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Full text of "Modern Money Mechanics"

MODERN MONEY MECHANICS 



A Workbook on Bank Reserves and Deposit Expansion 
Federal Reserve Bank of Chicago 



This complete booklet is was originally produced and distributed free by: 

Public Information Center 
Federal Reserve Bank of Chicago 
P. O. Box 834 
Chicago, IL 60690-0834 
telephone: 312 322 5111 
But it is now out of print. Photo copies can be made available by monques@myhome.net . 

Introduction 

The purpose of this booklet is to describe the basic process of money creation in a 
"fractional reserve" banking 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 shown are based on simplifying assumptions. For the sake of simplicity, 
the relationships are shown 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 relationship 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 following 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 section deals with some of the elements that modify, at least in the short 
run, the simple mechanical relationship between bank reserves and deposit money. 
Money is such a routine part of everyday living that its existence and acceptance 
ordinarily are taken for granted. 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 



convertible into each other and both can be used directly 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. Treasury, 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 designated as M1 in the Federal 
Reserve's money stock statistics. Broader concepts of money (M2 and M3) include M1 
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 fairly 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 M1. 
The distribution between the currency and deposit components of money 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 the public. Conversely, when 
people have more currency than is needed, some is returned to banks in exchange for 
deposits. 

While currency is used for a great variety of small transactions, most of the dollar 
amount of money payments 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 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 services are more or less valuable because there are more or less of 
them relative to the amounts people want. Money's usefulness is its unique 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 unexpected transactions, and the forgone 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 measured 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 because 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 nations's labor force, factories, and other 
production facilities will not be fully employed, or both. 

Just how large the stock of money needs to be in order to handle the transactions of the 
economy without exerting undue influence on the price level depends on how 
intensively money is being used. Every transaction deposit balance and every dollar bill 
is part of somebody'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.(1_) As noted 
earlier, checkable liabilities of banks are money. These liabilities are customers' 
accounts. 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 business was discovered many centuries ago. 
It started with goldsmiths. As early bankers, they initially provided safekeeping services, 
making a profit from 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 acceptable 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 whatever volume of notes was presented 
for payment. 

Transaction deposits are the modern counterpart of bank notes. It was a small step from 
printing notes to making book entries crediting deposits of borrowers, which the 
borrowers in turn could "spend" by writing checks, thereby "printing" their own money. 
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 sufficient to keep the nation's productive resources fully employed 
without price inflation? Like its predecessor, the modern bank must keep available, to 



make payment on demand, a considerable amount of currency and funds on deposit 
with the central bank. The bank must be prepared to convert deposit money into 
currency for those depositors who request currency. It must make remittance on checks 
written by depositors and presented for payment by other banks (settle adverse 
clearings). Finally, it must maintain legally required reserves, in the form of vault cash 
and/or balances at its Federal Reserve Bank, equal to a prescribed percentage of its 
deposits. 

The public's demand for currency varies greatly, but generally follows a seasonal 
pattern that is quite predictable. The effects on bank funds of these variations in the 
amount of currency held by the public usually are offset by the central bank, which 
replaces the reserves absorbed by currency withdrawals from banks. (Just how this is 
done will be explained later.) For all banks taken together, there is no net drain of funds 
through clearings. A check drawn on one bank normally will be deposited to the credit of 
another account, if not in the same bank, then in some other bank. 
These operating needs influence the minimum amount of reserves an individual bank 
will hold voluntarily. However, as long as this minimum amount is less than what is 
legally required, operating needs are of relatively minor importance as a restraint on 
aggregate deposit expansion in the banking system. Such expansion cannot continue 
beyond the point where the amount of reserves that all banks have is just sufficient to 
satisfy legal requirements under our "fractional reserve" system. For example, if 
reserves of 20 percent were required, deposits could expand only until they were five 
times as large as reserves. Reserves of $10 million could support deposits of $50 
million. The lower the percentage requirement, the greater the deposit expansion that 
can be supported by each additional reserve dollar. Thus, the legal reserve ratio 
together with the dollar amount of bank reserves are the factors that set the upper limit 
to money creation. 
What Are Bank Reserves? 

Currency held in bank vaults may be counted as legal reserves as well as deposits 
(reserve balances) at the Federal Reserve Banks. Both are equally acceptable in 
satisfaction of reserve requirements. A bank can always obtain reserve balances by 
sending currency to its Reserve Bank and can obtain currency by drawing on its reserve 
balance. Because either can be used to support a much larger volume of deposit 
liabilities of banks, currency in circulation and reserve balances together are often 
referred to as "high-powered money" or the "monetary base." Reserve balances and 
vault cash in banks, however, are not counted as part of the money stock held by the 
public. 

For individual banks, reserve accounts also serve as working balances.(2) Banks may 
increase the balances in their reserve accounts by depositing checks and proceeds 
from electronic funds transfers as well as currency. 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 relevant reserve maintenance period, reserve balances at their 
Reserve Bank and vault cash which together are equal to its required reserves, as 
determined by the amount of its deposits in the reserve computation period. 
Where Do Bank Reserves Come From? 



Increases or decreases in bank reserves can result from a number of factors discussed 
later in this booklet. From the standpoint of money creation, however, the essential point 
is that the reserves of banks are, for the most part, liabilities of the Federal Reserve 
Banks, and net changes in them are largely determined by actions of the Federal 
Reserve System. Thus, the Federal Reserve, through its ability to vary both the total 
volume of reserves and the required ratio of reserves to deposit liabilities, influences 
banks' decisions with respect to their assets and deposits. One of the major 
responsibilities of the Federal Reserve System is to provide the total amount of reserves 
consistent with the monetary needs of the economy at reasonably stable prices. Such 
actions take into consideration, of course, any changes in the pace at which money is 
being used and changes in the public's demand for cash balances. 
The reader should be mindful that deposits and reserves tend to expand simultaneously 
and that the Federal Reserve's control often is exerted through the market place as 
individual banks find it either cheaper or more expensive to obtain their required 
reserves, depending on the willingness of the Fed to support the current rate of credit 
and deposit expansion. 

While an individual bank can obtain reserves by bidding them away from other banks, 
this cannot be done by the banking system as a whole. Except for reserves borrowed 
temporarily from the Federal Reserve's discount window, as is shown later, the supply 
of reserves in the banking system is controlled by the Federal Reserve. 
Moreover, a given increase in bank reserves is not necessarily accompanied by an 
expansion in money equal to the theoretical potential based on the required ratio of 
reserves to deposits. What happens to the quantity of money will vary, depending upon 
the reactions of the banks and the public. A number of slippages may occur. 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 answers 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 transactions on the quantity of money 
are described and illustrated. The basic working tool is the "T" account, 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. 



1 1n order to describe the money-creation process as simply as possible, the term "bank" used in this booklet should be understood to 
encompass all depository institutions. Since the Depository Institutions Deregulation and Monetary Control Act of 1980, all depository 
institutions have been permitted 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. 

back 

2part of an individual bank's reserve account may represent its reserve balance used to meet its reserve requirements while another part 
may be its required clearing balance on which earnings credits are generated to pay for Federal Reserve Bank services, back 



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 objectives. One way the central bank can initiate such an expansion 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 the 
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 securities.{3) In 
today's world of computerized financial transactions, the Federal Reserve Bank pays for 
the securities with an "telectronic" check drawn on itself.(4) Via its "Fedwire" transfer 
network, the Federal Reserve notifies the dealer's designated bank (Bank A) that 
payment for the securities should be credited to (deposited 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 amount of the securities purchase. The Federal Reserve System has added 
$10,000 of securities 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 "multiple" 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 fraction of their 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 transaction accounts is 10 percent.(5) Assuming, for simplicity, a uniform 
10 percent reserve requirement against all transaction 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 money received from the sale of securities. If the dealer 
immediately 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 
System'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 $1000. 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 credits 
constitute new additions to the total deposits of the banking system. See illustration 3 . 



