System — the central bank of the United States.
The relationships shoum are based on simplifying
assumptions. For the sake of simplicity, the relationships
are shoum as if they were mechanical, but they are not,
as is described later in the booklet. Thus, they should not
be interpreted to imply a close and predictable relation-
ship between a specific central bank transaction and
the quantity of money.
The introductory pages contain a brief general
description of the characteristics of money and how the
U.S. money system works. The illustrations in the fol-
lowing two sections describe two processes: first, how
bank deposits expand or contract in response to changes
in the amount of reserves supplied by the central bank;
and second, how those reserves are affected by both
Federal Reserve actions and other factors. A final sec-
tion deals with some of the elements that modify, at least
in the short run, the simple mechanical relationship
between bank reserves and deposit money.
2 Modem Money Mechanics
Money is such a routine part of everyday living that
its existence and acceptance ordinarily are taken for grant-
ed. A user may sense that money must come into being
either automatically as a result of economic activity or as
an outgrowth of some government operation. But just how
this happens all too often remains a mystery.
What Is Money?
If money is viewed simply as a tool used to facilitate
transactions, only those media that are readily accepted in
exchange for goods, services, and other assets need to be
considered. Many things — from stones to baseball cards
— have served this monetary function through the ages.
Today, in the United States, money used in transactions is
mainly of three kinds — currency (paper money and coins
in the pockets and purses of the public); demand deposits
(non-interest-bearing checking accounts in banks); and
other checkable deposits, such as negotiable order of
withdrawal (NOW) accounts, at all depository institutions,
including commercial and savings banks, savings and loan
associations, and credit unions. Travelers checks also are
included in the definition of transactions money. Since $1
in currency and $1 in checkable deposits are freely con-
vertible into each other and both can be used dfrectiy for
expenditures, they are money in equal degree. However,
only the cash and balances held by the nonbank public are
counted in the money supply. Deposits of the U.S. Trea-
sury, depository institutions, foreign banks and official
institutions, as well as vault cash in depository institutions
This transactions concept of money is the one desig-
nated as Ml in the Federal Reserve's money stock statis-
tics. Broader concepts of money (M2 and M3) include Ml
as well as certain other financial assets (such as savings
and time deposits at depository institutions and shares in
money market mutual funds) which are relatively liquid
but believed to represent principally investments to their
holders rather than media of exchange. While funds can
be shifted feirly easily between transaction balances and
these other liquid assets, the money-creation process takes
place principally through transaction accounts. In the
remainder of this booklet, "money" means Ml.
The distribution between the currency and deposit
components of nioney depends largely on the preferences
of the public. When a depositor cashes a check or makes
a cash withdrawal through an automatic teller machine, he
or she reduces the amount of deposits and increases the
amount of currency held by tiie public. Conversely, when
people have more currency than is needed, some is re-
turned to banks in exchange for deposits.
While currency is used for a great variety of small
transactions, most of the dollar amount of money pay-
ments in our economy are made by check or by electronic
transfer between deposit accounts. Moreover, currency
is a relatively small part of the money stock. About 69
percent, or $623 billion, of the $898 billion total money
stock in December 1991, was in the form of transaction
deposits, of which $290 billion were demand and $333
billion were other checkable deposits.
What Makes Money Valuable?
In the United States neither paper currency nor
deposits have value as commodities. Intrinsically, a dollar
bill is just a piece of paper, deposits merely book entries.
Coins do have some intrinsic value as metal, but generally
far less than their face value.
What, then, makes these instruments — checks,
paper money, and coins — acceptable at face value in
payment of all debts and for other monetary uses? Mainly,
it is the confidence people have that they will be able to
exchange such money for other financial assets and for
real goods and services whenever they choose to do so.
Money, like anything else, derives its value from its
scarcity in relation to its usefulness. Commodities or ser-
vices are more or less valuable because there are more or
less of them relative to the amounts people want Money's
usefulness is its imique ability to command other goods
and services and to permit a holder to be constantly ready
to do so. How much money is demanded depends on
several factors, such as the total volume of transactions
in the economy at any given time, the payments habits of
the society, the amount of money that individuals and
businesses want to keep on hand to take care of unexpect-
ed transactions, and the foregone earnings of holding
financial assets in the form of money rather than some
Control of the quantity of money is essential if its
value is to be kept stable. Money's real value can be mea-
sured only in terms of what it will buy. Therefore, its value
varies inversely with the general level of prices. Assuming
a constant rate of use, if the volume of money grows more
rapidly than the rate at which the output of real goods and
services increases, prices will rise. This will happen be-
cause there will be more money than there will be goods
and services to spend it on at prevailing prices. But if, on
the other hand, growth in the supply of money does not
keep pace with the economy's current production, then
prices will fall, the nation's labor force, factories, and other
production facilities will not be fiilly employed, or both.
Just how large the stock of money needs to be in
order to handle the transactions of the economy wifliout
exerting undue influence on the price level depends on
how intensively money is being used. Every transaction
deposit balance and every dollar bill is a part of some-
body's spendable funds at any given time, ready to move
to other owners as transactions take place. Some holders
spend money quickly after they get it making these funds
available for other uses. Others, however, hold money for
longer periods. Obviously, when some money remains
idle, a larger total is needed to accomplish any given
volume of transactions.
Who Creates Money?
Changes in the quantity of money may originate with
actions of the Federal Reserve System (the central bank) ,
depository institutions (principally commercial banks), or
the public. The major control, however, rests with the
The actual process of money creation takes place
primarily in banks.' As noted earlier, checkable liabilities
of banks are money. These liabilities are customers' ac-
counts. They increase when customers deposit currency
and checks and when the proceeds of loans made by the
banks are credited to borrowers' accounts.
In the absence of legal reserve requirements, banks
can build up deposits by increasing loans and investments
so long as they keep enough currency on hand to redeem
whatever amounts the holders of deposits want to convert
into currency. This unique attribute of the banking busi-
ness was discovered many centuries ago.
It started with goldsmiths. As early bankers, they
initially provided safekeeping services, making a profit fi-om
vault storage fees for gold and coins deposited with them.
People would redeem their "deposit receipts" whenever
they needed gold or coins to purchase something, and
physically take the gold or coins to the seller who, in turn,
would deposit them for safekeeping, often with the same
banker. Everyone soon found that it was a lot easier simply
to use the deposit receipts directly as a means of payment
These receipts, which became known as notes, were ac-
ceptable as money since whoever held them could go to
the banker and exchange them for metallic money.
Then, bankers discovered that they could make loans
merely by giving their promises to pay, or bank notes, to
borrowers. In this way, banks began to create money.
More notes could be issued than the gold and coin on hand
because only a portion of the notes outstanding would be
presented for payment at any one time. Enough metallic
money had to be kept on hand, of course, to redeem what-
ever volume of notes was presented for payment
Transaction deposits are the modem counterpart of
bank notes. It was a small step fi-om printing notes to mak-
ing book entries crediting deposits of borrowers, which the
borrowers in turn could "spend" by writing checks, thereby
"printing" their own money.
' In order to describe the money-creation process as simply as possible, the
term "bank" used in this booldet should be understood to encompass all
depository institutions. Since the Depository Institutions Deregulation and
Monetary Control Act of 1980, all depository institutions have been permit-
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 all such institutions, not just commercial banks, have the
potential for creating money.
What Limits the Amount of Money Banks
If deposit money can be created so easily, what is to
prevent banks from making too much — more than suffi-
cient to keep the nation's productive resources fully em-
ployed without price inflation? Like its predecessor, the
modem bank must keep available, to make payment on
demand, a considerable amount of currency and funds on
deposit with flie central bank. The bank must be prepared
For individual banks, reserve accounts also serve as
working balances.^ Banks may increase the balances in
their reserve accounts by depositing checks and proceeds
from electronic funds transfers as well as ciurency. Or
they may draw down these balances by writing checks on
them or by authorizing a debit to them in payment for
currency, customers' checks, or other funds transfers.
Although reserve accounts are used as working
balances, each bank must maintain, on the average for the
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money will vary, depending upon the reactions of the
banks and the public. A number of slippages may occiu".
What amount of reserves will be drained into the public's
currency holdings? To what extent will the increase in
total reserves remain unused as excess reserves? How
much will be absorbed by deposits or other liabilities not
defined as money but against which banks might also have
to hold reserves? How sensitive are the banks to policy
actions of the central bank? The significance of these
questions will be discussed later in this booklet The an-
swers indicate why changes in the money supply may be
different than expected or may respond to policy action
only after considerable time has elapsed.
In the succeeding pages, the effects of various trans-
actions on the quantity of money are described and illus-
trated. The basic working tool is the T" accoimt, which
provides a simple means of tracing, step by step, the effects
of these transactions on both the asset and liability sides of
bank balance sheets. Changes in asset items are entered
on the left half of the T' and changes in liabilities on the
right half. For any one transaction, of course, there must
be at least two entries in order to maintain the equality of
assets and liabilities.
Bank Deposits — How They Expand or Contract
Let us assume that expansion in the money stock is
desired by the Federal Reserve to achieve its policy objec-
tives. One way the central bank can initiate such an expan-
sion is through purchases of securities in the open market
Payment for the securities adds to bank reserves. Such
purchases (and sales) are called "open market operations."
How do open market purchases add to bank reserves
and deposits? Suppose flie Federal Reserve System,
through its trading desk at the Federal Reserve Bank of
New York, buys $10,000 of Treasury bills from a dealer in
U.S. government secimties.' In today's world of computer-
ized financial transactions, the Federal Reserve Bank
pays for the securities with an "electronic" check drawn
on itself.* Via its "Fedwire" transfer network, the Federal
Reserve notifies the dealer's designated bank (Bank N)
that payment for the securities should be credited to (de-
posited in) the dealer's account at Bank A At the same
time. Bank A's reserve account at the Federal Reserve
is credited for the amoimt of the securities purchase.
The Federal Reserve System has added $10,000 of securi-
ties to its assets, which it has paid for, in effect, by creating
a liability on itself in the form of bank reserve balances.
These reserves on Bank A's books are matched by
$10,000 of the dealer's deposits that did not exist before.
See illustration 1.
How the Multiple Expansion Process Works
If the process ended here, there would be no "multi-
ple" expansion, i.e., deposits and bank reserves would
have changed by the same amount However, banks are
required to maintain reserves equal to only a fiaction of
flieir deposits. Reserves in excess of this amount may be
used to increase earning assets — loans and investments.
Unused or excess reserves earn no interest Under current
regulations, the reserve requirement against most transac-
tion accounts is 10 percent' Assuming, for simplicity, a
uniform 10 percent reserve requirement against all transac-
tion deposits, and further assuming that all banks attempt
to remain fully invested, we can now trace the process of
expansion in deposits which can take place on the basis of
the additional reserves provided by the Federal Reserve
System's purchase of U.S. government securities.
The expansion process may or may not begin with
Bank A, depending on what the dealer does with the mon-
ey received from the sale of securities. K the dealer imme-
diately writes checks for $10,000 and all of them are
deposited in other banks, Bank A loses both deposits and
reserves and shows no net change as a result of the Sys-
tem's open market purchase. However, other banks have
received them. Most likely, a part of the initial deposit will
remain with Bank A, and a part will be shifted to other
banks as the dealer's checks clear.
It does not really matter where this money is at any
given time. The important fact is that these deposits do not
disappear. They are in some deposit accounts at all times.
All banks together have $10,000 of deposits and reserves
that they did not have before. However, they are not
required to keep $10,000 of reserves against the $10,000
of deposits. All they need to retain, under a 10 percent
reserve requirement, is $1,000. The remaining $9,000 is
"excess reserves." This amount can be loaned or invested.
See illustration 2.
If business is active, the banks with excess reserves
probably will have opportunities to loan the $9,000. Of
course, they do not really pay out loans from the money
they receive as deposits. If they did this, no additional
money would be created. What they do when they make
loans is to accept promissory notes in exchange for credits
to the borrowers' transaction accounts. Loans (assets)
and deposits (liabilities) both rise by $9,000. Reserves are
unchanged by the loan transactions. But the deposit cred-
its constitute new additions to the total deposits of the
banking system. See illustration 3.
