(navigation image)
Home American Libraries | Canadian Libraries | Universal Library | Community Texts | Project Gutenberg | Children's Library | Biodiversity Heritage Library | Additional Collections
Search: Advanced Search
Anonymous User (login or join us)
Upload
See other formats

Full text of "Modern Money Mechanics"

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 
are excluded. 

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 
other asset 

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 
central bank. 

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. 



Introduction 



What Limits the Amount of Money Banks 
Can Create? 

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 



V- 



V 









*■' i. 






I' t 









'ir •■ , I.' 



V 1 - 



* 1 .> 



f \ 






t «■ 






K V 



•■ " f ' 



. *' 



' I > 



. 1 • 









t 






J- t 



, ^'...jr 



♦ • ' V,<' 
' . . ' ■•-■-% 






I If t 



^ I '.'■'■ 






■' ' '' . 



% / 



t - 



t , 









, t 



I . < II 






- 4 ' ^ f 



' I 



V *. 



•■ .1' 'l 



<■ .-,. 



J. >■•- if 



f.. 






I- . • 

< T > 






*• t t 



'!■• \ 






* r * t * 



V I. 






> ' 



:^•^ > \. 



,< ^' '0 



»» . > 



t- ' 



^ •. 



:\ 



f r\, c 






'\" 



.. \ 






■•" '^ "* 






<■ >. •' 



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. 



Introduction 



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. 



I 



Deposit Expansion 



1 



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 



Assets 



FEDERAL RESERVE BANK 



Liabilities 



Assets 



Liabilities 



U.S. government 
securities + 10,000 



Reserve accounts: Reserves with 

Banl<A +10,000-4 ►F.R.Banks +10,000 



Customer 
deposit 



+ 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 



3 



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 



Assets 



Liabilities 



Loans 



+ 9,000 



Borrower 
deposits 



+ 9,000 



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 
loan operations. 



J. As a result of the process so far, total assets and 
total liabilities of all banks together have risen 
19,000. 



ALL BANKS 



Assets 




Liabilities 




Reserves with 
F.R. Banks 

Loans 


+ 10,000 
+ 9,000 
+ 19,000 


Deposits: 
Initial 
Stage 1 

Total 


+ 10,000 
+ 9,000 


Total 


+ 19,000 



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. 



Assets 



FEDERAL RESERVE BANK 



Liabilities 



Reserve accounts: 
Stage I banks 
Other banks 



Assets 



Liabilities 



9,000 
9,000 



Reserves v/ith 
■F.R. Banks 



9,000 



Borrower 
deposits 



9,000 



OTHER BANKS 



Assets 



Liabilities 



Reserves with 
►F.R. Banks 



+ 9.000 



Deposits 



+ 9,000 



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 



Assets 



Liabilities 



Loans 



+ 8,100 



Borrower 
deposits 



+ 8,100 



8 



Now the banking system's assets and liabilities 
have risen by 27,100. 



Assets 




Liabilities 




Reserves with 
F.R. Banks 

Loans: 
Stage 1 
Stage 2 


+ 10,000 

+ 9,000 
+ 8,100 

+ 27.100 


Deposits: 
Initial 
Stage 1 
Stage 2 

Total 


+ 10,000 
+ 9,000 
+ 8,100 


Total 


+ 27,100 



But there are still 7,290 of excess reserves in the 
banking system. 



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 

i 

to 
Stage 3 
banks 



10 



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 2 

Stage 3 

Stage 4 

Stage 5 

Stage 6 

Stage 7 

Stage 8 

Stage 9 

Stage 10.... 

Stage 20 .... 
Final stage. 



Assets 








Liabilities 




Reserves 




Loans and 
Investments 




Total 


[Required] 


[Excess] 


Deposits 


10,000 


1,000 


9.000 


~ 


10,000 


10,000 


1,900 


8,100 


9,000 


19,000 


10,000 


2,710 


7,290 


17,100 


27,100 


10,000 


3,439 


6.56/ 


24,390 


34.390 


10,000 


4,095 


5.905 


30,951 


40,951 


10,000 


4,686 


5.314 


36,856 


46.856 


10,000 


5,2/7 


4.783 


42,170 


52.170 


10,000 


5,695 


4.305 


46,953 


56,953 


10,000 


6,/ 26 


3.874 


51,258 


61,258 


10,000 


6,5/3 


3.487 


55,132 


65.132 


10,000 


6,862 


3.138 


58,619 


68,619 


10,000 


8,906 


1.094 


79,058 


89,058 


10,000 


10,000 





90,000 


100,000 



. . . 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 

reserve-creating action. 