3Dollar amounts used in the various illustrations do not necessarily bear any resemblance to actual transactions. For example, open market 
operations typically are conducted with many dealers and in amounts totaling several billion dollars, back 

4lndeed, many transactions today are accomplished through an electronic transfer of funds between accounts rather than through issuance 
of a paper check. Apart from the time of posting, the accounting entries are the same whether a transfer is made with a paper check or 

electronically. The term "check," therefore, is used for both types of transfers, back 

5For each bank, the reserve requirement is 3 percent on a specified base amount of transaction accounts and 10 percent on the amount 
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 Garn-St. Germain Act of 1982 further modified these requirements by exempting the first $2 million of reservable 
liabilities from reserve requirements. 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. back 



Deposit Expansion 

1 . When the Federal Reserve Bank purchases government securities, bank reserves 
increase. This happens because the seller of the securities receives payment 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. 



FR BANK 



BANK A 



Assets Liabilities Assets Liabilities 

US govt Reserve acct. Reserves with Customer 

securities.. +10,000 Bank A.. +10,000 FR Banks.. +10,000 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, back 



A . As a result, all banks taken together 

now have "excess" reserves on which 
deposit expansion can take place. 

back 



Total reserves gained from new deposits 10,000 

less: required against new deposits (at 10%)... 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 
account, i.e., by creating additional deposit money, back 

STAGE 1 BANKS 



Assets 



Liabilities 



Loans +9,000 Borrower deposits.... +9,000 

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 $9000) 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 will be deposited 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 expecHo lose these deposits - and an 
equal amount of reserves - as the borrowers' checks are paid, they will not lend more 
than their excess reserves. Like the original $10,000 deposit, the loan-credited deposits 
may be transferred 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 deposits created in Stage 1 in turn make 
loans equal to their excess reserves, then loans and deposits will rise by a further 
$8,100 in the second stage of expansion. This process can continue until 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 pagesW 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 investments 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 (loans and investments) 
and supports a total of $100,000 in new deposits under a 10 percent reserve 
requirement. The deposit expansion factor for a given amount of new reserves is thus 
the reciprocal of the required reserve percentage (1/.10 = 10). Loan expansion will be 
less by the amount of the initial injection. The multiple expansion 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 the total 
reserves. 

Expansion through Bank Investments 

Deposit expansion can proceed from 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 crediting the customers' transaction accounts, deposit liabilities would 
rise just as if loans had been made. More likely, these banks would purchase the 
securities through dealers, 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. 



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

|f " ALL BANKS | 

Assets Liabilities 

Reserves with F. R. Banks... +10,000 Deposits: Initial +10,000 

Loans + 9,000 Stage 1 + 9,000 

Total +19,000 Total +19,000 



^Excess reserves have been reduced by the amount required against the deposits 
created by the loans made in Stage 1 . back 



Total reserves gained from initial deposits. . . . 10,000 

less: Required against initial deposits -1,000 

less: Required against Stage 1 requirements -900 

equals: Excess reserves 8,100 



Why do these banks stop increasing their loans 
and deposits when they still have excess reserves? 

6 ...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, back 

STAGE 1 BANKS 

Assets Liabilities 

Reserves with F. R. Banks . -9000 Borrower deposits . . . -9,000 
(matched under FR bank (shown as additions to 

liabilities) other bank deposits) 



1 


FEDERAL RESERVE BANK 






Assets Liabilities 






Reserve accounts: Stage 1 banks 


. -9,000 




Other banks 


+9,000 


OTHER BANKS 



Assets Liabilities 

Reserves with F. R. Banks . +9,000 Deposits +9,000 

Deposit expansion has just begun! 

Page 10. 

"^Expansion continues as the 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 



8 



Assets Liabilities 

Loans + 8100 Borrower deposits . . . +8,100 

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



ALL BANKS 



Assets Liabilities 

Reserves with F. R. Banks . +10,000 Deposits: Initial +10,000 

Loans: Stage 1 + 9,000 Stage 1 +9,000 

Stage 2 + 8,100 Stage 2 +8,100 

Total +27,000 Total +27,000 



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

Total reserves gained from initial deposits 10,000 

less: Required against initial deposits . -1,000 

less: Required against Stage 1 deposits . -900 

less: Required against Stage 2 deposits . -810 ... 2,710 

equals: Excess reserves 7,290 — > to Stage 3 banks 



10 As borrowers make payments, these reserves will be further 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 1 1 , more than two-thirds of the deposit 
expansion potential is reached after the first ten stages. 

It should be understood that the stages 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. 

End page 10. back 



Page 11. 

Thus through stage after stage of expansion, 



"money" can grow to a total of 10 times the new 
reserves supplied to the banking system.... 


Assets | 


Liabilities 




[ 




Reserves 


] 










Total 


(Required) 


(Excess) 


Loans and 
Investments 


Deposits 


Reserves provided 


10,000 


1,000 


9,000 


- 


10,000 


Exp. Stage 1 




10,000 


1900 


8,100 


9,000 


19,000 


Stage2 




10,000 


2,710 


7,290 


17,100 


27,100 


Stage 3 




10,000 


3,439 


6,561 


24,390 


34,390 


Stage 4 




10,000 


4,095 


5,905 


30,951 


40,951 


Stage 5 




10,000 


4,686 


5,314 


36,856 


46,856 


Stage 6 




10,000 


5,217 


4,783 


42,170 


52,170 


Stage 7 




10,000 


5,695 


4,305 


46,953 


56,953 


Stage 8 




10,000 


6,126 


3,874 


51,258 


61,258 


Stage 9 




10,000 


6,513 


3,487 


55,132 


65,132 


Stage 10 




10,000 


6,862 


3,138 


58,619 


68,619 


Stage 20 




10,000 


8,906 


1,094 


79,058 


89,058 


Final Stage 




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. 





I0D.QO0 




Inilial 1 £ 3 < S 6 7 S 9 10 11 12 13 1* 15 ifl 17 1& 19 2n Drill 

oaposits Expansion sligts 

End page 11. back 



Page 12. 

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 government securities by the Federal Reserve System can provide 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 As reserve account at a Federal Reserve Bank 
is reduced by $10,000. As a result, the Federal Reserve System's holdings of securities 
and the reserve accounts of banks are both reduced $10,000. The $10,000 reduction in 
Bank A's depost liabilities constitutes 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 interbank 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 this 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 another until total deposits have been reduced to the point where the 
smaller volume of reserves is adequate to support 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 impact 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 outstanding ones to replace those currently maturing. Thus, deposits built up 
by borrowers for the purpose of loan retirement would be extinguished as loans were 
repaid. 

There is one important difference between the expansion and contraction processes. 
When the Federal Reserve System adds to bank reserves, expansion 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 this 
difference should not be overemphasized. Because excess reserve balances do not 
earn interest, there is a strong incentive to convert them into earning assets (loans and 
investments). 

End of page 12. forward 
Page 13. 