6 Modem Money Mechanics
^Dollar amounts used in the various illustrations do not necessarily bear
any resemblance to actual transactions. For example, open market opera-
tions typically are conducted with many dealers and in amounts totaling
several billion dollars.
transier oi tunds Detween accounts ratner man tnrougn issuance oi a f
check. Apart from the timing of posting, the accounting entries ari
same whether a transfer is made with a paper check or electronically. The
term "check," therefore, is used for botfi types of transfers.
^For each bank, the reserve requirement is 3 percent on a specified base
amount of transaction accounts and 10 percent on the amoimt above this
base. Initially, the Monetary Control Act set this base amount — called the
"low reserve tranche" — at $25 million, and provided for it to change
annually in line with the growth in transaction deposits nationally. The low
reserve tranche was $41.1 million in 1991 and $42.2 million in 1992. The
Gam-St Germain Act of 1982 further modified these requirements by
exempting the first $2 million of reservable liabilities from reserve require-
ments. Like the low reserve tranche, the exempt level is adjusted each year
to reflect growth in reservable liabilities. The exempt level was $3.4 million
in 1991 and $3.6 million in 1992.
When the Federal Reserve Bank purchases government securities, bank reserves increase. This happens
because the seller of the securities receives pajmient through a credit to a designated deposit account
at a bank (Bank A) which the Federal Reserve effects by crediting the reserve account of Bank A
FEDERAL RESERVE BANK
securities + 10,000
Reserve accounts: Reserves with
Banl<A +10,000-4 ►F.R.Banks +10,000
The customer deposit at Bank A likely will be transferred, in part, to other banks and quickly loses its identity amid the huge
interbank flow of deposits.
As a result, all banks taken together now have
"excess" reserves on which deposit expansion
can take place.
Total reserves gained from new deposits 1 0,000
less: Required against new deposits
(at 10 percent) 1,000
equals: Excess reserves 9,000
Expansion — Stage 1
Expansion takes place only if the banks that hold
these excess reserves (Stage 1 banks) increase
their loans or investments. Loans are made by
crediting the borrower's deposit account, i.e.,
by creating additional deposit money.
STAGE I BANKS
Deposit Expansion and Contraction 7
This is the beginning of the deposit expansion process.
In the first stage of the process, total loans and deposits of
the banks rise by an amount equal to the excess reserves
existing before any loans were made (90 percent of the
initial deposit increase) . At the end of Stage 1, deposits
have risen a total of $19,000 (the initial $10,000 provided
by the Federal Reserve's action plus the $9,000 in deposits
created by Stage 1 banks). See illustration 4. However,
only $900 (10 percent of $9,000) of excess reserves have
been absorbed by the additional deposit growth at Stage 1
banks. See illustration 5.
The lending banks, however, do not expect to retain
the deposits they create through their loan operations.
Borrowers write checks that probably wH be depoated in
other banks. As these checks move through the collection
process, the Federal Reserve Banks debit the reserve
accounts of the paying banks (Stage 1 banks) and credit
those of the receiving banks. See illustration 6.
Whether Stage 1 banks actually do lose the deposits
to other banks or whether any or all of the borrowers'
checks are redeposited in these same banks makes no
difference in the expansion process. If the lending banks
expect to lose these deposits — and an equal amoimt of
reserves — as the borrowers' checks are paid, diey will not
lend more than their excess reserves. Like the original
$10,000 deposit, the loan-created deposits may be trans-
ferred to other banks, but they remain somewhere in the
banking system. Whichever banks receive them also
acquire equal amounts of reserves, of which all but 10
percent will be "excess."
Assuming that the banks holding the $9,000 of de-
posits created in Stage 1 in turn make loans equal to their
excess reserves, then loans and deposits will rise by a
fiirther $8,100 in the second stage of expansion. This
process can continue imtil deposits have risen to the point
where all the reserves provided by the initial purchase of
government securities by the Federal Reserve System are
just sufficient to satisfy reserve requirements against the
newly created deposits. (See pages 10 and 11.)
The individual bank, of course, is not concerned as
to the stages of expansion in which it may be participating.
Inflows and outflows of deposits occur continuously. Any
deposit received is new money, regardless of its ultimate
source. But if bank policy is to make loans and invest-
ments equal to whatever reserves are in excess of legal
requirements, the expansion process will be carried on.
How Much Can Deposits Expand
in the Banking System?
The total amount of expansion that can take place
is illustrated on page 11. Carried through to theoretical
limits, the initial $10,000 of reserves distributed within the
banking system gives rise to an expansion of $90,000 in
bank credit floans and investments) and supports a total of
$100,000 in new deposits under a 10 percent reserve re-
quirement The deposit expansion factor for a given
8 Modem Money Mechanics
amount of new reserves is thus the reciprocal of the re-
quired reserve percentage (I/.IO = 10). Loan expansion
will be less by the amount of the initial injection. The multi-
ple e}q)ansion is possible because the banks as a group
are like one large bank in which checks drawn against
borrowers' deposits result in credits to accounts of other
depositors, with no net change in total reserves.
Expansion throt^ Bank Investments
Deposit expansion can proceed fi-om investments
as well as loans. Suppose that the demand for loans at
some Stage 1 banks is slack. These banks would then
probably purchase securities. If the sellers of the securities
were customers, the banks would make payment by credit-
ing the customers' transaction accounts; deposit liabilities
would rise just as if loans had been made. More likely,
these banks would purchase the securities through deal-
ers, paying for them with checks on themselves or on their
reserve accounts. These checks would be deposited in
the sellers' banks. In either case, the net effects on the
banking system are identical with those resulting from
J. As a result of the process so far, total assets and
total liabilities of all banks together have risen
Excess reserves have been reduced by the
amount required against the deposits created
by the loans made in Stage 1.
Total reserves gained from initial deposits 10,000
less: Required against initial deposits 1 ,000
less: Required against Stage I deposits 900 1,900
equals: Excess reserves 8,100
Why do these banks stop increasing their loans
and deposits when they still have excess reserves?
. . .because borrowers write checks on their
accounts at the lending banks. As these checks
are deposited in the payees' banks and cleared,
the deposits created by Stage 1 loans and an
equal amount of reserves may be transferred
to other banks.
FEDERAL RESERVE BANK
Stage I banks
Deposit expansion has just begun!
Deposit Expansion and Contraction 9
Expansion continues as flie banks that have
excess reserves increase their loans by that
amount, crediting borrowers' deposit accounts
in the process, thus creating still more money.
STAGE 2 BANKS
Now the banking system's assets and liabilities
have risen by 27,100.
But there are still 7,290 of excess reserves in the
Total reserves gained from initial deposits 1 0,000
less: Required a^nst initial deposits 1 ,000
less: Required a^nst Stage I deposits 900
less: Required against Stage 2 deposits 8 1 .... 2,710
equals: Excess reserves 7,290
As borrowers make payments, these reserves will be fiirther dispersed, and the process can continue through
many more stages, in progressively smaller increments, until the entire 10,000 of reserves have been absorbed
by deposit growth. As is apparent from the summary table on page 11, more than two-thirds of the deposit
expansion potential is reached after the first ten stages.
It should be understood that the steles of expansion occur neither simultaneously nor in
the sequence described above. Some banks use their reserves incompletely or only after a
considerable time lag, while others expand assets on the basis of expected reserve growth.
The process is, in fact, continuous and may never reach its theoretical limits.
10 Modem Money Mechanics
llius through stage after stage of expansion,
"money" can grow to a total of 10 times the new
reserves suppliedto the bankingsystem . . .
Initial reserves provided
Expansion — Stage I
Stage 20 ....
. . . as the new deposits created by loans
at each stage are added to those created at all
earlier stages and those supplied by the initial
9 10 11 12 13 14 15 16 17 18 19 20
Deposit Expansign and Cantmction 1 1
How Open Market Sales Reduce Bank Reserves
Now suppose some reduction in the amount of
money is desired. Normally this would reflect temporary
or seasonal reductions in activity to be financed since, on
a year-to-year basis, a growing economy needs at least
some monetary expansion. Just as purchases of govern-
ment securities by the Federal Reserve System can pro-
vide the basis for deposit expansion by adding to bank
reserves, sales of securities by the Federal Reserve System
reduce the money stock by absorbing bank reserves. The
process is essentially the reverse of the expansion steps
Suppose the Federal Reserve System sells $10,000 of
Treasury bills to a U.S. government securities dealer and
receives in payment an "electronic" check drawn on Bank
A. As this payment is made. Bank A's reserve account at
a Federal Reserve Bank is reduced by $10,000. As a result,
the Federal Reserve System's holdings of securities and
tiie reserve accounts of banks are both reduced $10,000.
The $10,000 reduction in Bank A's deposit liabilities consti-
tutes a decline in the money stock. See illustration 11.
Contraction Also Is a Cumulative Process
While Bank A may have regained part of the initial
reduction in deposits from other banks as a result of inter-
bank deposit flows, all banks taken together have $10,000
less in both deposits and reserves than they had before
the Federal Reserve's sales of securities. The amount of
reserves freed by the decline in deposits, however, is only
$1,000 (10 percent of $10,000) . Unless the banks that lose
the reserves and deposits had excess reserves, they are
left with a reserve deficiency of $9,000. See illustration 12.
Although they may borrow from the Federal Reserve
Banks to cover this deficiency temporarily, sooner or later
the banks will have to obtain the necessary reserves in
some other way or reduce their needs for reserves.
One way for a bank to obtain the reserves it needs
is by selling securities. But, as the buyers of the securities
pay for them with funds in their deposit accounts in the
same or other banks, the net result is a $9,000 decline in
securities and deposits at all banks. See illustration 13.
At the end of Stage 1 of the contraction process, deposits
have been reduced by a total of $19,000 (the initial $10,000
resulting from the Federal Reserve's action plus the $9,000
in deposits extinguished by securities sales of Stage 1
banks). See illustration 14.
However, there is now a reserve deficiency of $8,100
at banks whose depositors drew down their accounts to
purchase the securities from Stage 1 banks. As the new
group of reserve-deficient banks, in turn, makes up ttiis
deficiency by selling securities or reducing loans, further
deposit contraction takes place.
Thus, contraction proceeds through reductions in
deposits and loans or investments in one stage after anoth-
er until total deposits have been reduced to the point
12 Modem Money Mechanics
where the smaller voliraie of reserves is adequate to sup-
port them. The contraction multiple is the same as that
which applies in the case of expansion. Under a 10 percent
reserve requirement, a $10,000 reduction in reserves would
ultimately entail reductions of $100,000 in deposits and
$90,000 in loans and investments.
As in the case of deposit expansion, contraction of
bank deposits may take place as a result of either sales of
securities or reductions of loans. While some adjustments
of both kinds undoubtedly would be made, the initial im-
pact probably would be reflected in sales of government
securities. Most types of outstanding loans cannot be
called for payment prior to their due dates. But the bank
may cease to make new loans or refuse to renew outstand-
ing ones to replace those currentiy maturing. Thus, depos-
its built up by borrowers for the purpose of loan retirement
would be extinguished as loans were repaid.
There is one important difference between the expan-
sion and contraction processes. When the Federal Reserve
Sjretem adds to bank reserves, e3q)ansion of credit and
deposits may take place up to the limits permitted by the
minimum reserve ratio that banks are required to maintain.
But when the System acts to reduce the amount of bank
reserves, contraction of credit and deposits must take place
(except to the extent that existing excess reserve balances
and/or surplus vault cash are utilized) to the point where
the required ratio of reserves to deposits is restored. But
the significance of tiiis difference should not be overempha-
sized. Because excess reserve balances do not earn inter-
est, there is a strong incentive to convert them into earning
assets Ooans and investments).
When the Federal Reserve Bank sells government securities, bank reserves decline. This happens because the buyer
of the securities makes payment through a debit to a designated deposit account at a bank (Bank A) , with the transfer of
fimds being effected by a debit to Bank A's reserve account at the Federal Reserve Bank.
