modern money mechanics (exposed)

8/8/2019 Modern Money Mechanics (Exposed)

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Modern MoneyMechanics

AWorkbook on Bank Reserves and Deposit Expansion

Federal Reserve Bank of Chicago


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Modern Money MechanicsThe purpose of this booklet is to desmmbehe basic

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

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

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

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

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

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


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

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

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

volume of transactions.

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

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

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

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

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


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What Iimits the Amount of MoneyBanksCan Create?

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

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

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

4 Modem MoneyMechanics

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

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

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


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

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

Introduction 5


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

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

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

6 Modem Money Mechanics

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

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

3Dollar amounts used in the various illustrations do not necessarily bearany resem blance to actual transactions. For example, open market opera-tions typically are conducted with many dealers and in amounts totalingsevera l billion dollars.'Indeed , many transactions today are accom plished hrough an electron ictransfer of funds betw een accou nts rather than through issuance of a papercheck. Apart from the timing of posting, the accounting entries are thesame whether a transfer is made with a paper check or electronically. Theterm "check," herefore , is used for both types of transfers.SFor ach bank, the reserve requirement is 3 percent on a specified baseamount of transaction accounts and 10percent on the amount above thisbase. Initially, the Monetary Control Act set this base amount- alled the"low reserve tranche"- t $25 million, and provided for it to changeannually n line with the growth in transaction deposits nationally. The lowreserve tranche was $41.1 million in 1991 and $42.2 million in 1992. T heGarn-St Germain Act of 1982 further mod iied these requirements byexemp ting the first $2 million of reservable iabilities from reserve req uirements. Like the low reserve tranche, the exem pt evel is adjusted each yearto reflectgrowth in reservable liabilitie s. The exem pt level was $3.4 millionin 1991 and $3.6million in 1992.


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Deposit Ezpansion

1

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

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

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

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

2

I their loans or investments. Loans aremade by Assets Liabilities

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

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

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

Customerdeposit + 10,000

Deposit Expansion and Contraction 1 7

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


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

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

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

How Much Can Deposits Expandin the Banking System?

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

8 Modern Monqr Mechanics

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

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


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

LiabilitiesDeposits:Initial + 10,000Stage I

+ 19,000

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

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

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

Deposit expansion hasjust begun!

Borrowerdeposits - 9,000

Assets Liabilities Assets LiabilitiesJ

Deposit Erpansionand Contmctwn 9

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


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7

8

toStage 3banks

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

9

Loans + 8,100

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

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

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

Borrowerdeposits + 8,100

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

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

10

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

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

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


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AssetsReserves

To tal [Required] [Excess]Initial reserves provide d ................... 10*000 1. 000 9. 000Expansion- Stage l ..................... 10.00 0 1,900 8. 100

Stage 2 ..................... 10.00 0 2.710 7. 29 0Stage3 ..................... 10.000 3.439 6, 56 1Stage 4 ..................... 10.00 0 4, 095 5. 905Stage 5 ..................... lO.Oo0 4. 686 5.3 14Stage 6 ..................... 10,00 0 5,2 17 4. 783Stage 7 ..................... 10,00 0 5, 695 4.305Stage 8 ..................... 10,000 6. 126 3.874Stage 9 ..................... lo,00 0 6. 51 3 3.48 7Stage I 0 ................... lo.00 0 6. 862 3. I38Stage 20 ................... 10.000 8.906 1. 094Final stage ................ 10,000 / 0. 000 0

Loans andInvestments

Liabilities

Deposits10.00 0

Deposit w o w t a r a& Corfmctiopz


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

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

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

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

12 / Modem MoneyMnhanics

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

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

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


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Assets Liabilities Liabilities

11

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

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

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

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

12

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

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

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

+ 9,000

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

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

US.government Stage Isecurities 9,000Total - 19.000

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

I Futthn ontractionmust ake #lace!

Deposits - 9,000

Deposit E*palrtion and C ontraction 13


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

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

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

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

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

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

modern money mechanics (exposed)

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