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 funds 
being effected by a debit to Bank As reserve account at the Federal Reserve Bank, 
back 



FEDERAL RESERVE BANK BANK A 



Assets 



Liabilities 



Assets 



Liabilities 



U.S govt Reserve Accts. Reserves with Customer 
securities.. ..-10,000 Bank A.. ..-10,000 F.R Banks.. ..-10,000 deposts -10,000 

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

1 2 The loss of reserves means that all banks taken together now have a reserve 

deficiency, back 

Total reserves lost from deposit withdrawal 10,000 

less: Reserves freed by deposit decline(10%) 1,000 

equals: Deficiency in reserves against remaining deposits . . 9,000 

Contraction - Stage 1 

1 3 The banks with the reserve deficiencies (Stage 1 banks) can sell government 

securities to acquire reserves, but this causes a decline in the deposits and reserves of 
the buyers ' banks, back 



STAGE 1 BANKS 



Assets Liabilities 



U.S. government securities ...-9,000 
Reserves with F.R. Banks. .+9,000 



FEDERAL RESERVE BANK 



Assets Liabilities 

Reserve Accounts: 

Stage 1 banks +9,000 

Other banks -9,000 



OTHER BANKS 



Assets Liabilities 

Reserves with F.R. Banks . . -9,000 Deposits -9,000 



1 4 As a result 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, 1 00. back 



ALL BANKS 



Assets 

Reserves with F.R. Banks . . -10,000 
U.S. government securities . . -9,000 
Total -19,000 



Liabilities 

Deposits: 

Initial -10,000 

Stage 1 -9,000 

Total -19,000 



Further contraction must 



take place! 



End of page 13. forward 



Bank Reserves - How They Change 

Money has been defined as the sum of transaction accounts in depository institutions, 
and currency and travelers checks in the hands of the public. Currency is something 
almost everyone uses every day. Therefore, when most people think of money, they 
think of currency. Contrary 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 amounts of currency in 
relation to their total transactions than do individuals. 

Since the most important component of money is transaction deposits, and since these 
deposits must be supported by reserves, the central bank's influence over money 
hinges on its control over the total amount of reserves and the conditions under which 
banks can obtain them. 

The preceding illustrations of the 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 Department, by the banks, or by foreign and international 
institutions. 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 opposite page . 
This tabulaton also indicates the nature of the balancing entries on the Federal 
Reserve's books. (To the extent that the 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 several ways that 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 increase 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, the Federal Reserve Banks, and the depository 
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 the 
Reserve Banks. As is shown later, any buildup in balances 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 Reserve System. The way System open market purchases and 
sales of securities affect reserves has already been described. In addition, there are two 



other ways in which the System can affect bank reserves and potential deposit volume 
directly; first, through loans to depository institutions, and second, through changes in 
reserve requirement percentages. A change in the required reserve ratio, of course, 
does not alter the dollar volume of reserves directly but does change the 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 the System's gross open market transactions 
are undertaken to offset drains from or additions to bank reserves from 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 transactions that can have important 
week-to-week effects on bank reserves are traced in detail. Other factors that normally 
have only a small influence are described briefly on page 35. 

Factors Changing Reserve Balances - 
Independent and Policy Actions 

FEDERAL RESERVE BANKS 



Assets Liabilities 

Reserve 
balances 

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 515 .. 

Gold sales (outflows)* - + 

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 

Purchases 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 currency .... 
Decrease in assets denominated in foreign currency .. 

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 



+ 



+ 



+ 



+ 



+ 



+ 



+ 



+ 



+ 



+ 



+ 



+ 



+ 



+ 



+ 
+ 

* * * 



+ 



+ 



+ 



+ 



+ 



Currency held by the public 

w*ekry averages, billion* of dollars, not 



Ify adjusted 



290 




* 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, back 

Forward 



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 the 
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 cashing 
checks. (6) 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 increase 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 reduced $100. See illustration 15 . 

Now the bank has less currency. It may replenish its vault cash by ordering currency 
from its Federal Reserve 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 offset 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 amount of paper 
currency still outstanding but no longer issued, are obligations of the Treasury. To the 
extent that shipments of cash to banks are in the form of coin, the offsetting 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 required against the $100 of deposits was 
only $10, while a full $100 of reserves have been drained away by the disbursement 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 provided from 
some other source, bank assets and deposits will have to be reduced (according to the 
contraction process 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 that's 
beyond normal pocket money needs. Most of it probably will have changed hands, and 
it will be deposited by operators of motels, gasoline stations, restaurants, and retail 
stores. This process is exactly the 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 17 . 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(7). 
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 normally are offset by System open market 
operations. 

6~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, back 

7under 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, back 



15 

back 



When a depositor cashes a check, both deposits and vault cash reserves decline. 



BANK A 



Assets 

Vault cash reserves . . -100 
(Required . . -10) 
(Deficit ....90) 



Liabilities 

Deposits -100 



16 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, back 



FEDERAL RESERVE BANK 



BANK A 



Assets Liabilities 

Vault cash +100 

Reserves with F.R. Banks . -100 



Assets Liabilities 

Reserve accounts: Bank A ... -100 
F.R. notes . . . +100 



17 



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



BANK A 



Assets 

Vault cash reserves . . +100 



Liabilities 

Deposits +100 



{Required. . . +10) 
(Excess +90) 



18 If the currency is returned to the Federal reserve, reserve accounts are credited 
and Federal Reserve notes are taken out of circulation, back 



FEDERAL RESERVE BANK 


Assets 


Liabilities 






Reserve accounts: Bank A . 


.+100 




F.R. notes 


-100 


BANK A 


Assets 


Liabilities 




Vault cash , , , 


-100 




Reserves with F.R. Banks . 


.+100 





Operating cash balance th* U r S. Treasury 
weekly averages, billions of dollar's, r>t>t Masorially adjuiitd 



Page 18 

Changes in U.S. Treasury Deposits in Federal Reserve 
Banks 

Reserve accounts of depository institutions 
constitute the bulk of the deposit liabilities of 
the Federal Reserve System. Other 

B institutions, however, also maintain balances 
i riL,»to b*i™ . th Federa | Reserve Banks . main | y the 

'I'' U.S. Treasury, foreign central banks, and 

international financial institutions. In general, 
when these balances rise, bank reserves fall, 
and vice versa. This occurs because the 
funds 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 funds in banks. Through the collection process these banks 
receive credit to their reserve accounts. 

The most important nonbank depositor is the U.S. Treasury. Part 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" (TT&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 




1930 



1931 



sufficient funds are available to cover Treasury checks as they are presented for 
payment. {8} 

Bank Reserves Decline as the Treasury's Deposits at the Reserve Banks 
Increase 

Calls on TT&L note accounts drain reserves from the banks by the full amount of the 
transfer as funds move from the TT&L balances (via charges to bank reserve accounts) 
to Treasury balances at the Reserve Banks. Because reserves are not required against 
TT&L note accounts, these transfers do not reduce required reserves.Q) 
Suppose a Treasury call payable by Bank A amounts to $1,000. The 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 depository institutions. 

Bank Reserves Rise as the Treasury'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 full amount of these deposits 
although the corresponding increase in their required reserves is only 10 percent of this 
amount. 

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. The Reserve Bank 
then credits Bank A's reserve account and charges the Treasury's account. As a result, 
the bank gains both reserves and deposits. While there is no change in the assets or 
total liabilities of the Reserve Banks, the funds drawn away from the Treasury's 
balances have been shifted to bank reserve accounts. See illustration 20 . 
One of the objectives of the TT&L note program, which requires 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 
require extensive offsetting open market operations can be avoided. Nevertheless, 
there are still periods when these fluctuations 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 billion to +$8.57 billion. 