FEDERAL RESERVE BANK
securities - 10,000
Reserve accounts: Reserves with
Bank A -10,000-^ ►F.R.Banks -10,000
This reduction in the customer deposit at Bank A may be spread among a number of banks through interbank deposit flows.
The loss of reserves means that all banks taken
together now have a reserve deficiency.
Total reserves bstfrxxn deposit withdrawal 10,000
less: Reserves freed b/ deposit decline
(at 10 percent) 1,000
equals: Deficiency in reserves against remaining deposits . 9,000
Contraction — Stage 1
banks) can sell government securities to acquire
reserves, but this causes a decline in the deposits
and reserves of the buyers' banks.
— F.R. Banks
FEDERAL RESERVE BANK
Stage 1 ban
ks + 9,000 <^
5 - 9,000
As a resuk of the process so far, assets and total
deposits of all banks together have declined 19,000.
Stage 1 contraction has freed 900 of reserves, but
there is still a reserve deficiency of 8,100.
ALL BANKS 1
Further contraction must take place!
Deposit Expansion and Contraction 13
Bank Reserves — How They Change
Money has been defined as the sum of transaction
accounts in depository institutions, and currency and trav-
elers checks in the hands of the public. Currency is some-
thing almost everyone uses every day. Therefore, when
most people think of money, they think of currency. Con-
trary to this popular impression, however, transaction
deposits are the most significant part of the money stock.
People keep enough currency on hand to effect small face-
to-face transactions, but they write checks to cover most
large expenditures. Most businesses probably hold even
smaller amoimts of currency in relation to their total trans-
actions than do individuals.
Since the most important component of money is
transaction deposits, and since these deposits must be sup-
ported by reserves, the central bank's influence over mon-
ey hinges on its control over the total amount of reserves
and the conditions under which banks can obtain them.
The preceding illustrations of flie expansion and
contraction processes have demonstrated how the central
bank, by purchasing and selling government securities,
can deliberately change aggregate bank reserves in order
to affect deposits. But open market operations are only
one of a number of kinds of transactions or developments
that cause changes in reserves. Some changes originate
from actions taken by the public, by the Treasury Depart-
ment, by the banks, or by foreign and international institu-
tions. Other changes arise from the service functions and
operating needs of the Reserve Banks themselves.
The various factors that provide and absorb bank
reserve balances, together with symbols indicating the
effects of these developments, are listed on the oppoate
page. This tabulation also indicates the nature of the bal-
ancing entries on the Federal Reserve's books. (To the
extent fliat flie impact is absorbed by changes in banks'
vault cash, the Federal Reserve's books are unaffected.)
Independent Factors Versus Policy Action
It is apparent that bank reserves are affected in sev-
eral ways tiiat are independent of the control of the central
bank. Most of these "independent" elements are changing
more or less continually. Sometimes their effects may last
only a day or two before being reversed automatically.
This happens, for instance, when bad weather slows up the
check collection process, giving rise to an automatic in-
crease in Federal Reserve credit in the form of "float"
Other influences, such as changes in the public's currency
holdings, may persist for longer periods of time.
Still other variations in bank reserves result solely
from the mechanics of institutional arrangements among
the Treasury, fee Federal Reserve Banks, and the deposi-
tory institutions. The Treasury, for example, keeps part of
its operating cash balance on deposit with banks. But
virtually all disbursements are made from its balance in
14 Modem Money Mechanics
the Reserve Banks. As is shown later, any buildup in bal-
ances at the Reserve Banks prior to expenditure by the
Treasury causes a dollar-for-dollar drain on bank reserves.
In contrast to these independent elements that affect
reserves are the policy actions taken by the Federal Re-
serve System. The way System open market purchases and
sales of securities affect reserves has already been de-
scribed. In addition, there are two other ways in which the
System can affect bank reserves and potential deposit vol-
ume diredi)^: first, through loans to depository institutions;
and second, through changes in reserve requirement per-
centages. A change in the required reserve ratio, of course,
does not alter the dollar volume of reserves directiy but
does change tiie amount of deposits that a given amount of
reserves can support
Any change in reserves, regardless of its origin, has
the same potential to affect deposits. Therefore, in order to
achieve the net reserve effects consistent with its monetary
policy objectives, the Federal Reserve System continuously
must take account of what the independent factors are
doing to reserves and then, using its policy tools, offset or
supplement them as the situation may require.
By far the largest number and amount of tiie Sys-
tem's gross open market transactions are undertaken to
offeet drains from or additions to bank reserves fi-om non-
Federal Reserve sources that might otherwise cause abrupt
changes in credit availability. In addition. Federal Reserve
purchases and/or sales of securities are made to provide
the reserves needed to support the rate of money growth
consistent with monetary policy objectives.
In this section of the booklet several kinds of trans-
actions that can have important week-to-week effects on
bank reserves are traced in detail. Other factors that nor-
mally have only a small influence are described briefly on
Factors Changing Reserve Balances — Independent and Policy Actions
Increase 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) or 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 balances/adjustments
Decrease in service-related balances/adjustments
Increase in foreign and other deposits in F.R. Banks
Decrease in foreign and other deposits in F.R. Banks
Federal Reserve actions
Purchoses of securities
Sales of securities
Loans to depository institutions
Repayment of loans to depository institutions
Increase in Federal Reserve float
Decrease in Federal Reserve float
Increase 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**
Increase in reserve requirements
Decrease in reserve requirements
* These factors represent assets and liabilities of the Treasury. Changes in them typically affect reserve balances through
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.
Factors Affecting Banli Reserves 15
Changes in the Amount of
Currency Held by the Public
Changes in the amount of currency held by the
public typically follow a fairly regular intramonthly pattern.
Major changes also occur over holiday periods and during
flie Christmas shopping season — times when people find
it convenient to keep more pocket money on hand. (See
chart.) The public acquires currency from banks by cash-
ing checks.* When deposits, which are fractional reserve
money, are exchanged for currency, which is 100 percent
reserve money, the banking system experiences a net
reserve drain. Under the assumed 10 percent reserve
requirement, a given amount of bank reserves can support
deposits ten times as great, but when drawn upon to meet
currency demand, the exchange is one to one. A $1 in-
crease in currency uses up $1 of reserves.
Suppose a bank customer cashed a $100 check to
obtain currency needed for a weekend holiday. Bank
deposits decline $100 because the customer pays for the
currency with a check on his or her transaction deposit;
and the bank's currency (vault cash reserves) is also re-
duced $100. See illustration 15.
Now the bank has less currency. It may replenish
its vault cash by ordering currency from its Federal Re-
serve Bank — making payment by authorizing a charge
to its reserve account On the Reserve Bank's books, the
charge against the bank's reserve account is ofeet by an
increase in the liability item "Federal Reserve notes." See
illustration 16. The Reserve Bank shipment to the bank
might consist, at least in part, of U.S. coins rather than
Federal Reserve notes. All coins, as well as a small amotmt
of paper currency still outstanding but no longer issued,
are obligations of the Treasury. To the extent that ship-
ments of cash to banks are in the form of coin, the offset-
ting entry on the Reserve Bank's books is a decline in its
asset item "coin."
The public now has the same volume of money as
before, except that more is in the form of currency and
less is in the form of transaction deposits. Under a 10
percent reserve requirement, the amount of reserves re-
quired against the $100 of deposits was only $10, while a
M $100 of reserves have been drained away by the dis-
bursement of $100 in currency. Thus, if the bank had no
excess reserves, the $100 withdrawal in currency causes a
reserve deficiency of $90. Unless new reserves are pro-
vided from some other source, bank assets and deposits
will have to be reduced (according to the contraction pro-
cess described on pages 12 and 13) by an additional $900.
At that point, the reserve deficiency caused by the cash
withdrawal would be eliminated.
When Currency Returns to Banks, Reserves Rise
After holiday periods, currency returns to the banks.
The customer who cashed a check to cover anticipated
cash expenditures may later redeposit any currency still
held thaf s beyond normal pocket money needs. Most of it
16 Modem Money Mechanics
Currency held by the public
weekly averages, billions of dollars, not seasonally adjusted
probably will have changed hands, and it will be deposited
by operators of motels, gasoline stations, restaurants, and
retail stores. This process is exactly tiie reverse of the
currency drain, except that the banks to which currency
is returned may not be the same banks that paid it out
But in the aggregate, the banks gain reserves as 100
percent reserve money is converted back into fractional
When $100 of currency is returned to the banks,
deposits and vault cash are increased. See illustration 1 7.
The banks can keep the currency as vault cash, which also
counts as reserves. More likely, the currency will be
shipped to the Reserve Banks. The Reserve Banks credit
bank reserve accounts and reduce Federal Reserve note
liabilities. See illustration 18. Since only $10 must be held
against the new $100 in deposits, $90 is excess reserves
and can give rise to $900 of additional deposits. ''
To avoid multiple contraction or expansion of deposit
money merely because the public wishes to change the
composition of its money holdings, the effects of changes
in the public's currency holdings on bank reserves nor-
mally are offset by System open market operations.
'The same balance sheet entries apply whether the individual physically
cashes a paper check or obtains currency by withdrawing cash through an
automatic teller machine.
'Under current reserve accounting regulations, vault cash reserves are
used to satisfy reserve requirements in a future maintenance period while
reserve balances satisfy requirements in the current period. As a result,
the impact on a bank's current reserve position may differ from that shown
unless the bank restores its vault cash position in the current period via
changes in its reserve balance.
2 S When a depositor cashes a check, both
deposits and vault cash reserves decline.
1 /C If the bank replenishes its vault cash, its account at the Reserve Bank is drawn down in exchange for notes
issued by the Federal Reserve.
FEDERAL RESERVE BANK
1 y When currency comes back to the banks, both
deposits and vault cash reserves rise.
7 ^ If the currency is returned to the Federal Reserve, reserve accounts are credited and Federal Reserve
notes are taken out of circulation.
FEDERAL RESERVE BANK
Factors Affecting Bank Reserves 1 7
Chafiges in U,S. Treasury
Deposits in Federal Reserve Banks
Reserve accounts of depository institutions consti-
tute the bulk of the deposit liabilities of the Federal Re-
serve System. Other institutions, however, also maintain
balances in the Federal Reserve Banks — mainly the U.S.
Treasury, foreign central banks, and international ifinandal
institutions. In general, when these balances rise, bank
reserves fall, and vice versa. This occurs because the
fimds used by these agencies to build up their deposits in
the Reserve Banks ultimately come from deposits in
banks. Conversely, recipients of payments from these
agencies normally deposit the ftmds in banks. Hirough
flie collection process these banks receive credit to their
The most important nonbank depositor is the U.S.
Treasury, Fart of the Treasury's operating cash balance
is kept in the Federal Reserve Banks; the rest is held in
depository institutions all over the country, in so-called
'Treasury tax and loan" CTT&L) note accounts. (See
chart.) Disbursements by the Treasury, however, are
made against its balances at the Federal Reserve. Thus,
transfers from banks to Federal Reserve Banks are made
through regularly scheduled "calls" on TT&L balances to
assure that sufficient funds are available to cover Treasury
checks as they are presented for payment*
Bank Reserves Decline as liie Treasuiy*s Deposits
at the Reserve Ifanks Increase
Calls on TT&L note accounts drain reserves from
the banks by the M amount of the transfer as ftmds move
from the TT&L balances (via charges to bank reserve
accounts) to Treasury balances at the Reserve Banks.
Because reserves are not requfred against TT&L note
accounts, these transfere do not reduce required reserves."