100,000 



80,000 



60,000 



40,000 



- 20,000 



Initial 
deposits 



9 10 11 12 13 14 15 16 17 18 19 20 
Expansion stages 



Deposit Expansign and Cantmction 1 1 



How Open Market Sales Reduce Bank Reserves 
and Deposits 

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 
just described. 

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). 



I 



Deposit Contraction 



11 



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. 



Assets 



FEDERAL RESERVE BANK 



Liabilities 



Assets 



Liabilities 



U.S. government 
securities - 10,000 



Reserve accounts: Reserves with 

Bank A -10,000-^ ►F.R.Banks -10,000 



Customer 
deposit 



10,000 



This reduction in the customer deposit at Bank A may be spread among a number of banks through interbank deposit flows. 



12 



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 



13 






1 

Assets 








banks) can sell government securities to acquire 
reserves, but this causes a decline in the deposits 


STAGE 


BANKS 




Liabilities 


and reserves of the buyers' banks. 




U.S. govemme 
securities 

Reserves with 
— F.R. Banks 

Assets 


nt 

- 9,000 

+ 9,000 




1 


1 


FEDERAL RESERVE BANK 


1 


OTHER 


BANKS 


Assets 


Liabilities 






Liabilities 








Reserve acco 
Stage 1 ban 
Other bank 


jnts: 

ks + 9,000 <^ 

5 - 9,000 


Reserves with 
|>F.R. Banks 


- 9,000 


Deposits 


- 9,000 



14 


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 


Assets 




Liabilities 


Reserves with 
F.R. Banks 

U.S. government 
securities 

Total 


- 10,000 

- 9,000 

- 19,000 


Deposits: 
Initial 
Stage 1 

Total 


- 10,000 

- 9,000 


- 19,000 



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 
page 35. 



I 



Factors Changing Reserve Balances — Independent and Policy Actions 



^«EeEMlsL^|liSERye»A«i*IS.■; 



Public 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 



Assets 


Liabilities 






Reserve 
balances 


Other 




. 


+ 




+ 


- 






+ 




+ 


- 




+ 


- 




- 


+ 




+ 


- 




- 


+ 




+ 


- 






+ 






+ 




+ 


- 




- 


+ 




+ 


- 




- 


+ 




+ 


- 


+ 


+ 




+ 


+ 




+ 


+ 








* 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 



280 



260 



240 - 



220 - 



200 




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 
reserve money. 

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. 













BANK A 


Assets 




Liabilities 


Vault cash 
reserves 
[Required 
[Defidt 


-lOl 
90] 


-100 


Deposits 


-100 



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. 



Assets 



FEDERAL RESERVE BANK 



Liabilities 



Assets 



Reserve accounts: 
Bank A 

F.R. notes 



-100 
+ 100 



'^ Res 
1->F.R. 



Vault cash 

Reserves with 
Banks 



Liabilities 



+ 100 
-100 



1 y When currency comes back to the banks, both 
deposits and vault cash reserves rise. 









1 


BANK A 


Assets 


Liabilities 


Vault cash 
reserves 
[Required 
^cess 


+ 100 

+iol 

+90] 


Deposits 


+ 100 



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 



Assets 



Liabilities 



Assets 



Liabilities 



Reserve accounts: 
Bank A 

F.R. notes 



+ 100 
-100 



■^ Res 
•"►RR. 



Vault cash 

Reserves with 
Banks 



-100 
+ 100 



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 
reserve accounts. 

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- 
tory institutions. 

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 
this amount. 



18 Modem Money Mechanics 



Operating cash balance of the U.S. Treasury 

weekly averages, billions of dollars, not seasonally adjusted 



60 



STT&L note balances 
Balances M rodfral 
nebon/H Banks 




1990 



1991 



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. 