8when the Treasury'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. back 

9Tax payments received by institutions designated as Federal tax depositories 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, back 

End page 18. forward 



Page 19. 

1 9 When the Treasury builds up its deposits at the Federal Reserve through "calls" 
on TT&L note balances, reserve accounts are reduced, back 



FEDERAL RESERVE BANK 



Assets 



Liabilities 

Reserve accounts: Bank A . . -1,000 
U.S. Treasury deposits . . +1,000 



BANK A 



Assets 

Reserves with F.R. Banks . . -1,000 

(Required . . . . 0) 
(Deficit. . 1,000) 



Liabilities 

Treasury tax and loan note account 

. . -1,000 



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, back 



FEDERAL RESERVE BANK 


Assets 


Liabilities 






Reserve accounts: Bank A . 


.+1,000 




U.S. Treasury deposits . 


. -1,000 


BANK A 

l 1 


Assets 


Liabilities 




Reserves with F.R. Banks . 


.+1,000 Private deposits . 


.+1,000 


{Required . 


. +100) 




{Excess 


+900) 




End of paqe 19. forward 





Changes in Federal Reserve Float 

A large proportion of checks drawn on banks and deposited in other banks is cleared 
(collected) through the Federal Reserve Banks. Some of these checks are credited 
immediately to the reserve accounts of the depositing banks and are collected the same 
day by debiting the reserve accounts of the banks on which the checks are drawn. All 
checks are credited to the accounts of the 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 after they 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. "(10) On the books of the Federal Reserve Banks, balance sheet float, or 
statement float as it is sometimes called, is the difference between the asset account 
"items in process of collection," and the liability account "deferred credit items." 
Statement float is usually positive since it is more often the case that reserve credit is 
given before the checks are actually collected 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 published, Federal Reserve float 
includes statement float, as defined above, as well as float-related "as-of 
adjustments. d 1) These adjustments represent corrections for errors that arise in 
processing transactions related to Federal Reserve priced services. As-of adjustments 
do not change the balance sheets of either the Federal Reserve Banks or an individual 
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 totaling $100 drawn on Banks B, C, and D, all in distant cities. Bank 
A increases the accounts of its depositors $100, and sends the items to a Federal 
Reserve Bank for collection. Upon receipt of the checks, the Reserve Bank increases its 
own asset account "items in process of collection," and increases its liability account 
"deferred credit items" (checks and other items not yet credited to the sending bank's 
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 the next business day (assuming Banks B, C, and D are one-day deferred 
availability points), the Reserve Bank pays Bank A. The Reserve Bank's "deferred credit 
items" account is reduced, and Bank As reserve account is increased $100. If these 
items actually take more than one business day to collect so that "items in process of 
collection" are not reduced that day, the credit to Bank A represents an addition to total 
bank reserves since the reserve accounts of Banks B, C, and D will not have been 
commensurately reduced. (12) See illustration 22 . 
A Decline in Federal Reserve Float Reduces Bank Reserves 

Only when the checks are actually collected 
from Banks B, C, and D does the float 
involved in the above example disappear - 
"items in process of collection" of the 
Reserve Bank decline as the reserve 
accounts of Banks B, C, and D are reduced. 
See illustration 23 . 

On an annual average basis, Federal 
Reserve float declined dramatically from 
1979 through 1984, in part reflecting actions 
taken to implement provisions of the 
Monetary Control Act that directed the 
Federal Reserve to reduce and price float. 



Federal Reserve Ami (including »*-of adjustments) 

annual average*, bullio-ni of dollars 




1991 



(See chart.) Since 1984, Federal Reserve float has been fairly stable on an annual 
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 increase unexpectedly, for 
example, if weather conditions ground planes transporting checks to paying banks for 
collection. However, such periods typically are followed by ones where actual 
collections exceed new items being received for collection. Thus, reserves gained from 
float expansion usually are quite temporary. 

I OFederal Reserve float also arises from other funds transfer services provided by the Fed, and automatic clearinghouse transfers, back 

II 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 . back 

1 2 If the checks received from Bank A had 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, back 



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 nef transaction accounts, i.e., total 
transaction accounts minus both cash items in process of collection and deposits due 
from domestic depository institutions.) back 

FEDERAL RESERVE BANK 

Assets Liabilities 

Items in process of collection . . +100 Deferred credit items . . +100 

BANK A 

Assets Liabilities 

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, back 



FEDERAL RESERVE BANK 



Assets 



Liabilities 

Deferred credit items . . -100 
Reserve account: Bank A . . +100 



r 



BANK A 



Assets 

Cash items in process of collection . . -100 

Reserves with F.R. Banks . . . +100 
(Reauired . . . . +10) 



Liabilities 



{Excess. 



+90) 



23 



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



FEDERAL RESERVE BANK 



Assets 

Items in process 

of collection -100 



Liabilities 

Reserve accounts: 

Banks B, C, and D -100 



BANK B, C, and D 



Assets 

Reserves with F.R.Banks 



•100 



Liabilities 

Deposits 



-100 



{Required . . . -10) 
{Deficit 90) 



Page 22. 

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 services. 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. (13) Except for float, all 
services covered by the Act were priced by the end of 1982. Implementation of float 
pricing essentially was completed in 1983. 

The advent of Federal reserve priced services led to several changes that affect the use 
of funds in banks' reserve 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 balances are 
"required clearing balances" held by banks that use Federal Reserve services while 
"adjustments" represent balances held by banks that pay for float with as-of 
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 of 1981 . A bank may be 
required to hold a clearing balance if it has no required reserve balance or if its required 
reserve balance (held to satisfy reserve requirements) is not large enough to handle its 
volume of clearings. Typically a bank holds both reserve balances and required clearing 
balances in the same reserve account. Thus, as required clearing balances are 
established or increased, the amount of funds in reserve accounts identified as reserve 
balances declines. 



Suppose Bank A wants to use Federal Reserve services but has a reserve balance 
requirement that is less than its expected operating needs. With its Reserve Bank, it is 
determined that Bank A must maintain a required clearing balance of $1,000. If Bank A 
has no excess reserve balance, it will have to obtain funds from some other source. 
Bank A could sell $1 ,000 of securities, but this will reduce the amount of total bank 
reserve balances and deposits. See illustration 24 . 

Banks are billed each month for the Federal Reserve services they have used with 
payment collected on a specified day the following month. All required clearing balances 
held generate "earnings credits" which can be used only to offset charges for Federal 
Reserve services. (14) Alternatively, banks can pay for services through a direct charge 
to their reserve accounts. If accrued earnings credits are used to pay for services, then 
reserve balances are unaffected. On the other hand, if payment for services takes the 
form of a direct charge to the bank's reserve account, then reserve balances decline. 
See illustration 25 . 

Float Pricing As -Of Adjustments Reduce Reserve Balances 

In 1983, the Federal Reserve began pricing explicitly for float,(15) specifically 
"interterritory" check float, i.e., float generated by checks deposited by a bank served by 
one Reserve Bank but drawn on a bank served by another Reserve Bank. The 
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 as-of adjustment. If either of the first two options is chosen, the 
accounting entries are the same as paying for other priced services. If the as-of 
adjustment option is chosen, however, the balance sheets of the Reserve Banks and 
the bank are not directly 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 
requirements. Float pricing as-of adjustments 
are applied two weeks after the related float 
is generated. Thus, 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 pricing as-of adjustments lead to a 
decline in total bank reserve balances. 