Suppose a Treasury call payable by Bank A amounts
to $1,000. TTie Federal Reserve Banks are authorized to
transfer the amount of the Treasury call from Bank A's
reserve account at the Federal Reserve to the account of
the U.S. Treasury at the Federal Reserve. As a result of
the transfer, both reserves and TT&L note balances of the
bank are reduced. On the books of the Reserve Bank,
bank reserves decline and Treasury deposits rise. See
illustration 19. This withdrawal of Treasury funds will
cause a reserve deficiency of $1,000 since no reserves are
released by the decline in TT&L note accounts at deposi-
Bank Reserves ffise as the Treasuiy's Deposits
at the Reserve Banks Decline
As the Treasury makes expenditures, checks drawn
on its balances in the Reserve Banks are paid to the public,
and these funds find their way back to banks in the form of
deposits. The banks receive reserve credit equal to the fill
amount of these deposits although the coiresponding
increase in their requfred reserves is only 10 percent of
18 Modem Money Mechanics
Operating cash balance of the U.S. Treasury
weekly averages, billions of dollars, not seasonally adjusted
STT&L note balances
Balances M rodfral
Suppose a government employee deposits a $1,000
expense check in Bank A The bank sends the check to
its Federal Reserve Bank for collection. TTie Reserve Bank
then credits Bank A's reserve account and charges the
Treasury's account. As a result, the bank gains both re-
serves and deposits. While there is no change in the as-
sets or total liabiMes of the Reserve Banks, tiie funds
dravm away from the Treasury's balances have been shift-
ed to bank reserve accounts. See illustration 20.
One of the objectives of the TT&L note program,
which requfres depository institutions that want to hold
Treasury funds for more than one day to pay interest on
them, is to allow the Treasury to hold its balance at the
Reserve Banks to the minimum consistent with current
payment needs. By maintaining a fairly constant balance,
large drains from or additions to bank reserves from wide
swings in the Treasury's balance that would requfre exten-
sive offsetting open market operations can be avoided.
Nevertheless, there are still periods when these fluctua-
tions have large reserve effects. In 1991, for example,
week-to-week changes in Treasury deposits at the Reserve
Banks averaged only $56 million, but ranged from -$4.15
bilHon to +$8.57 billion.
"When theTreasury's balance at the Federal Reserve rises above expected
payment needs, the Treasury may place the excess funds in TT&L note
accounts through a "direct investment." The accounting entries are the
same, but of opposite signs, as those shown when funds are transferred
from TT&L note accounts to Treasury deposits at the Fed.
'Tax payments received by institutions designated as Federal tax depositar-
ies initially are credited to reservable demand deposits due to the U.S.
government Because such tax payments typically come from reservable
transaction accounts, required reserves are not materially affected on this
day. On the next business day, however, when these funds are placed either
in a nonreservable note account or remitted to the Federal Reserve for
credit to the Treasury's balance at the Fed, required reserves decline.
2 Q When the Treasury builds up its deposits at the Federal Reserve through "calls" on TT&L note balances,
reserve accounts are reduced.
FEDERAL RESERVE BANK
Treasury tax and
loan note account - 1 ,000
2 Q Checks written on the Treasury's account at the Federal Reserve Bank are deposited in banks. As these are
collected, banks receive credit to their reserve accounts at the Federal Reserve Banks.
FEDERAL RESERVE BANK
+ 1,000 -^
-►F.R. Banks +1,000
Private deposits + 1 .000
Factors Affecting Bank Reserves 19
Changes in Federal Reserve Float
A large proportion of checks drawn on banks and
deposited in oflier banks is cleared (collected) through the
Federal Reserve Banks. Some of these checks are credit-
ed immediately to the reserve accounts of the depositing
banks and are coEected flie same day by debiting ttie
reserve accounts of the banks on which the checks are
drawn. M checks are credited to the accounts of flie
depositing banks according to availability schedules
related to the time it normally takes the Federal Reserve to
collect the checks, but rarely more than two business days
ater ttiey are received at the Reserve Banks, even though
they may not yet have been collected due to processing,
transportation, or other delays.
The reserve credit given for checks not yet collected
is included in Federal Reserve "float"'" On the books of
the Federal Reserve Banks, balance sheet float, or state-
ment float as it is sometimes caled, is the difference be-
tween the asset account "items in process of collection,"
and the liability account "deferred credit items." State-
ment float is usuafly positive since it is more often the case
that reserve credit is given before the checks are actually
coEected than the other way around.
Published data on Federal Reserve float are based
on a "reserves-factor" framework rather than a balance
sheet accounting framework. As pubEshed, Federal Re-
serve float includes statement float, as defined above, as
weE as float-related "as-of adjustments." Tliese adjust-
ments represent corrections for errors that arise in pro-
cessing transactions related to Federal Reserve priced
services. As-of adjustments do not change the balance
sheets of either the Federal Reserve Banks or an individ-
ual bank. Rather they are corrections to the bank's reserve
position, thereby affecting the calculation of whether or
not the bank meets its reserve requirements.
An Increase in Federal Reserve Float Increases
As float rises, total bank reserves rise by the same
amount For example, suppose Bank A receives checks
totaHng $100 drawn on Banks B, C, and D, aB in distant
cities. Bank A increases the accounts of ite depositor
$100, and sends the items to a Federal Reserve Bank for
coEection. Upon receipt of the checks, the Reserve Bank
increases its own asset account "items in process of coEec-
tion," and increases its liability account "deferred credit
items" (checks and other items not yet credited to the
sending banks' reserve accounts) . As long as these two
accounts move together, there is no change in float or in
total reserves from this source. See illustration 21.
On tiie next business day (assuming Banks B, C,
and D are one-day deferred avaflabiEty points), the Re-
serve Bank pays Bank A The Reserve Bank's "deferred
credit items" account is reduced, and Bank A's reserve
account is increased $100. If these items actually take
more than one business day to coBect so that "items in
20 Modem Money Mechanics
Federal Reserve float (including as-of adjustments)
annual averages, billions of dollars
I I I I I I I I
process of coEection" are not reduced that day, tiie credit
to Bank A represents an addition to total bank reserves
since the reserve accounts of Banks B, C, and D wiE not
have been commensurately reduced.*^ See illustration 22.
A Decline in Federal Reserve Float Reduces
Only when the checks are actuaEy coEected from
Banks B, C, and D does the float involved in the above ex-
ample disappear — "items in process of coEection" of the
Reserve Bank decEne as the reserve accounts of Banks B,
C, and D are reduced. See iUustration 23.
On an annual average basis. Federal Reserve float
declined dramaticaEy from 1979 through 1984, in part
reflecting actions taken to implement provisions of the
Monetary Control Act that dfrected the Federal Reserve to
reduce and price float (See chart.) Since 1984, Federal
Reserve float has been feirly stable on an armual average
basis, but often fluctuates sharply over short periods.
From the standpoint of the effect on bank reserves, the
significant aspect of float is not that it exists but that its
volume changes in a difficult-to-predict way. Float can
incre^e unexpectedly, for example, if weather conditions
ground planes transporting checks to paying banks for
coEection. However, such periods typicaEy are followed
by ones where actual coEections exceed new items being
received for coEection. TTius, reserves gained from float
expansion usuaEy are quite temporary.
'"Federal Reserve float also arises from other funds transfer services
provided by the Fed, such as wire transfers, securities transfers, and
automatic clearinghouse transfers.
"As-of adjustments also are used as one means of pricing float, as discussed
on page 22, and for nonfloat-related corrections, as discussed on page 35.
"If the checks received from Bank Ahad been erroneously assigned a two-
day deferred availability, then neither statement float nor reserves would
increase, although both should. Bank A's reserve position and published
Federal Reserve float data are corrected for this and similar errors through
When a bank receives deposits in the form of checks drawn on other banks, it can send them to the Federal
Reserve Bank for collection. (Required reserves are not affected immediately because requirements apply to
net transaction accounts, i.e., total transaction accounts minus both cash items in process of collection and
deposits due from domestic depository institutions.)
FEDERAL RESERVE BANK
Items in process
Cash items in
If the reserve account of the payee bank is credited before the reserve accounts of the paying banks are debited,
total reserves increase.
FEDERAL RESERVE BANK
Cash items in
•4—1 Reserves with
But upon actual collection of the items, accounts of the paying banks are charged, and total reserves decline.
FEDERAL RESERVE BANK
BANKS B, C, AND D
Items in process
Factors Affecting Bank Reserves 2 1
Changes in Service-Related Balances
In order to foster a safe and efficient payments system,
the Federal Reserve offers banks a variety of payments ser-
vices. Prior to passage of the Monetary Control Act in 1980,
the Federal Reserve offered its services free, but only to
banks that were members of the Federal Reserve System.
The Monetary Control Act directed the Federal Reserve to
offer its services to all depository institutions, to charge for
these services, and to reduce and price Federal Reserve
float" Except for float, all services covered by the Act were
priced by the end of 1982. hnplementation of float pricing
essentially was completed in 1983.
The advent of Federal Reserve priced services led
to several changes ttiat affect the use of funds in banks' re-
serve accounts. As a result, only part of the total balances in
bank reserve accounts is identified as "reserve balances"
available to meet reserve requirements. Other balances held
in reserve accounts represent "service-related balances and
adjustments (to compensate for float)." Service-related bal-
ances are "required clearing balances" held by banks that use
Federal Reserve services while "adjustments" represent bal-
ances held by banks that pay for float with asot adjustments.
An Increase in Required Clearing Balances
Reduces Reserve Balances
Procedures for establishing and maintaining clearing
balances were approved by the Board of Governors of the
Federal Reserve System in February 1981. A bank may be
required to hold a clearing balance if it has no required re-
serve balance or if its required reserve balance (held to satis-
fy reserve requirements) is not large enough to handle its
volume of clearings. Typically a bank holds both reserve bal-
ances and required clearing balances in the same reserve
account TTius, as required clearing balances are established
or increased, the amount of ftinds in reserve accounts identi-
fied as reserve balances declines.
Suppose Bank A wants to use Federal Reserve services
but has a reserve balance requirement that is less than its
Service-related balances and adjustments
weekly averages, billions of dollars, not seasonally adjusted
Float Pricing As-Of Adjustments Reduce
In 1983, the Federal Reserve began pricing explicitly
for float,'* specifically "interterritory" check float, i.e., float
generated by checks deposited by a bank served by one Re-
serve Bank but drawn on a bank served by another Reserve
Bank. TTie depositing bank has three options in paying for
interterritory check float it generates. It can use its earnings
credits, authorize a direct charge to its reserve account, or
pay for the float with an asof adjustment If either of the first
two options is chosen, the accounting enhies are the same as
paying for other priced services. If the asof adjustment op-
tion is chosen, however, the balance sheets of the Reserve
Banks and the bank are not directiy affected. In effect what
happens is that part of the total balances held in the bank's
reserve account is identified as being held to compensate the
Federal Reserve for float This part, then, cannot be used to
satisfy either reserve requirements or clearing balance re-
quirements. Float pricing asof adjustments are applied two
weeks after the related float is generated. Tlius, an individual
bank has sufficient time to obtain funds from other sources in
order to avoid any reserve deficiencies that might result from
float pricing as-of adjustments. If all banks together have no
excess reserves, however, the float pricinof as-of adjustments
* . .»
When Bank A establishes a required clearing
balance at a Federal Reserve Bank by selling
securities, the reserve balances and deposits of
other banks decline.
FEDERAL RESERVE BANK
Bank A +1,000
Other banks -1,000-
with F.R. Banks:
with F.R. Banks:
Reserve balances _- 1,000
When Bank A is billed monthly for Federal Reserve services used, it can pay for these services by having
earnings credits applied and/or by authorizing a direct chai^ge to its reserve account Suppose Bank A has
accrued earnings credits of $100 but incurs fees of $125. Then both methods would be used. On the Federal
Reserve Bank's books, the liability account "earnings credits due to depository institutions" declines by $100
and Bank A's reserve account is reduced by $25. Of^tting these entries is a reduction in the Fed's (other)
asset account "accrued service income." On Bank A's books, the accounting entries might be a $100 reduc-
tion to its asset account "earnings credit due from Federal Reserve Banks " and a $25 reduction in its reserve
account, which are offeet by a $125 decline in its liability "accounts payable." While an individual bank may
use different accounting entries, the net effect on reserves is a reduction of $25, the amount of billed fees that
were paid through a direct charge to Bank A's reserve account
FEDERAL RESERVE BANK
due to depository
- 25 <♦■
F.R. Banks -100
-►F.R. Banks - 25
Factors Affecting Bank Reserves 23
Changes in Loans to
Prior to passage of the Monetary Control Act of 1980,
only banks that were members of the Federal Reserve Sys-
tem had regular access to the Fed's "discount window."