Assets 



FEDERAL RESERVE BANK 



Liabilities 



Assets 



Liabilities 



Reserve accounts: 
Bank A 

U.S. Treasury 
deposits 



1.000-4- 



+ 1,000 



Reserves with 
■>F.R. Banks 
[Required 
l_Deficit l,000i 



I 



-1,000 



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. 



Assets 



FEDERAL RESERVE BANK 



Liabilities 



Assets 



Liabilities 



Reserve accounts: 
Bank A 

U.S. Treasury 
deposits 



+ 1,000 -^ 



1.000 



Reserves with 
-►F.R. Banks +1,000 

[Required +I0d] 
[Excess +900/ 



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 
Bank Reserves 

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 




2 - 



I I I I I I I I 



1971 



1976 



1981 



1986 



1991 



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 
Bank Reserves 

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 
as-of adjustments. 



21 



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.) 



Assets 



FEDERAL RESERVE BANK 



Liabilities 



Assets 



Liabilities 



Items in process 
of collection 



+ 100 



Deferred 
credit items 



+ 100 



Cash items in 
process 
of collection 



+ 100 



Deposits 



+ 100 



22 



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 



Assets 


Liabilities 






Deferred 






credit items 


-100 




Reserve accounts: 






Bank A 


+ 100 



Assets 



Liabilities 



Cash items in 
process of 
collection 



•4—1 Reserves with 
•-►F.R. Banks 
jkequind 
[^Excess 



+/o7 

+90j 



100 



+ 100 



23 



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



Assets 



FEDERAL RESERVE BANK 



Liabilities 



Assets 



BANKS B, C, AND D 



Liabilities 



Items in process 




Reserve accounts: 




of collection 


-100 


BankB 
BankC 
BankD 




-100 



,^ 



Reserves v^ith 
F.R. Banks 
[Required 
ipefidt 



-10 
90i 



I 



-100 



Deposits 



100 



Factors Affecting Bank Reserves 2 1 



Changes in Service-Related Balances 
and Adjustments 

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 




1989 



1990 



1991 



Float Pricing As-Of Adjustments Reduce 

Reserve Balances 

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 



* . .» 



24 



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 



Assets 


Liabilities 




Reserve accounts: 




Required clearing 




balances: 




Bank A +1,000 




Reserve balances: 




Other banks -1,000- 



Assets 




Liabilities 


U.S. government 
securities 

Reserve account 
with F.R. Banks: 

Required clearing 

balance 


-1.000 
+ 1,000 





OTHER BANKS 



Assets 



Liabilities 



5 



Reserve accounts 
with F.R. Banks: 

Reserve balances _- 1,000 

fRequired -100, 

fpefidt 9001 



'^oi 

loj 



Deposits 



1,000 



25 



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 



Assets 



FEDERAL RESERVE BANK 



Liabilities 



Assets 



Liabilities 



Accrued service 
income 



125 



Earnings credits 
due to depository 
institutions 

Reserve accounts: 
Bank A 



100 



- 25 <♦■ 



Earnings credits 

due from 

F.R. Banks -100 

Reserves with 
-►F.R. Banks - 25 



Accounts 
payable 



125 



Factors Affecting Bank Reserves 23 



Changes in Loans to 
Depository Institutions 



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 




1985 



1987 



1989 



1991 



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 
market operations. 

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 
of reserves. 

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 



26 


A bank may incur a reserve defidency if it niakes 
loans when it has no excess reserves. 


Assets 






BANK A 


Liabilities 


Loans 

Reserves with 
F.R. Banks 
[Required 
iDefidt 


+ 100 

no change 
+ iOl 

loj 


Deposits 


+ 100 



27 



Borrowing from a Federal Reserve Bank to cover such a deficit is accompanied by a direct credit to the 
bank's reserve account 



Assets 



FEDERAL RESERVE BANK 



Liabilities 



Assets 



Liabilities 



Loans to depository 
institutions: 
Bank A + 10 



Reserve accounts: Reserves with 

Bank A + 10^ ►F.R.Banks + 10 



Borrowings from 

F.R. Banks + 10 



Nofiirtiier expansion can take place on the new reserves because they are all needed against the deposits created in (26). 



28 



Before a bank can repay borrowings, it must 
gain reserves from some other source. 