Service-related balances and adjustments 

weekly averages, tulltofis of dollars, not seasonally adjusted 



3 - 



|Adj ustmenls to 

I tooi pen tats fur NoliI 
IHequir-Bd dearing balarcas 




1965 



-950 



1991 



Week-to-week changes in service-related balances and adjustments can be volatile, 
primarily reflecting adjustments to compensate for float. (See chart. ) Since these 
changes are known in advance, any undesired impact on reserve balances can be 
offset easily through open market operations. 

1 3~The Act specified that fee schedules cover services such as check clearing and collection, wire transfer, automated clearinghouse, 

settlement, securities safekeeping, noncash collection, Federal Reserve float, and any new services offered, back 

14 "Earnings credits" are calculated by multiplying the actual average clearing balance held over a maintenance period, up to that required 
plus the clearing balance band, times a rate based on the average federal funds rate. The clearing balance band is 2 percent of the required 

clearing balance or $25,000, whichever amount is larger, back 



1 5\A/hile some types of float are priced directly, the Federal Reserve prices other types of float indirectly, for example, by including the cost 
of float in the per-item fees for the priced service, back 

End of page 22. back 



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, back 



BANK A 



Assets 

U.S. government securities . . - 

1,000 

Reserve account with F.R. 

Banks: 

Required clearing balance . . +1000 



Liabilities 



FEDERAL RESERVE BANK 



Assets 



Liabilities 

Reserve accounts: 
Required clearing 
balances Bank A +1000 

Reserve balances: 

Other banks -1000 



OTHER BANKS 



Assets 

Reserve accounts with F.R. Banks: 
Reserve balances .... -1,000 

{Required . . . -100) 
{Deficit 900) 



Liabilities 

Deposits -1,000 



When Bank A is billed monthly for Federal Reserve services used, it can pay for 

these services by having earnings credits applied and/or by authorizing a direct charge 
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. Offsetting 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 reduction to its asset account "earnings 
credit due from Federal Reserve Banks" and a $25 reduction in its reserve account, 
which are offset 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, back 




FEDERAL RESERVE BANK 



Assets Liabilities 

. ... Earnings credits due to depository 

Accrued service income -125 . ..... ir i, 

institutions -100 

Reserve accounts: Bank A . . -25 



BANK A 



Assets Liabilities 

Earnings credits due from F.R. . 

, Accounts payable -125 

Banks . . -100 

Reserves with F.R. Banks -25 



Changes in Loans to Depository Institutions 

Loans to depository institutions Prior to passage of the Monetary Control Act 

monthly averagei. billions of dollars, not seasonally adjust f 1 gso, only banks that were members of 

the Federal Reserve System 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 extended credit. (16) The 
average amount of each type of discount 
window credit provided varies over time. (See 
chart.) 

When a bank borrows from a Federal Reserve Bank, it borrows reserves. The 
acquisition of reserves in this manner differs in an important way from the cases already 
illustrated. Banks normally borrow adjustment credit only to avoid reserve deficiencies 
or overdrafts, not to obtain excess reserves. 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 
frequently make loans in anticipation 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 their reserves to required levels within the required 
time period. In either case, a bank may borrow reserves temporarily from its Reserve 
Bank. 

Suppose a customer of Bank A wants to borrow $100. On the basis of the 
managements'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 reserves 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 institutions" and 
crediting Bank A's reserve account. Bank A gains reserves and a corresponding liability 
"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 borrowing, therefore, 
reduces both reserves and "borrowings from Federal Reserve Banks." See illustration 
29. 

Unlike loans made under the seasonal and extended credit programs, adjustment credit 
loans to banks generally 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 window" tend to transfer 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 borrowing. 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 initiated by banks, the amount of 
reserves that banks can acquire in this way ordinarily is limited by the Federal Reserve's 
administration of the discount window and by its control of the rate charged banks for 
adjustment credit loans - the discount rate. (17) Loans are made only for approved 
purposes, and other reasonably available sources of funds must have been fully used. 
Moreover, banks are discouraged from borrowing adjustment credit too frequently or for 
extended time periods. Raising the discount rate tends to restrain borrowing by 
increasing its cost relative to the cost of alternative sources of reserves. 
Discount window administration 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 strains on the reserve positions of individual banks, there is 
generally a strong incentive for a bank to repay borrowing before adding further to its 
loans and investments. 

1 6Adjustment credit is short-term credit available to meet temporary needs for funds. Seasonal credit is available for longer periods to 
smaller institutions 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 borrowing typically are offset by open market 

operations, back 

1 7Flexible 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, back 



26 



A bank may incur a reserve deficiency if it makes loans when it has no excess 
reserves, back 



BANK A 



Assets 

Loans +100 

Reserves with F. R. Banks . . no change 
{Required .... +10) 
(Deficit 10) 



Liabilities 

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, back 



FEDERAL RESERVE BANK 



Assets 

Loans to depository institution: 

Bank A +10 



Liabilities 

Reserve accounts: Bank A . . +10 



BANK A 



Assets Liabilities 

Reserves with F.R. Banks . . +10 Borrowings from F.R.Banks . . +10 

No further 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, back 



BANK A 



Assets 

Securities -10 

Reserves with F.R. Banks . . . +10 



Liabilities 



29 



Repayment of borrowings from the Federal Reserve Bank reduces reserves, back 



FEDERAL RESERVE BANK 



Assets 

Loans to depository institutions: 

Bank A -10 



Liabilities 

Reserve accounts: Bank A 



-10 



BANK A 



Assets Liabilities 

Reserves with F.R. Bank . . -10 Borrowings from F.R. Bank . . -10 



Changes in Reserve Requirements 

Thus far 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 expansion or contraction by 
changing the required minimum 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 Federal 
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 requirements that apply 
uniformly to all depository institutions. The 1980 statute established the following limits: 

On transaction accounts 

first $25 million 3% 

above $25 million 8% to 14% 

On nonpersonal time deposits .... 0% to 9% 
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 
million "low reserve tranche" was indexed to change each year in line with 80 percent of 
the growth in transaction accounts 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 liabilities. (18) (Initially the Board set a 3 percent requirement on 
Eurocurrency liabilities.) 

The Garn-St. Germain Act of 1982 modified these provisions somewhat by exempting 
from reserve requirements the first $2 million of total reservable liabilities at each 
depository institution. Similar to the low reserve tranche adjustment for transaction 
accounts, the $2 million "reservable liabilities exemption amount" was indexed to 80 
percent of annual 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 deposit. (The Board initially imposed the 3 percent nonpersonal 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 institutions, requirements changed according to a predetermined 
schedule, without any action by the Federal Reserve Board. Apart from these legally 
prescribed changes, once the Monetary Control Act provisions were implemented in late 
1980, 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 April 1992, the reserve requirement on transaction accounts 
above the low reserve tranche was lowered from 12 percent to 10 percent. 
When 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 reduction in the legal requirement to 
8 percent would tie up only $8, freeing $2 out of each $10 of reserves for use in creating 
additional 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-sixth less than before. See illustration 32 . 
Reserve Requirements and Monetary Policy 

The power to change reserve requirements, like purchases and sales of securities by 
the Federal Reserve, is an instrument of monetary policy. Even a small change in 
requirements - say, one-half of one percentage point - can have a large and widespread 
impact. Other instruments 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 
requirements alter the expansion power of every reserve dollar. Thus, such changes 
affect the leverage of all subsequent increases or decreases in reserves from 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 indication 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. 