Since then, all institutions having deposits reservable under
the Act also have been able to borrow from the Fed. Under
conditions set by the Federal Reserve, loans are available
under three credit programs: adjustment, seasonal, and ex-
tended credit'* The average amount of each type of discount
window credit pro^^ded varies over time. (See chaff. )
When a bank borrows from a Federal Reserve Bank, it
borrows reserves. ITie acquisition of reserves in this manner
differs in an important way from the cases already illustrated.
Banks normally borrow adjustment credit only to avoid re-
serve deficiencies or overdrafts, not to obtain excess re-
serves. Adjustment credit borrowings, therefore, are
reserves on which expansion has already taken place. How
can this happen?
In their efforts to accommodate customers as well as to
keep fully invested, banks frequentiy make loans in anticipa-
tion of inflows of loanable funds from deposits or money
market sources. Loans add to bank deposits but not to bank
reserves. Unless excess reserves can be tapped, banks will
not have enough reserves to meet the reserve requirements
against the new deposits. Likewise, individual banks may
incur deficiencies through unexpected deposit outflows and
corresponding losses of reserves through clearings. Other
banks receive these deposits and can increase their loans
accordingly, but the banks that lost them may not be able to
reduce outstanding loans or investments in order to restore
thefr reserves to required levels within the requfred time
period. In either case, a bank may borrow reserves tempo-
rarily from its Reserve Bank.
Suppose a customer of Bank A wants to borrow $100.
On the basis of the management's judgment that the bank's
reserves will be sufficient to provide the necessary funds, the
customer is accommodated. The loan is made by increasing
"loans" and crediting the customer's deposit account Now
Bank A's deposits have increased by $100. However, if re-
serves are insufficient to support the higher deposits. Bank A
will have a $10 reserve deficiency, assuming requirements of
10 percent See illustration 26. Bank A may temporarily
borrow the $10 from its Federal Reserve Bank, which makes
a loan by increasing its asset item "loans to depository institu-
tions" and crediting Bank A's reserve account. Bank A
gains reserves and a corresponding Eability "borrowings from
Federal Reserve Banks." See illustration 27.
To repay borrowing, a bank must gain reserves through
either deposit growth or asset liquidation. See illustration 28.
A bank makes payment by authorizing a debit to its reserve
account at the Federal Reserve Bank. Repayment of borrow-
ing, therefore, reduces both reserves and "borroviings from
Federal Reserve Banks." See illustration 29.
Unlike loans made under the seasonal and extended
credit programs, adjustment credit loans to banks generally
Loans to depository institutions
monthly averages, billions of dollars, not seasonally adjusted
must be repaid within a short time since such loans are made
primarily to cover needs created by temporary fluctuations in
deposits and loans relative to usual patterns. Adjustments,
such as sales of securities, made by some banks to "get out
of the wdndow" tend to fransfer reserve shortages to other
banks and may force these other banks to borrow, especially
in periods of heavy credit demands. Even at times when the
total volume of adjustment credit borrowing is rising, some
individual banks are repaying loans while others are borrow-
ing. In the aggregate, adjustment credit borrowing usually
increases in periods of rising business activity when the
public's demands for credit are rising more rapidly than
nonborrowed reserves are being provided by System open
Discount Window as a Tool of Monetary Policy
Although reserve expansion through borrowing is initi-
ated by banks, the amount of reserves that banks can acqmre
in this way ordinarily is Emited by the Federal Reserve's ad-
ministration of the discount window and by its confrol of the
rate charged banks for adjustment credit loans — the discount
rate." Loans are made only for approved purposes, and other
reasonably available sources of funds must have been fiilly
used. Moreover, banks are discouraged from borrowing ad-
justment credit too frequentiy or for extended time periods.
Raising the discount rate tends to resfrarn borrowing by
increasing its cost relative to the cost of alternative sources
Discount window adminisfration is an important adjunct
to the other Federal Reserve tools of monetary policy. While
the privilege of borrowing offers a "safety valve" to temporarily
relieve severe sfrains on the reserve positions of individual
banks, there is generally a sfrong incentive for a bank to repay
borrowing before adding further to its loans and investments.
"Adjustment credit is short-term credit available to meet temporary needs
for fimds. Seasonal credit is available for longer periods to smaller institu-
tions having regular seasonal needs for funds. Extended credit may be made
available to an institution or group of institutions experiencing sustained
liquidity pressures. The reserves provided through extended credit borrow-
ing typically are offset by open market operations.
"Flexible discount rates related to rates on money market sources of funds
currently are charged for seasonal credit and for extended credit outstanding
more than 30 days.
2 4 Modern Money Mechanics
A bank may incur a reserve defidency if it niakes
loans when it has no excess reserves.
Borrowing from a Federal Reserve Bank to cover such a deficit is accompanied by a direct credit to the
bank's reserve account
FEDERAL RESERVE BANK
Loans to depository
Bank A + 10
Reserve accounts: Reserves with
Bank A + 10^ ►F.R.Banks + 10
F.R. Banks + 10
Nofiirtiier expansion can take place on the new reserves because they are all needed against the deposits created in (26).
Before a bank can repay borrowings, it must
gain reserves from some other source.
Repayment of borrowings from the Federal Reserve Bank reduces reserves.
FEDERAL RESERVE BANK
Loans to depository
Factors Affecting Bank Reserves 2 5
Changes in Reserve Requirements
Thus fer we have described transactions that affect the
volume of bank reserves and the impact these transactions
have upon the capacity of the banks to expand their assets
and deposits. It is also possible to influence deposit expan-
sion or contraction by changing the required minimtmi ratio
of reserves to deposits.
The authority to vary required reserve percentages for
banks that were members of the Federal Reserve System
(member banks) was first granted by Congress to the Fed-
eral Reserve Board of Governors in 1933. The ranges within
which this authority can be exercised have been changed
several times, most recently in the Monetary Control Act of
1980, which provided for the establishment of reserve re-
quirements that apply uniformly to all depository institutions.
The 1980 statute established the following limits:
On transaction accounts
first $25 million
above $25 million
On nonpersonal time deposits
8% to 14%
The 1980 law initially set the requirement against transaction
accounts over $25 million at 12 percent and that against
nonpersonal time deposits at 3 percent The initial $25 mil-
lion "low reserve tranche" was indexed to change each year
in line with 80 percent of the growth in transaction accoxmts
at all depository institutions. (For example, the low reserve
tranche was increased from $41.1 million for 1991 to $42.2
million for 1992.) In addition, reserve requirements can be
imposed on certain nondeposit sources of funds, such as
Eurocurrency Habilities.^* (Initially tiie Board set a 3 percent
requirement on Eurocurrency liabilities.)
The Gam-St Germain Act of 1982 modified these provi-
sions somewhat by exempting from reserve requirements
the first $2 million of total reservable liabilities at each depos-
itory institution. Similar to the low reserve tranche adjust-
ment for transaction accounts, the $2 million "reservable
liabilities exemption amount" was indexed to 80 percent of
aimual increases in total reservable liabilities. (For example,
the exemption amount was increased from $3.4 million for
1991 to $3.6 million for 1992.)
The Federal Reserve Board is authorized to change, at
its discretion, the percentage requirements on transaction
accounts above the low reserve tranche and on nonpersonal
time deposits within the ranges indicated above. In addition,
the Board may impose differing reserve requirements on
nonpersonal time deposits based on the maturity of the de-
posit (Jhe Board initially imposed the 3 percent nonper-
sonal time deposit requirement only on such deposits with
original maturities of under four years.)
During the phase-in period, which ended in 1984 for
most member banks and in 1987 for most nonmember insti-
tutions, requirements changed according to a predetermined
schedule, witiiout any action by the Federal Reserve Board.
Apart fi-om these legally prescribed changes, once the Mone-
tary Control Act provisions were implemented in late 1980,
2 6 Modem Money Mechanics
the Board did not change any reserve requirement ratios until
late 1990. (The original maturity break for requirements on
nonpersonal time deposits was shortened several times, once
in 1982 and twice in 1983, in connection with actions taken to
deregulate rates paid on deposits.) In December 1990, the
Board reduced reserve requirements against nonpersonal
time deposits and Eurocurrency liabilities from 3 percent to
zero. Effective in ^ril 1992, the reserve requirement on
transaction accounts above the low reserve tranche was low-
ered from 12 percent to 10 percent
AVhen reserve requirements are lowered, a portion of
banks' existing holdings of required reserves becomes excess
reserves and may be loaned or invested. For example, with a
requirement of 10 percent, $10 of reserves would be required
to support $100 of deposits. See illustration 30. But a reduc-
tion in the legal requirement to 8 percent would tie up only $8,
freeing $2 out of each $10 of reserves for use in creating addi-
tional bank credit and deposits. See illustration 31.
An increase in reserve requirements, on the other hand,
absorbs additional reserve funds, and banks which have no
excess reserves must acquire reserves or reduce loans or
investments to avoid a reserve deficiency. Thus an increase
in the requirement from 10 percent to 12 percent would boost
required reserves to $12 for each $100 of deposits. Assuming
banks have no excess reserves, this would force them to
liquidate assets until the reserve deficiency was eliminated,
at which point deposits would be one-sbcth less than before.
See illustration 32.
Reserve Requirements and Monetary Policy
The power to change reserve requirements, like pur-
chases and sales of securities by the Federal Reserve, is an
instrument of monetary policy. Even a small change in re-
quirements — say, one-half of one percentage point — can
have a large and widespread impact Other instiimients of
monetary policy have sometimes been used to cushion the
initial impact of a reserve requirement change. Thus, the
System may sell securities (or purchase less than otherwise
would be appropriate) to absorb part of the reserves released
by a cut in requirements.
It should be noted that in addition to their initial impact
on excess reserves, changes in requiremente alter the expan-
sion power of every reserve dollar. Thus, such changes affect
the leverage of all subsequent increases or decreases in re-
serves fi-om any source. For this reason, changes in the total
volume of bank reserves actually held between points in time
when requirements differ do not provide an accurate indica-
tion of the Federal Reserve's policy actions.
Both reserve balances and vault cash are eligible to
satisfy reserve requirements. To the extent some institutions
normally hold vault cash to meet operating needs in amounts
exceeding their required reserves, they are unlikely to be
affected by any change in requirements.
'*The 1980 statute also provides that "under extraordinary circumstances"
reserve requirements can be imposed at any level on any liability of
depository institutions for as long as sk months; and, if essential for the
conduct of monetary policy, supplemental requirements up to 4 percent of
transaction accounts can be imposed.
QQ Under a 10 percent reserve requirement,
$10 of reserves are needed to support each
$100 of deposits.
With a reduction in requirements from 10
percent to 8 percent, fewer reserves are
required against the same volume of deposits
so that excess reserves are created. These can
be loaned or invested.
FEDERAL RESERVE BANK
There is no change in the total amount of bank reserves.
^2 ^th an increase in requirements from 10
percent to 12 percent, more reserves are
required against the same volume of deposits.
The resulting deficiencies must be covered by
liquidation of loans or investments . . .
FEDERAL RESERVE BANK
. . .because the total amount of bank reserves remains
Factors Affecting Bank Reserves 27
Changes in Foreign-Related Factors
The Federal Reserve has engaged in foreign currency
operations for its own account since 1962. In addition,
it acts as the agent for foreign currency transactions of the
U.S. Treasury, and since the 1950s has executed transac-
tions for customers such as foreign central banks. Perhaps
the most publicized type of foreign currency transaction
undertaken by the Federal Reserve is intervention in the
foreign exchange markets. Intervention, however, is only
one of several foreign-related transactions that have the
potential for increasing or decreasing reserves of banks,
thereby affecting money and credit growth.
Several foreign-related transactions and their effects
on U.S. bank reserves are described in the next few pages.
Included are some but not all of the types of transactions
used. The key point to remember, however, is that the
Federal Reserve routinely ofeets any undesired change in
U.S bank reserves resulting from foreign-related transac-
tions. As a result, such transactions do not affect money
and credit growtii in the United States.