Assets 



Securities 

Reserves with 
F.R. Banks 



Liabilities 



- 10 
+ 10 



29 



Repayment of borrowings from the Federal Reserve Bank reduces reserves. 



Assets 



FEDERAL RESERVE BANK 



Liabilities 



Loans to depository 
institutions: 
Bank A 



Assets 



10 



Reserve accounts: 
Bank A 



lO"*- 



Reserves with 
-►F.R. Banks 



Liabilities 



10 



Borrowings from 
F.R. Banks 



10 



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 



3% 
8% to 14% 

0%to9% 



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. 



Assets 



Liabilities 



Loans and 
investments 

Reserves 

jRequired 

l_Excess 



90 
10 



»J 



Deposits 



100 



31 



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. 



Assets 



Liabilities 



Loans and 
investments 

Reserves 

jRequired 

/Excess 



'J 



90 
10 



Deposits 



100 



FEDERAL RESERVE BANK 



Assets 



Liabilities 



NO CHANGE 



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 . . . 



Assets 



Liabilities 



Loans and 
investments 

Reserves 

JRequired 
[Defidt 



'ij 



90 
10 



Deposits 



100 



Assets 



FEDERAL RESERVE BANK 



Liabilities 



NO CHANGE 



. . .because the total amount of bank reserves remains 
unchanged. 



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 
initially fall. 

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 
U.S. banks. 

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 
40 




1979 



1982 



1985 



1988 



1991 



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 
(ESF account)." 

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 

25 
20 
15 
10 
5 - 

1951 1961 1971 1981 1991 



;^ 


\ 




_ 


^Si* Gold stock 




- 


Gold\\ 




cei lilicalos ^^^^^ "^ 


r 


- 


SDR 
certificates/ 


. — ' 









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 
this page.) 

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 
payments transactions. 

Factors Affecting Bank Reserves 2 9 



33 



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. 



Assets 



FEDERAL RESERVE BANK 



Liabilities 



Deposits at 
Foreign Central 
Bank + 



100 



Reserves: 
U.S. bank 



+ I00-4- 



34 



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. 



Assets 



FEDERAL RESERVE BANK 



Liabiiities 



Deposits at 
Foreign Central 
Bank 



100 



Reserves: 
U.S. bank 



100 •♦■ 



35 



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. 



^H 


Liabiiities 




U.S. TREASURY ^H 


Assets 


Assets 


Liabilities 


Deposits at 

F.R. Banks - 100 

Deposits at 
Foreign Central 
Bank + 100 











Assets 



FEDERAL RESERVE BANK 



Liabilities 



Reserves: 
U.S. bank 



+ 100-4- 



Other deposits: 
ESF - 100 



36 



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. 



U.S. TREASURY 



Assets 




Liabilities 


U.S. govt 
securities 

Deposits at 
F.R. Banks 


- 100 
+ 100 





Assets 



Uabilities 



Assets 



FEDERAL RESERVE BANK 



Liabilities 



TT&L accts. 



100 



Deposits at 
F.R. Banks net 

[imm US bank +100 
jja ESF -100 






Securities 
issued ESF 



100 



Reserves: 
U.S. banks 

Treas. deps.: 



- 100-4- 
netO 



f^USbank +1001 
[to ESF -lOOJ 

Other deposits: 
ESF + 100 



37 



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. 