18The 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 six months; and, if essential for the conduct of monetary policy, supplemental requirements up 

to 4 percent of transaction accounts can be imposed, back 



Under a 10 percent reserve requirement, $10 of reserves are needed to support 
each $10 of deposits, back 

BANK A 




Assets 



Liabilities 



Loans and investments ... 90 

Reserves 10 

{Required . . . . 10) 
{Excess 0) 



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, back 



BANK A 



Assets 

Loans and investments 90 

Reserves 10 

{Required 8) 

{Excess 2) 



Liabilities 

Deposits . 



100 



|- 



FEDERAL RESERVE BANK 



Assets Liabilities 

No change No change 

There is no change in the total amount of reserves. 



32 



With 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... back 



BANK A 



Assets 

Loans and investments 90 

Reserves 10 

{Required. .... 12) 
{Deficit 2) 



Liabilities 

Deposits . . . 



100 



FEDERAL RESERVE BANK 



Assets Liabilities 

No change No change 

.because the total amount of bank reserves remains unchanged. 



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 transactions for customers such as foreign 
central banks. Perhaps the most publicized type of foreign currency transaction 



undertaken by the Federal Reserve is intervention in 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 offsets any undesired change in U.S. bank reserves resulting from foreign- 
related transactions. As a result, such transactions do not affect money and credit 
growth 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 account, (19) 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, (20) and pays for this foreign currency deposit by crediting $100 to the 
U.S. bank's reserve account at the Fed. The Federal Reserve deposits the foreign 
currency proceeds in its account at a Foreign Central Bank, and as this transaction 
clears, the foreign bank's reserves at the Foreign Central Bank decline. See illustration 
33 . Initially, then, the Fed's intervention sale of dollars in this example leads to an 
increase in Federal Reserve Bank assets denominated 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. (The 
Federal Reserve might have to sell some of its 
foreign currency investments to build up its 
deposits at the Foreign Central Bank, but this 
would 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 via a $100 charge 
to its reserve account at the Federal Reserve. See illustration 34 . 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. 



Federal Reserve Bank assets denominated 

in foreign currencies 

end of mpnth, billion; of dollars, not seasonally adjusted 
*0 




1979 



19H? 



1B6G 



1391 



As noted earlier, the Federal Reserve offsets or "sterilizes" any undesired change in 
U.S. bank reserves stemming from foreign exchange intervention sales or purchases of 
dollars. For example, Federal Reserve Bank assets denominated in foreign currencies 
rose dramatically in 1989, in part due to significant U.S. intervention sales of dollars. 
(See chart.) Total reserves of U.S. banks, however, declined slightly in 1989 as open 
market operations were used to "sterilize" the initial intervention-induced increase in 
reserves. 

Monthly Revaluation of Foreign Currency Assets 

Another set of accounting transactions that affects Federal Reserve Bank assets 
denominated in foreign currencies 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 offsetting accounting 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 directly. However, since the Federal 
Reserve turns over its net earnings to the Treasury each week, the revaluation affects 
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 . 
Foreign -Related Transactions for the Treasury 

U.S. intervention in foreign exchange markets by the Federal Reserve usually is divided 
between its own account and the Treasury's Exchange Stabilization Fund (ESF) 
account. The impact on U.S. bank reserves from the intervention transaction is the 
same for both - sales of dollars add to reserves while purchases of dollars drain 
reserves. See illustration 35 . 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 ESF's 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 foreign currency deposits acquired by the ESF in the intervention 
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 the 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 ESF's account at the Fed. (On the Federal Reserve's 
balance sheet, the ESF's 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 the 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 offset by the 
drain in U.S. bank reserves from the TT&L call. See illustrations 35 and 36. 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. 

Offsetting actions by the Federal Reserve would be needed, however, if the Treasury 
restored deposits affected by foreign-related transactions through a number of 
transactions involving the Federal Reserve. These include the Treasury's issuance of 



SDR or gold certificates to the Federal Reserve and the "warehousing" of foreign 
currencies by the Federal Reserve. 

SDR certificates. Occasionally the Treasury acquires dollar deposits for the ESF's 
account by issuing certificates to the Federal Reserve against allocations of Special 
Drawing Rights (SDRs) received from the International Monetary Fund. (21) For 
example, $3.5 billion of SDR certificates were issued in 1989, and another $1.5 billion in 
1990. This "monetization" of SDRs is reflected on the Federal Reserve's balance 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 directly in an intervention sale of dollars, then the 
intervention-induced increase in U.S. bank reserves is not altered. See illustrations 35 
and 37. If not needed immediately for an intervention transaction, the ESF might use the 
dollar deposits from issuance of SDR certificates to buy securities from the Treasury, 
resulting in a transfer of funds from the ESF's account at the Federal Reserve to the 
Treasury's account at the Fed. U.S. bank reserves would then increase as the Treasury 
spent the funds or transferred them to banks through a direct investment to TT&L note 
accounts. 

u.s fuid stoc k t B oid C e rti .ka t c S an d sdh certificate Gold stock and 9old certificates. Changes in 
end of yc 3r . biiM^ of dollar* the U.S. monetary gold stock used to be an 

important factor affecting bank reserves. 
However, the gold stock and gold certificates 
issued to the Federal Reserve in "monetizing" 
gold, have not changed significantly since the 
early 1970s. (See chart.) 
Prior to August 1 971 , 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 



HI 











NS-yGold 


slock 




GoW \\ 




L 


1 . 1 1 II 1 1 1 b 1 L 1 1 


SDR . ' 

■ ■ I i j ■ /Ti . . I .ii 



1951 1961 107- 1991 , , _ , , , , . , . 

U.S. monetary gold stock, and paid for from 
its account at the Federal Reserve. As the sellers deposited the Treasury's checks in 
banks, reserves increased. To replenish its balance at the Fed, the Treasury issued 
gold certificates to the Federal Reserve and received a credit to its deposit balance. 
Treasury sales of gold have the opposite effect. Buyers' checks are credited to the 
Treasury's account and reserves decline. Because the official U.S. gold stock is now 
fully "monetized," the Treasury currently has to use its deposits to retire gold certificates 
issued to the Federal Reserve whenever gold is sold. However, the value of gold 
certificates retired, 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 dollar deposits at the Federal Reserve 
by "warehousing" foreign currencies with the Fed. (For example, $7 billion of foreign 



Marketable U.S fownunent securities held in 
custody for foreign customers during 1 991 

Wednesday outstandings, billions of dollars 



265 



currencies were warehoused in 1989.) The Treasury or ESF acquires foreign currency 
assets as a result of transactions 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, (22) "Federal Reserve Banks assets 
denominated in foreign currencies" increase as do Treasury deposits 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 currencies 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 
maintain 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 little from week to 
week. For example, 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" their Federal Reserve 
balances to desired levels daily by buying 
and selling U.S. government securities. The 
extent of these foreign customer "cash management" transactions is reflected, in part, 
by large and frequent changes in marketable U.S. government securities held in 
custody by the Federal Reserve for foreign customers. (See chart.) The net effect of 
foreign customers' cash management transactions usually is to leave U.S. bank 
reserves unchanged. 

Managing 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 these 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 desired levels, foreign customers will replenish their Federal 
Reserve deposits by selling U.S. government securities. Acting as their 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 reserves from the disbursement transactions. The 
net effect is to leave U.S. bank reserves unchanged when U.S. government securities of 
customers are sold in the market. 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 illustration 38 and 40. The Federal reserve might choose to 




L 11 L L t L I 1 L , I I L I. . I I 1 .. ■ 



execute sell orders with the System's account if an increase in reserves is desired for 
domestic policy reasons. 