Foreign Exchange Intervention for the Federal
Reserve's Own Account
When the Federal Reserve intervenes in foreign
exchange markets to sell dollars for its own accoimf it
acquires foreign currency assets and reserves of U.S. banks
initially rise. In contrast, when the Fed intervenes to buy
dollars for its own account, it uses foreign currency assets
to pay for the dollars purchased and reserves of U.S. banks
Consider the example where the Federal Reserve
intervenes in the foreign exchange markets to sell $100 of
U.S. dollars for its own account In this transaction, the
Federal Reserve buys a foreign-currency-denominated
deposit of a U.S. bank held at a foreign commercial bank,^
and pays for this foreign currency deposit by crediting $100
to tiie U.S. bank's reserve account at ttie Fed. The Federal
Reserve deposits the foreign currency proceeds in its ac-
count at a Foreign Central Bank, and as this transaction
clears, the foreign bank's reserves at the Foreign Central
Bank decline. See illustration 33 on pages 30-31. Initially,
then, the Fed's intervention sale of dollars in this example
leads to an increase in Federal Reserve Bank assets denom-
inated in foreign currencies and an increase in reserves of
Suppose instead that the Federal Reserve intervenes
in the foreign exchange markets to buy $100 of U.S. dollars,
again for its own account The Federal Reserve purchases a
dollar-denominated deposit of a foreign bank held at a U.S.
bank, and pays for this dollar deposit by drawing on its
foreign currency deposit at a Foreign Central Bank. CThe
Federal Reserve might have to sell some of its foreign cur-
rency investments to build up its deposits at the Foreign
Central Bank, but this woxdd not affect U.S. bank reserves.)
As the Federal Reserve's account at the Foreign Central
Bank is charged, the foreign bank's reserves at the Foreign
Central Bank increase. In turn, the dollar deposit of the
foreign bank at the U.S. bank declines as the U.S. bank
transfers ownership of those dollars to the Federal Reserve
2 8 Modem Money Mechanics
Federal Reserve Bank assets denominated
in foreign currencies
end of month, billions of dollars, not seasonally adjusted
via a $100 charge to its reserve accoimt at the Federal Re-
serve. See illustration 34 on pages 30-31. Initially, then, the
Fed's intervention purchase of dollars in this example leads
to a decrease in Federal Reserve Bank assets denominated in
foreign currencies and a decrease in reserves of U.S. banks.
As noted earlier, the Federal Reserve offsets or "ster-
ilizes" any undesired change in U.S. bank reserves stemming
from foreign exchange intervention sales or purchases of
dollars. For example. Federal Reserve Bank assets denomi-
nated in foreign currencies rose dramatically in 1989, in part
due to significant U.S. intervention sales of dollars. (See chart
on this page.) Total reserves of U.S. banks, however, declined
slightly in 1989 as open market operations were used to "ster-
ilize" the initial intervention-induced increase in reserves.
Monthfy^ Revaluation of Foreign Currency Assets
Another set of accounting transactions that affects
Federal Reserve Bank assets denominated in foreign curren-
cies is the monthly revaluation of such assets. Two business
days prior to the end of the month, the Fed's foreign currency
assets are increased if their market value has appreciated or
decreased if their value has depreciated. The offeetting ac-
counting entry on the Fed's balance sheet is to the "exchange-
translation account" included in "other F.R. liabilities." These
changes in the Fed's balance sheet do not alter bank reserves
directiy. However, since the Federal Reserve turns over its
net earnings to the Treasury each week, the revaluation af-
fects the amount of the Fed's payment to the Treasury, which
in turn influences the size of TT&L calls and bank reserves.
(See explanation on pages 18 and 19.)
"Overall responsibility for U.S. intervention in foreign exchange markets
rests with the U.S. Treasury. Foreign exchange transactions for the
Federal Reserve's account are carried out under directives issued by the
Federal Reserve's Open Market Committee within the general framework
of exchange rate policy established by the U.S. Treasury in consultation
with tiie Fed. They are implemented at the Federal Reserve Bank of New
York, typically at die same time that similar transactions are executed for
the Treasury's Exchange Stabilization Fund.
^Americans traveling to foreign countries engage in "foreign exchange"
transactions whenever they obtain foreign coins and paper currency in
exchange for U.S. coins and currency. However, most foreign exchange
transactions do not involve the physical exchange of coins and currency.
Rather, most of these transactions represent the buying and selling of
foreign currencies by exchanging one bank deposit denominated in one
currency for another bank deposit denominated in another currency. For
ease of exposition, the examples assume that U.S. banks and foreign banks
are the market participants in the intervention transactions, but the impact
on reserves would be the same if the U.S. or foreign public were involved.
Foreign-Related Transactions for the Treasury
U.S. intervention in foreign exchange markets by the
Federal Reserve usually is di^nded between its own account
and the Treasury's Exchange Stabilization Fund (ESF) ac-
count The impact on U.S. bank reserves from the interven-
tion transaction is the same for both — sales of dollars add
to reserves while purchases of dollars drain reserves. See
illustration 35 on pages 30-31. Depending upon how the
Treasury pays for, or finances, its part of the intervention,
however, the Federal Reserve may not need to conduct
offsetting open market operations.
The Treasury typically keeps only minimal balances
in the ESFs account at the Federal Reserve. Therefore,
the Treasury generally has to convert some ESF assets into
dollar or foreign currency deposits in order to pay for its part
of an intervention transaction. Likewise, the dollar or for-
eign currency deposits acquired by tiie ESF in the interven-
tion typically are drawn down when the ESF invests the
proceeds in earning assets.
For example, to finance an intervention sale of dollars
(such as that shown in illustration 35) , the Treasury might
redeem some of ttie U.S. government securities issued to
the ESF, resulting in a transfer of funds from the Treasury's
(general account) balances at the Federal Reserve to the
ESFs account at the Fed. (On the Federal Reserve's bal-
ance sheet, the ESFs account is included in the liability
category "other deposits.") The Treasury, however, would
need to replenish its Fed balances to desired levels, perhaps
by increasing ttie size of TT&L calls — a transaction that
drains U.S. bank reserves. The intervention and financing
transactions essentially occur simultaneously. As a result,
U.S. bank reserves added in the intervention sale of dollars
are offeet by the drain in U.S. bank reserves from the TT&L
call. See illustrations 35 and 36 on pages 30-31. Thus, no
Federal Reserve offsetting actions would be needed if the
Treasury financed the intervention sale of dollars through
a TT&L call on banks.
Offeetting actions by the Federal Reserve would be
needed, however, if the Treasury restored deposits affected
by foreign-related transactions through a number of transac-
tions involving the Federal Reserve. These include the
Treasury's issuance of SDR or gold certificates to the Feder-
al Reserve and the "warehousing" of foreign currencies by
the Federal Reserve.
SDR certificates. Occasionally the Treasury acquires
dollar deposits for the ESFs account by issuing certificates
to the Federal Reserve against aDocations of Special Draw-
ing Rights (SDRs) received from the International Monetary
Fund.2' For example, $3.5 billion of SDR certificates were
issued in 1989, and another $1.5 billion in 1990. This "mone-
tization" of SDRs is reflected on the Federal Reserve's bal-
ance sheet as an increase in its asset "SDR certificate
account" and an increase in its liability "other deposits
If the ESF uses these dollar deposits dfrectly in an
intervention sale of dollars, then flie intervention-induced
increase in U.S. bank reserves is not altered. See illustra-
tions 35 and 37 on pages 30-31. If not needed immediately
for Ml intervention transaction, the ESF might use tiie dollar
deposits from issuance of SDR certificates to buy sectuities
U.S gold stock, gold certificates and SDR certificates
end of year, billions of dollars
1951 1961 1971 1981 1991
^Si* Gold stock
cei lilicalos ^^^^^ "^
. — '
from the Treasury, resulting in a transfer of funds from the
ESFs account at the Federal Reserve to the Treasury's ac-
coimt at the Fed. U.S. bank reserves would then increase as
the Treasury spent the fiinds or transferred them to banks
through a dfrect investment to TT&L note accounts.
Gold stock and gold certificates. Changes in the U.S.
monetary gold stock used to be an important fector affecting
bank reserves. However, the gold stock and gold certificates
issued to the Federal Reserve in "monetizing" gold, have not
changed significantiy since the early 1970s. (See chart on
Prior to August 1971, the Treasury bought and sold
gold for a fixed price in terms of U.S. dollars, mainly at the
initiative of foreign central banks and governments. Gold
purchases by the Treasury were added to the U.S. monetary
gold stock, and paid for from its accotmt at the Federal
Reserve. As the sellers deposited the Treasury's checks in
banks, reserves increased. To replenish its balance at the
Fed, the Treasiuy issued gold certificates to the Federal
Reserve and received a credit to its deposit balance.
Treasiuy sales of gold have the opposite effect Buy-
ers' checks are credited to the Treasury's account and re-
serves decline. Because the official U.S. gold stock is now
fully "monetized," the Treasiuy currentiy has to use its
deposits to retire gold certificates issued to the Federal
Reserve whenever gold is sold. However, the value of gold
certificates retfred, as well as the net contraction in bank
reserves, is based on the official gold price. Proceeds from
a gold sale at the market price to meet demands of domestic
buyers likely would be greater. The difference represents
the Treasury's profit which, when spent restores deposits
and bank reserves by a like amount
While the Treasury no longer purchases gold and
sales of gold have been limited, increases in the official price
of gold have added to the value of the gold stock. (The
official gold price was last raised, from $38.00 to $42.22 per
troy ounce, in 1973.)
Warehousing. The Treasury sometimes acquires dol-
lar deposits at the Federal Reserve by "warehousing" foreign
currencies with tiie Fed. (For example, $7 billion of foreign
^'SDRs were created in 1970 for use by governments in ofScial balance of
Factors Affecting Bank Reserves 2 9
When the Federal Reserve intervenes to seD dollars for its own
account, it pays for a foreign-currency-denominated deposit of a U.S.
bank at a foreign commercial bank by crediting the reserve account of
the U.S. bank, and acquires a foreign currency asset in the form of a
deposit at a Foreign Central Bank. The Federal Reserve, however, will
offeet the increase in U.S. bank reserves if it is inconsistent with
domestic policy objectives.
FEDERAL RESERVE BANK
When the Federal Reserve intervenes to buy dollars for its own
account, it draws down its foreign currency deposits at a Foreign
Central Bank to pay for a dollar-denominated deposit of a foreign bank
at a U.S. bank, which leads to a contraction in reserves of the U.S.
bank. This reduction in reserves will be offset by the Federal Reserve
if it is inconsistent with domestic policy objectives.
FEDERAL RESERVE BANK
In an intervention sale of dollars for the U.S. Treasury, deposits of the ESF at the Federal Reserve are used to pay
for a foreign currency deposit of a U.S. bank at a foreign bank, and the foreign currency proceeds are deposited in
an account at a Foreign Central Bank. U.S. bank reserves increase as a result of this intervention transaction.
U.S. TREASURY ^H
F.R. Banks - 100
Bank + 100
FEDERAL RESERVE BANK
ESF - 100
Concurrentiy, the Treasury must finance the intervention transaction in (35) . The Treasury might build up depoats in
the ESPs account at the Federal Reserve by redeeming securities issued to the ESF, and replenish its ovra (general
account) deposits at the Federal Reserve to desired levels by issuing a call on TT&L note accounts. This set of transac-
tions drains reserves of U.S. banks by the same amount as the intervention in (35) added to U.S. bank reserves.
FEDERAL RESERVE BANK
F.R. Banks net
[imm US bank +100
jja ESF -100
[to ESF -lOOJ
ESF + 100
Alternatively, the Treasury might finance the intervention in (35) by issuing SDR certificates to the Federal
Reserve, a transaction that would not disturb flie addition of U.S. bank reserves in intervention (35) . The Federal
Reserve, however, would offset any undesired change in U.S. bank reserves.