U.S. TREASURY 



Assets 



Liabilities 



Assets 



Liabilities 



Assets 



FEDERAL RESERVE BANK 



Liabilities 



Deposits at 
F.R. Banks 



+ 100 



SDR certificates 

issued to 

F.R. Banks + 100 



SDR certificate 
account + 



00 



Other deposits: 
ESF + 100 



3 Modem Money Mechanics 

























U.S. BANK 


1 


FOREIGN BANK 




FOREIGN CENTRAL BANK 


Assets 


Liabilities 


Assets Uabilities 


Assets 


Liabilities 


Reser 


ves with 
anks 

sits at 
n bank 


+ 100 
- 100 




Reserves with 
Foreign Central 
Bank - 100 


Deposits of 
U.S. bank 


100 






Deposits of 
F.R. Banks + 

Reserves of 
foreign bank - 


100 
100 


► F.R. B 

Depo 
foreig 



















1 




U.S. BANK 




FOREIGN BANK 




FOREIGN CENTRAL BANK 


Asse 


ts 


Liabilities 


Assets Uabilities 


Assets 


Liabilities 


Reser 


ves with 
anks 


- 100 


Deposits of 
foreign bank 


Deposits at 
100 U.S. bank - 100 

Reserves with 
Foreign Central 
Bank + 100 








Deposits of 

F.R. Banks - 100 

Reserves of 
foreign bank +100 





FOREIGN BANK 



Assets 



Liabilities 



Assets 



Liabilities 



Assets 



FOREIGN CENTRAL BANK 



Liabilities 



Reserves with 
-►F.R. Banks +100 

Deposits at 
foreign bank - 100 



Reserves with 
Foreign Central 
Bank 



100 



Deposits of 
U.S. bank 



100 



Deposits of 
ESF 

Reserves of 
foreign bank 



+ 100 



100 













U.S. BANK 


Asse 


ts 


Liabilities 


Reser 


ves with 
anks 


- 100 


TT&L accts. 


100 





Assets 



Liabilities 



NO CHANGE 



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 
foreign currencies. 

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 



265 



255 - 



245 



235 




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 
recent years. 



^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. 



38 



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. 



Assets 



FEDERAL RESERVE BANK 



Liabilities 



Reserves: 
U.S. bank 

Foreign 
deposits 



Assets 



Liabilities 



Assets 



FOREIGN CENTRAL BANK 



Liabilities 



Reserves with 
+ I004>F.R. Banks 



100 



+ 100 



Deposits + 100 



Deposits at 
F.R. Banks 



- 100 



Accounts 
payable 



100 



39 



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) . 



Assets 



FEDERAL RESERVE BANK 



Liabilities 



Reserves: 
U.S. bank 

Foreign 
deposits 



Assets 



Liabilities 



Assets 



FOREIGN CENTRAL BANK 



Liabilities 



- 100 



+ 100 



Reserves with 
F.R. Banks 



100 



Deposits of 

securities 

buyer 



- 100 



Deposits at 
F.R. Banks 

U.S. govt 
securities 



+ 100 



100 



40 



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. 



Assets 



FEDERAL RESERVE BANK 



Liabilities 



Assets 



Liabilities 



Assets 



FOREIGN CENTRAL BANK 



Liabilities 



U.S. govt 
securities 



+ 100 



Foreign 
deposits 



+ 100 



NO CHANGE 



Deposits at 
F.R. Banks 

U.S. govt 
securities 



+ 100 



- 100 



41 



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). 



Assets 



FEDERAL RESERVE BANK 



Liabilities 



Assets 



Liabilities 



Assets 



FOREIGN CENTRAL BANK 



Liabilities 



Deposits at 
Foreign Central 
Bank + 100 



Foreign 
deposits 



+ 100 



NO CHANGE 



Deposits at 
F.R. Banks 



+ 100 



Deposits of 
F.R. Banks 



+ 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 



Reserve Impact 



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 
customer-related RPs) 

Redemption of Maturing Securities 

- Replace total amount maturing 

- Redeem part of amount maturing 

- Buy more than amount maturing* 



Permanent increase 
Permanent increase 
(No impact) 



Permanent decrease 
Permanent decrease 
(No impact) 

Temporary increase 



Temporary decrease 
No impact* 

(Temporary increase*) 



No impact 
Permanent decrease 
Permanent increase** 



* 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 
Bank Reserves 

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 
offsetting action. 

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 
absorb reserves. 

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 
bank reserves. 

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. 

Nonfloat-Related Adjustments 

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 
constantly changing. 

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- 
ual banks. 

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 
reserve requirement 

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 



$12.5 mil. 



$10 mil 



$8 3 mil 



$7 1 mil 



Transaction accounts 



$1.0 mil. 




8 



(percent of deposits raquimd as reserves) 



$1 million 



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 . . . 



3.0 



Weekly changes, 1 983 



27 




. but less variable afterward. 




-4.0 



-6.0 



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 

[312] 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 

REVISED 
May 1968 
September 1971 
June 1975 
October 1982 
June 1992 

February 1994 40M 
Printed in U.S.A. 

@ Printed on recycled paper 




FEDERAL RESERVE BANK 
OF CHICAGO