Managing foreign deposits through purchases of securitites. Foreign customers of the 
Federal Reserve also receive a variety of dollar denominated payments, including 
proceeds 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, 
reserves of U.S. banks decline. But if receipts of dollar-denominated payments raise 
their deposits at the Federal Reserve to levels higher than desired, foreign customers 
will buy U.S. government securities. The 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 acquire dollar deposits by 
activating the "swap" network, which consists of reciprocal short-term credit 
arrangements between the Federal Reserve and certain foreign central banks. When a 
foreign central 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 increase 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 of U.S. bank reserves 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. 



1 9overall 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 the Fed. They are implemented at the Federal 
Reserve Bank of New York, typically at the same time that similar transactions are executed for the Treasury's Exchange Stabilization Fund. 

back 

20Americans 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, back 

21 SDRs were created in 1970 for use by governments in official balance of payments transactions, back 

22Technically, 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 Treasury's agreement to repurchase the foreign currencies sometime in the future, back 



When the Federal Reserve intervenes to sell 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 
offset the increase in U.S. bank reserves if it is inconsistent with domestic policy 
objectives, back 




FEDERAL RESERVE BANK 



Assets Liabilities 

Deposits at Foreign Central Bank . . +100 Reserves: U.S. bank . . +100 



U. S. BANK 



Assets 

Reserves with F.R. Bank . . +100 
Deposits at foreign bank . . -100 



Liabilities 



FOREIGN BANK 



Assets 

Reserves with 

Foreign Central Bank . . -100 



Liabilities 



Deposits of U.S. bank . . -100 



FOREIGN CENTRAL BANK 



Assets 



Liabilities 

Deposits of F.R. Banks . . . +100 
Reserves of foreign bank ... -100 



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, back 



FEDERAL RESERVE BANK 



Assets Liabilities 

Deposits at Foreign Central Bank . -100 Reserves: U. S. bank . . -100 



U. S. BANK 



Assets Liabilities 

Reserves with F.R. Bank . . -100 Deposits of foreign bank 



•100 



FOREIGN BANK 



Assets 

deposits at U.S. bank . . . -100 
Reserves with Foreign Central Bank . +100 



Liabilities 



FOREIGN CENTRAL BANK 



Assets 



Liabilities 

Deposits of F.R. Banks . . -100 



Reserves of foreign bank . . +100 



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, back 



ESF 


Assets Liabilities 




Deposits at F.R. Bank -100 




Deposits at Foreign Central Bank . . +100 




U. S. Treasury 


Assets Liabilities 




No change No change 




FEDERAL RESERVE BANK 

1 . 1 


Assets Liabilities 




Reserves: U.S. bank . . . 


+100 


Other deposits: ESF . . 


. -100 


U. S. BANK 


Assets Liabilities 




Reserves with F.R. Bank . . . +100 




Deposits at foreign bank ... -100 




FOREIGN BANK 


Assets Liabilities 




Reserves with Foreign Central Bank . -100 Deposits of U.S. bank 


. -100 


FOREIGN CENTRAL BANK 




Assets Liabilities 




Deposits of ESF . . . 


+100 


Reserves of foreign bank . 


. -100 




Concurrently, the Treasury must finance the intervention transaction in (35). The 

Treasury might build up deposits in the ESF's account at the Federal Reserve by 
redeeming securities issued to the ESF, and replenish its own (general account) 
deposits at the Federal Reserve to desired levels by issuing a call on TT&L note 




accounts. This set of transactions drains reserves of U.S. banks by the same amount as 



ESF 


Assets 


Liabilities 




U.S govt, securities . 


. . -too 




Deposits at F.R. Banks 


. . +1UU 




i 


U. S. Treasury 




Assets 


Liabilities 




TT&L accts 


, , -100 Securities issued ESF . . 


. -100 


Deposits at F.R. Banks . 


. . net 




(from U.S bank . 


. +100) 




(to ESF 


-100) 





FEDERAL RESERVE BANK 



Assets 



Liabilities 

Reserves: U.S. bank . . . -100 

Treas. deps: .... net 
(from U.S. bank. +100) 
(to ESF. -100) 

Other deposits: ESF +100 



U. S. BANK 



Assets 

Reserves with F.R. Bank 



•100 



Liabilities 

TT&L accts 



-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 the addition of 
U.S. bank reserves in intervention (35). The Federal Reserve, however, would offset 
any undesired change in U.S. bank reserves, back 



ESF 



Assets Liabilities 

Deposits at F.R. Banks . . +100 SDR certificates issued to 

F.R. Banks +100 



U. S. Treasury 



Assets 

No change 



Liabilities 

No change 



FEDERAL RESERVE BANK 



Assets 

SDR certificate account 



+ 100 



Liabilities 

Other deposits: ESF 



+100 



U. S. BANK 



Assets 

No change 



Liabilities 

No change 



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, back 



FEDERAL RESERVE BANK 



Assets 



Liabilities 

Reserves: U.S. bank . . . +100 
Foreign deposits .... -100 



r 



U. S. BANK 



Assets 

Reserves with F.R. Banks . . +100 



Liabilities 

Deposits . . . 



+100 



FOREIGN CENTRAL BANK 



Assets 

Deposits at F.R. Banks 



•100 



Liabilities 

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 smount as reserves were increased in (38). back 



FEDERAL RESERVE BANK 



Assets 



Liabilities 

Reserves: U.S. bank -100 

Foreign deposits +100 



U. S. BANK 



Assets 

Reserves with F.R. Banks 



Liabilities 

-100 Deposits of securities buyer 



-100 



FOREIGN CENTRAL BANK 



Assets 

Deposits at F.R. Banks . . +100 



Liabilities 



U.S. govt, securities . . -100 



If the sell order is executed with the Federal Reserve's account, however, the 
increase in reserves from (38) will remain in place. The Federal Reserve might choose 
to execute the foreign customer's sell order with the System's account if an increase in 
reserves is desired for domestic policy reasons. 



FEDERAL RESERVE BANK 


Assets Liabilities 




U.S. govt, securities . . . . +100 Foreign deposits . . 


. .+100 


U. S. Bank 




Assets Liabilities 




No change No change 




FOREIGN CENTRAL BANK 



Assets Liabilities 

Deposits at F.R. Banks . . . +100 
U.S. govt, securities -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 i n (38). back 



FEDERAL RESERVE BANK 



Assets Liabilities 

deposits at Foreign Central Bank . . +100 Foreign deposits . 



U. S. Bank 



Assets 

No change 



Liabilities 

No change 



FOREIGN CENTRAL BANK 



Assets Liabilities 

Deposits at F.R. Banks . . . +100 Deposits of F.R. Banks 



+100 



+100 



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 offsets undesired changes in reserves through open market operations, that is, 
by buying and selling U.S. government securities in the market. However, outright 
purchases and sales of securities by the Federal Reserve in the market occur 
infrequently, 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 factors are accomplished 
through the use of transactions that change reserves temporarily. 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 transaction, 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 purchase orders in the market. 

Temporary transactions. Repurchase 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, and 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 securities and bank reserves are 
increased during the term of the RP, but decline again when the dealers repurchase the 
securities. Thus System RPs increase reserves only temporarily. Reserves are drained 
temorarily when the Fed executes what is known as a "System MSP." A System MSP 
works like a System RP, only in the opposite directions. 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. 