FEDERAL RESERVE BANK
F.R. Banks + 100
ESF + 100
3 Modem Money Mechanics
FOREIGN CENTRAL BANK
Bank - 100
F.R. Banks +
foreign bank -
► F.R. B
FOREIGN CENTRAL BANK
100 U.S. bank - 100
Bank + 100
F.R. Banks - 100
foreign bank +100
FOREIGN CENTRAL BANK
-►F.R. Banks +100
foreign bank - 100
Factors Affecting Bank Reserves 3 1
currencies were warehoused in 1989.) The Treasury or
ESF acquires foreign currency assets as a result of transac-
tions such as intervention sales of dollars or sales of U.S.
government securities denominated in foreign currencies.
When the Federal Reserve warehouses foreign currencies
for the Treasury,^ "Federal Reserve Bank assets denomi-
nated in foreign currencies" increase as do Treasury depos-
its at the Fed. As these deposits are spent, reserves of U.S.
banks rise. In contrast, the Treasury likely will have to
increase the size of TT&L calls — a transaction that drains
reserves — when it repurchases warehoused foreign cur-
rencies from the Federal Reserve. (In 1991, $2.5 billion of
warehoused foreign currencies were repurchased.) The
repurchase transaction is reflected on the Fed's balance
sheet as declines in both Treasury deposits at the Federal
Reserve and Federal Reserve Bank assets denominated in
Transactions for Foreign Customers
Many foreign central banks and governments main-
tain deposits at the Federal Reserve to facilitate dollar-
denominated transactions. These "foreign deposits" on the
liability side of the Fed's balance sheet typically are held at
minimal levels that vary litfle from week to week. For ex-
ample, foreign deposits at the Federal Reserve averaged
only $237 million in 1991, ranging from $178 million to $319
million on a weekly average basis. Changes in foreign
deposits are small because foreign customers "manage"
thefr Federal Reserve balances to desired levels daily by
bu5dng and selling U.S. government securities. The extent
of these foreign customer "cash managemenr transactions
is reflected, in part, by lat^e and frequent changes in mar-
ketable U.S. government securities held in custody by the
Federal Reserve for foreign customers. (See chart.) The
net effect of foreign customers' cash management transac-
tions usually is to leave U.S. bank reserves unchanged.
Manc^ng foreign deposits through sales of securities.
Foreign customers of the Federal Reserve make dollar-
denominated payments, including those for intervention
sales of dollars by foreign central banks, by drawing down
their deposits at the Federal Reserve. As tiiese funds are
deposited in U.S. banks and cleared, reserves of U.S. banks
rise. See illustration 38. However, if payments from their
accounts at the Federal Reserve lower balances to below
desfred levels, foreign customers will replenish their Feder-
al Reserve deposits by selling U.S. government securities.
Acting as thefr agent, the Federal Reserve usually executes
foreign customers' sell orders in the market As buyers pay
for the securities by drawing down deposits at U.S. banks,
reserves of U.S. banks fall and offset the increase in re-
serves from the disbursement transactions. The net effect
is to leave U.S. bank reserves unchanged when U.S. govern-
ment securities of foreign customers are sold in the mar-
ket. See illustrations 38 and 39. Occasionally, however, the
Federal Reserve executes foreign customers' sell orders
with the System's account When this is done, the rise in
reserves from the foreign customers' disbursement of funds
remains in place. See illustrations 38 and 40. The Federal
Reserve might choose to execute sell orders with the Sys-
tem's account if an increase in reserves is desfred for do-
mestic policy reasons.
3 2 Modem Money Mechanics
Marketable U.S government securities held in
custody for foreign customers during 1 991
Wednesday outstandings, billions of dollars
Managing foreign deposits through purchases of securi-
ties. Foreign customers of the Federal Reserve also receive
a variety of dollar-denominated payments, including pro-
ceeds from intervention purchases of dollars by foreign
central banks, that are drawn on U.S. banks. As these funds
are credited to foreign deposits at the Federal Reserve, re-
serves of U.S. banks decline. But if receipts of dollar-denom-
inated payments raise thefr deposits at the Federal Reserve
to levels higher flian desfred, foreign customers will buy U.S.
government securities. TTie net effect generally is to leave
U.S. bank reserves unchanged when the U.S. government
securities are purchased in the market
Using the swap network. Occasionally, foreign central
banks acqufre dollar deposits by activating the "swap" net-
work, which consists of reciprocal short-term credit arrange-
ments between the Federal Reserve and certain foreign
central banks. When a foreign cenfral bank draws on its
swap line at the Federal Reserve, it immediately obtains a
dollar deposit at the Fed in exchange for foreign currencies,
and agrees to reverse the exchange sometime in the future.
On the Federal Reserve's balance sheet activation of the
swap network is reflected as an increase in Federal Reserve
Bank assets denominated in foreign currencies and an in-
crease in the liability category "foreign deposits." When the
swap line is repaid, both of these accounts decline. Reserves
of U.S. banks will rise when the foreign central bank spends
its dollar proceeds from the swap drawing. See illustration
41. In contrast reserves of U.S. banks will fall as the foreign
central bank rebuilds its deposits at the Federal Reserve
in order to repay a swap drawing.
The accounting entries and impact on U.S. bank re-
serves are the same if the Federal Reserve uses the swap
network to borrow and repay foreign currencies. However,
the Federal Reserve has not activated the swap network in
^Technically, warehousing consists of two parts: the Federal Reserve's
agreement to purchase foreign currency assets from the Treasury or ESF
for dollar deposits now, and the Treasiiy s agreement to repurchase the
foreign currencies sometime in the fiiture.
When a Foreign Central Bank makes a dollar-denominated payment from its account at the Federal Reserve, the
recipient deposits the funds in a U.S. bank. As the payment order clears, U.S. bank reserves rise.
FEDERAL RESERVE BANK
FOREIGN CENTRAL BANK
+ I004>F.R. Banks
Deposits + 100
If a decline in its deposits at the Federal Reserve lowers the balance below desired levels, the Foreign Central Bank
will request that the Federal Reserve sell U.S. government securities for it If the sell order is executed in the
market, reserves of U.S. banks will fall by the same amount as reserves were increased in (38) .
FEDERAL RESERVE BANK
FOREIGN CENTRAL BANK
K die sell order is executed with the Federal Reserve's account, however, the increase in reserves from (38) will
remain in place. The Federal Reserve might choose to execute the foreign customer's sell order with the System's
account if an increase in reserves is desired for domestic policy reasons.
FEDERAL RESERVE BANK
FOREIGN CENTRAL BANK
When a Foreign Central Bank draws on a "swap" line, it receives a credit to its dollar deposits at the Federal
Reserve in exchange for a foreign currency deposit credited to the Federal Reserve's account Reserves of U.S.
banks are not affected by the swap drawing transaction, but will increase as the Foreign Central Bank uses the
funds as in (38).
FEDERAL RESERVE BANK
FOREIGN CENTRAL BANK
Bank + 100
Factors Affecting Bank Reserves 3 3
Federal Reserve Actions Affecting Its
Holdings of U.S. Government Securities
In discussing various factors that affect reserves, it
was often indicated that the Federal Reserve ofeets unde-
sired changes in reserves through open market operations,
feat is, by buying and selling U.S. government securities in
the market However, outright purchases and sales of secu-
rities by the Federal Reserve in the market occur infrequent-
ly, and typically are conducted when an increase or decrease
in another factor is expected to persist for some time. Most
market actions taken to implement changes in monetary
policy or to offset changes in other fectors are accomplished
through the use of transactions that change reserves tempo-
rarily. In addition, there are off-market transactions the
Federal Reserve sometimes uses to change its holdings of
U.S. government securities and affect reserves. (Recall the
example in illustrations 38 and 40.) The impact on reserves
of various Federal Reserve transactions in U.S. government
and federal agency securities is explained below. (See table
for a summary.)
Outright transactions. Ownership of securities is
transferred permanently to the buyer in an outright transac-
tion, and the funds used in the transaction are transferred
permanently to the seller. As a result, an outright purchase
of securities by the Federal Reserve from a dealer in the
market adds reserves permanently while an outright sale of
securities to a dealer drains reserves permanently. The
Federal Reserve can achieve the same net effect on reserves
through off-market transactions where it executes outright
sell and purchase orders from customers internally with the
System account In contrast there is no impact on reserves
if the Federal Reserve fills customers' outright sell and pur-
chase orders in the market
Temporary transactions. Repiu-chase agreements
(RPs), and associated matched sale-purchase agreements
(MSPs), transfer ownership of securities and use of funds
temporarily. In an RP transaction, one party sells securities
to another and agrees to buy them back on a specified future
date. In an MSP transaction, one party buys securities from
another and agrees to sell them back on a specified future
date. In essence, then, an RP for one party in the transaction
works like an MSP for the other party.
When the Federal Reserve executes what is referred
to as a "System RP," it acquires securities in the market from
dealers who agree to buy them back on a specified future
date 1 to 15 days later. Both the System's portfolio of securi-
ties and bank reserves are increased during the term of the
RP, but decline again when the dealers repurchase the secu-
rities. Thus System RPs increase reserves only temporarily.
Reserves are drained temporarily when the Fed executes
what is known as a "System MSP." A System MSP works
like a System RP, only in the opposite dfrection. In a System
MSP, the Fed sells securities to dealers in the market and
agrees to buy them back on a specified day. The System's
holdings of securities and bank reserves are reduced during
the term of the MSP, but both increase when the Federal
Reserve buys back the securities.
34 Modem Money Mechanics
Impact on reserves of Federal Reserve transactions
in U.S. government and federal agency securities
Federal Reserve Transaction
Outright Purchases of Securities
- From dealer in market
- To fill customer sell orders Internally
(If customer sell orders filled in market)
Outright Sales of Securities
- To dealer in market
- To fill customer buy orders internally
(If customer buy orders filled in market)
Repurchase Agreements (RPs)
- With dealer in market in a System RP
Matched Sale-Purchase Agreements (MSPs)
- With dealer in market in a System MSP
- To fill customer RP orders internally
(If customer RP orders passed to market as
Redemption of Maturing Securities
- Replace total amount maturing
- Redeem part of amount maturing
- Buy more than amount maturing*
* Impact based on assumption that the amount of RP orders done
internally is the same as on the prior day.
**The Federal Reserve currently is prohibited by law from buying securities
directly fi-om the Treasury, except to replace maturing issues.
The Federal Reserve also uses MSPs to fill foreign
customers' RP orders internally with tiie System account
Considered in isolation, a Federal Reserve MSP transac-
tion with customers would drain reserves temporarily.
However, these transactions occur every day, with the
total amount of RP orders being fairly stable from day
to day. Thus, on any given day, the Fed both buys back
securities from customers to fulfill the prior day's MSP,
and sells them about the same amount of securities to
satisfy that day's agreement As a result there generally is
litfle or no impact on reserves when the Fed uses MSPs to
fill customer RP orders internally with the System account
Sometimes, however, the Federal Reserve fills some of the
RP orders internally and the rest in the market The part
that is passed on to the market is known as a "customer-
related RP." The Fed ends up repurchasing more securi-
ties from customers to complete the prior day's MSP than
it sells to them in that day's MSP. As a result customer-
related RPs add reserves temporarily.
Maturing securities. As securities held by the Fed-
eral Reserve mature, they are exchanged for new seciui-
ties. Usually the total amount maturing is replaced so that
there is no impact on reserves since the Fed's total hold-
ings remain the same. Occasionally, however, the Federal
Reserve will exchange only part of the amount maturing.
Treasury deposits decline as payment for the redeemed
securities is made, and reserves fall as the Treasury re-
plenishes its deposits at flie Fed through TT&L calls. The
reserve drain is permanent If the Fed were to buy more
than the amount of securities maturing directly from the
Treasury, then reserves would increase permanentiy.
However, tiie Federal Reserve currently is prohibited by
law from buying securities directiy from the Treasury,
except to replace maturing issues.
MisceUaneous Factors Affecting
The factors described below normally have negligi-
ble effects on bank reserves because changes in them either
occur very slowly or tend to be balanced by concurrent
changes in other factors. But at times they may require
Treasury Currency Outstanding
Treasury currency outstanding consists of coins,
silver certificates and U.S. notes originally issued by ttie
Treasury, and other currency originally issued by commer-
cial banks and by Federal Reserve Banks before July 1929
but for which the Treasury has redemption responsibility.