Impact on reserves of Federal Reserve transactions 
in U.S. government and federal agency securities 



Federal Reserve Transactions Reserve Impact 

Outright purchase of Securities 



- From dealer in market Permanent increase 

- To fill customer sell orders Permanent increase 
(If customer buy orders filled in market) (No impact) 

Outright Sales of Securites 

- To dealer in market Permanent decrease 

- To fill customer buy orders internally Permanent decrease 
(If customer buy orders filled in market) (No impact) 

Repurchase Agreements (RPs) 

- With dealer in market in System RP Temporary increase 

Matched Sale-Purchase Agreements (MSPs) 

- With dealer in market in a system MSP Temporary decrease 

- To fill customer RP orders internally No impact* 
(If customer RP orders passed to market 

as customer related RPs) (Temporary increase*) 

Redemption of Maturing Securities 

- Replace total amount maturing No impact 

- Redeem part of amount maturing Permanent decrease 

- Buy more than amount maturing** 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 from the Treasury, except to replace maturing 
issues. 



The Federal Reserve also uses MSPs to fill foreign customers' RP orders internally with 
the System account. Considered in isolation, a Federal Reserve MSP transaction 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 little 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 securities 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 Federal Reserve mature, they are 
exchanged for new securities. Usually the total amount maturing is replaced so that 
there is no impact on reserves since the Fed's total holdings 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 replenishes its deposits at the 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 
permanently. However, the Federal Reserve currently is prohibited by law from buying 
securities directly from the Treasury, except to replace maturing issues. 

Page 35. 

Miscellaneous Factors Affecting Bank Reserves 

The factors described below normally have negligible 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 the Treasury, and other currency originally issued by commercial 
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 amount of Treasury currency outstanding currently 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 expenditures. 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) initially 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 funds 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 international 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 
directly, 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 Reserve 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 

Certain adjustments are incorporated into published data on reserve balances to reflect 
nonfloat-related corrections. 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 reserve balances than necessary in some past period. To correct 
for this error, a nonfloat-related as-of adjustment will be applied to the bank's reserve 
position. This essentially 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. Published 
data on reserve balances, however, are adjusted to show only those reserve balances 
held to meet the current and/or future period reserve requirements. 
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 securities. 
The same results follow from any Federal Reserve expenditure or receipt. Every 
payment made by the Reserve Banks, in meeting expenses or acquiring any assets, 
affects deposits and bank reserves in the same way as does payment to a dealer for 
government securities. Similarly, Reserve Bank receipts of interest on loans and 
securities and increases in paid-in capital absorb reserves. 

End of page 35. back 



The Reserve Multiplier - Why It Varies 

The deposit expansion and contraction associated with a given change in bank 
reserves, as illustrated earlier in this booklet, assumed a fixed reserve-to-deposit 
multiplier. That multiplier was determined by a uniform percentage reserve requirement 
specified for transaction accounts. Such an assumption is an oversimplification of the 
actual relationship between changes in reserves and changes in money, especially in 
the short-run. For a number of reasons, as discussed in this section, the quantity of 
reserves associated with a given quantity of transaction deposits is constantly changing. 
One slippage affecting the reserve multiplier is variation in the amount of excess 
reserves. In the real world, reserves are not always fully utilized. There are always 
some excess reserves in the banking system, reflecting frictions and lags as funds flow 
among thousands of individual banks. 

Excess reserves present a problem for monetary policy implementation only because 
the amount changes. To the extent that new reserves supplied are offset by rising 
excess reserves, actual money growth falls short of the theoretical maximum. 
Conversely, a reduction in excess reserves by the banking system has the same effect 
on monetary expansion as the injection of an equal amount of new reserves. 
Slippages also arise from reserve requirements being imposed on liabilities not included 
in money as well as differing reserve ratios being applied to transaction deposits 



The relationship between short-term charges in 
htstrves and transaction deposits wai quite 

volatile before the Monetary Control Act of 1980 . 



13 



l 1 



-2,2 



according to the size of the bank. From 1980 through 1990, reserve requirements were 
imposed on certain nontransaction liabilities of all depository institutions, and before 
then on all deposits of member banks. The reserve multiplier was 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 
transaction 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. 
In addition, the reserve multiplier is affected 
by conversions 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 between transaction 
deposits included in money and other 
transaction accounts that also are reservable 
but not included in money, such as demand 
deposits due to depository institutions, the 
U.S. government, and foreign banks and 
official institutions. In the aggregate, these 
non-money transaction deposits are relatively 
small in comparison to total transaction 
accounts, but can vary significantly from 
week to week. 



I Wcekv than rrra, 197 1 


I 

Tfensaction tJepDSiU 

1 (ogh\sca)si 


r T Qtal res&rves 1 





■ > . and before adaption of contemporaneous 
reserve accounting in . . . 




-.- but less Variable afterward. 




Note: All dam arc in bill w of dollar's., rlcri season ally adustcd. Ecilirg 
approximately reflects. «ich year'i nveiilgl! ratin dF trannctinn deposi-s 

ro rotai r&emei. 



A net injection of reserves has widely different effects depending on how it is absorbed. 
Only a dollar-for-dollar increase in the money supply would result if the new reserves 
were paid out in currency to the public. With a uniform 10 percent reserve requirement, 
a $1 increase in reserves would support $10 of additional transaction accounts. An even 



The growth potential of n f I million reserve injection 



$1 a.5 mil. 




57.1 <nil. 



Sl.n m,:. 




larger amount would be supported under the 
graduated system where smaller institutions 
are subject to reserve requirements below 10 
percent. But, $1 of new reserves also would 
support an additional $10 of certain 
reservable transaction accounts that are not 
counted as money. (See chart below.) 
Normally, an increase in reserves would be 
absorbed by some combination of these 
currency and transaction deposit changes. 
All of these factors are to some extent 
predictable and are taken into account in 
decisions as to the amount of reserves that 
need to be supplied to achieve the desired 
rate of monetary expansion. They help 
explain why short-run fluctuations in bank 
reserves often are disproportionate to, and 
sometimes in the opposite direction from, 
changes in the deposit component of money. 
Money Creation and Reserve 
»i nnifan 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 regulations 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 implemented in order to improve 
monetary control. 

In February 1984, banks shifted to maintaining average 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. However, some slippages still 
exist because of short-run uncertainties about the level of both reserves and transaction 



deposits near the close of reserve maintenance periods. Moreover, not all banks must 
maintain reserves according to the contemporaneous accounting system. Smaller 
institutions are either exempt completely or only have to maintain reserves quarterly 
against average deposits in one week of the prior quarterly period. 
On balance, however, variability in the reserve multiplier has been reduced by the 
extension of reserve requirements 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 requirement against transaction accounts above the 3 percent tranche in 
April 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 (M1) and the economy deteriorated. Because the M1 
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 M1 . 
Although every bank must operate within the system where the total amount of reserves 
is controlled by the Federal Reserve, its response to policy action is indirect. The 
individual bank does not know today precisely what its reserve position will be at the 
time the proceeds of today's loans are paid out. Nor does it know when new reserves 
are being supplied to the banking system. Reserves are distributed among thousands of 
banks, and the individual banker cannot distinguish between inflows originating from 
additons to reserves through Federal reserve action and shifts of funds from other 
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 relative 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 their 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, individual banks find it easy and relatively inexpensive to acquire reserves, and 
expansion in loans, investments, and deposits is encouraged. 

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