Short-run changes are small, and their effects on bank
reserves are indirect
The amoimt of Treasury currency outstanding cur-
rently increases only through issuance of new coin. The
Treasury ships new coin to the Federal Reserve Banks for
credit to Treasury deposits there. These deposits will be
drawn down again, however, as the Treasury makes expen-
ditures. Checks issued against these deposits are paid out
to the public. As individuals deposit these checks in banks,
reserves increase. (See explanation on pages 18 and 19.)
When any type of Treasury currency is retired, bank
reserves decline. As banks turn in Treasury currency for
redemption, they receive Federal Reserve notes or coin in
exchange or a credit to their reserve accounts, leaving
their total reserves (reserve balances and vault cash) ini-
tially unchanged. However, the Treasury's deposits in the
Reserve Banks are charged when Treasury currency is
retired. Transfers from TT&L balances in banks to the
Reserve Banks replenish these deposits. Such transfers
Treasury Cash Holdings
In addition to accounts in depository institutions and
Federal Reserve Banks, the Treasury holds some currency
in its own vaults. Changes in these holdings affect bank
reserves just like changes in the Treasury's deposit account
at the Reserve Banks. When Treasury holdings of currency
increase, they do so at the expense of deposits in banks.
As cash holdings of the Treasury decline, on the other
hand, these fimds move into bank deposits and increase
Other Deposits in Reserve Banks
Besides U.S. banks, the U.S. Treasury, and foreign
central banks and governments, there are some interna-
tional organizations and certain U.S. government agencies
that keep funds on deposit in the Federal Reserve Banks. In
general, balances are built up through transfers of deposits
held at U.S. banks. Such transfers may take place either
directiy, where these customers also have deposits in U.S.
banks, or indirectly by the deposit of funds acquired from
others who do have accounts at U.S. banks. Such transfers
into "other deposits" drain reserves.
When these customers draw on their Federal Re-
serve balances (say, to purchase securities), these funds
are paid to the public and deposited in U.S. banks, thus
increasing bank reserves. Just like foreign customers,
these "other" customers manage their balances at the
Federal Reserve closely so that changes in their deposits
tend to be small and have minimal net impact on reserves.
Certmn adjustments are incorporated into published
data on reserve balances to reflect nonfloat-related correc-
tions. Such a correction might be made, for example, if an
individual bank had mistakenly reported fewer reservable
deposits than actually existed and had held smaller re-
serve balances than necessary in some past period. To
correct for this error, a nonfloat-related as-of adjustinent
will be applied to the bank's reserve position. This essen-
tially results in the bank having to hold higher balances in
its reserve account in the current and/or future periods
than would be needed to satisfy reserve requirements in
those periods. Nonfloat-related as-of adjustments affect
the allocation of funds in bank reserve accounts but not
the total amount in these accounts as reflected on Federal
Reserve Bank and individual bank balance sheets. Pub-
lished data on reserve balances, however, are adjusted to
show only those reserve balances held to meet the current
and/or future period reserve reqmrements.
Other Federal Reserve Accounts
Earlier sections of this booklet described the way in
which bank reserves increase when the Federal Reserve
purchases securities and decline when the Fed sells secu-
rities. The same results follow from any Federal Reserve
expenditure or receipt Every payment made by the Re-
serve Banks, in meeting expenses or acquiring any assets,
affects deposits and bank reserves in the same way as does
the payment to a dealer for government securities. Simi-
larly, Reserve Bank receipts of interest on loans and secu-
rities and increases in paid-in capital absorb reserves.
Factors Affecting Bank Reserves 3 5
The Reserve Multiplier — Why It Varies
The deposit e}q}ansion and contraction associated
with a given change in bank reserves, as illustrated eariier
in this booklet, assumed a fixed reserve-to-deposit multi-
plier. That multiplier was determined by a uniform percent-
age reserve requirement specified for transaction accounts.
Such an assumption is an oversimplification of the actual
relationship between changes in reserves and changes in
money, e^)ecially in the short run. For a number of rea-
sons, as discussed in this section, the quantity of reserves
^sodated mth a given quantity of transaction deposits is
One slippage affecting the reserve multiplier is varia-
tion in the amotmt of excess reserves. In the real worid,
reserves are not always fiiDy utilized. There are always
some excess reserves in the banking system, reflecting
Mctions and lags as funds flow among tiiousands of individ-
Excess reserves present a problem for monetary
policy implementation onty^ because the amount changes.
To the extent that new reserves supplied are offeet by rising
excess reserves, actual money growth Ms short of the
theoretical maximum. Conversely, a reduction in excess
reserves by the banking system has the same dkd on
monetary expansion as the injection of an equal amount
of new reserves.
Slii^jages also arise from reserve requirements being
imposed on liabilities not included in money as well as
differing reserve ratios being ^^lied to transaction deposits
according to the size of the bank. From 1980 through 1990,
reserve requirements were imposed on certain nontransac-
tion liabilities of all depository institutions, and before then
on all deposits of member banks. The reserve multiplier
vras affected by flows of funds between institutions subject
to differing reserve requirements as well as by shifts of
funds between transaction deposits and other liabilities
subject to reserve requirements. The extension of reserve
requirements to all depository institutions in 1980 and the
elimination of reserve requirements against nonpersonal
time deposits and Eurocurrency liabilities in late 1990
reduced, but did not eliminate, this source of instability in
the reserve multiplier. The deposit expansion potential of
a given volume of reserves still is affected by shifts of trans-
action deposits between larger institutions and those either
exempt from reserve requirements or whose transaction
deposits are within the tranche subject to a 3 percent
to addition, the reserve multiplier is affected by con-
versions of deposits into currency or vice versa. This factor
was important in the 1980s as the public's desired currency
holdings relative to transaction deposits in money shifted
considerably. Also affecting the multiplier are shifts be-
tween transaction deposits included in money and other
transaction accounts that also are reservable but not includ-
ed in money, such as demand deposits due to depoatory
36 Modem Money Mechanics
institutions, the U.S government, and foreign banks and
official institutions, to the aggregate, these non-money
trans^^on deposits are relatively small m comparison to
total transaction accounts, but can vary significanfly fi"om
week to week.
A net mjection of reserves has widely different effects
depending on how it is absorbed. Only a dollar-for-doUar
mcrease to the money supply would result if tiie new re-
serves were paid out to currency to the public. With a uni-
form 10 percent reserve requirement, a $1 tocrease to
reserves would support $10 of additional transaction ac-
counts. An even larger amount would be supported under
the graduated system where smaller tostitutions are subject
to reserve requirements below 10 percent But $1 of new
reserves also would support an additional $10 of certato
reservable transaction accounts that are not counted as
money. (See chart below.) Normally, an tocrease to re-
serves would be absorbed by some combtoation of tiiese
currency and transaction deposit changes.
All of these fectors are to some extent predictable
and are taken toto account to decisions as to tiie amount of
reserves fliat need to be supplied to achieve the desired
rate of monetary expansion. They help e}q)lato why short-
run fluctuations to bank reserves often are disproportionate
to, and sometimes to the opposite direction from, changes
to the deposit component of money.
The growth potential of a $1 million reserve injection
$8 3 mil
$7 1 mil
(percent of deposits raquimd as reserves)
Money Creation and Reserve Management
Another reason for short-run variation in the amount
of reserves supplied is that credit expansion — and thus
deposit creation — is variable, reflecting uneven timing of
credit demands. Although bank loan policies normally take
account of the general availability of funds, the size and
timing of loans and investments made under those policies
depend largely on customers' credit needs.
In the real world, a bank's lending is not normally
constrained by the amount of excess reserves it has at
any given moment Rather, loans are made, or not made,
depending on the bank's credit policies and its expectations
about its ability to obtain the funds necessary to pay its
customers' checks and maintain required reserves in a
timely fashion. In fact, because Federal Reserve regula-
tions in effect from 1968 through early 1984 specified that
average required reserves for a given week should be
based on average deposit levels two weeks earlier ("lagged"
reserve accounting), deposit creation actually preceded the
provision of supporting reserves. In early 1984, a more
"contemporaneous" reserve accounting system was imple-
mented in order to improve monetary control.
In February 1984, banks shifted to maintaining aver-
age reserves over a two-week reserve maintenance period
ending Wednesday against average transaction deposits
held over the two-week computation period ending only
two days earlier. Under this rule, actual transaction deposit
expansion was expected to more closely approximate the
process explained at the beginning of this booklet How-
ever, some slippages still exist because of short-run uncer-
tainties about the level of both reserves and transaction
deposits near tiie close of reserve mmntenance periods.
Moreover, not all banks must maintain reserves according
to the contemporaneous accounting system. Smaller insti-
tutions are either exempt completely or only have to main-
tain reserves quarterly against average deposits in one
week of the prior quarterly period.
On balance, however, variability in the reserve multi-
plier has been reduced by the extension of reserve require-
ments to all institutions in 1980, by the adoption of
contemporaneous reserve accounting in 1984, and by the
removal of reserve requirements against nontransaction
deposits and liabilities in late 1990. As a result short-term
changes in total reserves and transaction deposits in money
are more closely related now than they were before. (See
charts on this page.) The lowering of the reserve require-
ment against transaction accounts above the 3 percent
tranche in ^ril 1992 also should contribute to stabilizing
the multiplier, at least in theory.
Ironically, these modifications contributing to a less
variable relationship between changes in reserves and
changes in transaction deposits occurred as the relationship
between transactions money (Ml) and the economy deteri-
orated. Because the Ml measure of money has become
less useful as a guide for policy, somewhat greater attention
has shifted to the broader measures M2 and M3. However,
reserve multiplier relationships for the broader monetary
measures are far more variable than that for Ml.
The relationship between short-term changes in
reserves and transaction deposits was quite
volatile before the Monetary Control Act of 1 980 .
. . . and before adoption of contemporaneous
reserve accounting in 1 984 . . .
Weekly changes, 1 983
. but less variable afterward.
Note: All data are in billions of dollars, not seasonally adusted. Scaling
approximately reflects each year's average ratio of transaction deposits
to total reserves.
Variability in the reserve multiplier 3 7
Although every bank must operate within the sys-
tem where the total amount of reserves is controlled by
the Federal Reserve, its response to policy action is indi-
rect The individual bank does not know today precisely
what its reserve position will be at the time the proceeds
of today's loans are pmd out Nor does it know when new
reserves are being supplied to the banking system. Re-
serves are distributed among thousands of banks, and the
individual banker caimot distinguish between inflows
originating from additions to reserves through Federal
Reserve action and shifts of funds from otiier banks that
occur in the normal course of business.
To equate short-run reserve needs with available
funds, therefore, many banks turn to the money market —
borrowing funds to cover deficits or lending temporary
surpluses. When the demand for reserves is strong rela-
tive to the supply, funds obtained from money market
sources to cover deficits tend to become more expensive
and harder to obtain, which, in turn, may induce banks to
adopt more restrictive loan policies and thus slow the rate
of deposit growth.
Federal Reserve open market operations exert
control over the creation of deposits mainly through thefr
impact on the availability and cost of funds in the money
market When the total amount of reserves supplied to
the banking system through open market operations falls
short of the amount required, some banks are forced to
borrow at the Federal Reserve discount window. Because
such borrowing is restricted to short periods, the need
to repay it tends to induce restraint on further deposit
expansion by the borrowing bank. Conversely, when
there are excess reserves in the banking system, individ-
ual banks find it easy and relatively inexpensive to acquire
reserves, and ejqKinsion in loans, investments, and depos-
its is encouraged.
3 8 Modem Money Mechanics
Copies of this workbook
are available from:
Public Information Center
Federal Reserve Bank of Chicago
P.O. Box 834
Chicago, IL 60690-0834
 322-51 II
This publication originally was written
by Dorothy M. Nichols in May 1961.
The June 1992 revision was prepared
by Anne Marie L. Gonczy
February 1994 40M
Printed in U.S.A.
@ Printed on recycled paper
FEDERAL RESERVE BANK