Modern Money Mechanics

A Workbook on Bank Reserves and Deposit Expansion

Federal Reserve Bank of Chicago

Modern Money Mechanics

The purpose of this booklet is to desmmbe the basic process of money creation in a ~actional 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 simplil5ring assumptions. For the sake of simplicity, the relationships are shown as ifthey were mechanical, but they are not, as is described later in the booklet. Thus, they should not be intwreted to imply a close and predictable relationship between a specific central bank transaction and the quantity of money.

The introductory pages contain a briefgeneral desm'ption of the characte*ics of money and how the US. money system works. me illustrations in the following two sections describe two processes: first, how bank akposits expand or contract in response to changes in the amount of reserves supplied by the centel bank; and second, how those reserves are afected by both Federal Reserve actions and others. A final section deals with some of the elements that modifi, at least the short Tun, 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 hancial 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 moneycreation process takes place principally through transaction accounts. In the remainder of this booklet, "money" means MI.

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 biion, of the $898 biion total money stock in December 1991,was in the form of transaction deposits, of which $290 billion were demand and $333 billion were other checkable deposits.

What Makes Money Valuable?
In the United States neither paper currency nor deposits have value as commodities. Intrinsically, a dollar bill is just a piece of paper, deposits merely book entries. Coins do have some intrinsic value as metal, but generally far less than their face value. What, then, makes these instruments checks,
paper money, and coins -acceptable at face value in payment of alldebts 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 foregone earnings of holding financial assets in the form of money rather than some
other asset.

Control of the quantity of money is essential if its value is to be kept stable. Money's real value can be 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 be cause there will be more money than there will be goods and services to spend it on at prevailing prices. But if, on the other hand, growth in the supply of money does not keep pace with the economy's current production, then prices will fall, the nation's labor force, factories, and other production facilities will not be 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 iduence on the price level depends on how intensively money is beiiused. Every transaction deposit balance and every dollar bill is a part of somebody's spendable funds at any given time, ready to move to other owners astransactions take place. Some holders spend money quickly after they get it, making these funds available for other uses. Others, however, hold money for longer periods. Obviously, when some money remains idle, a larger total is needed to accomplish any given volume of transactions.

Who Creates Money?
Changes in the quantity of money may originate with actions of the Federal Reserve System (the central bank), depository institutions (principally commercial banks), or the public. The major control, however, rests with the central bank.
The actual process of money creation takes place primarily in banks.' As noted earlier, checkable liabilities of banks are money. These liabilities are customers' 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 canbuild 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 acceptableasmoney 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 modem counterpart of bank notes. It was a small step from printing notes to making book entries crediting deposits of borrowers, which the borrowers in turncould "spend" by writing checks, thereby "printing" their own money.

In order to describe the moneycreation 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 an such institutions, not just commercial banks, have the
potential for creating money.

What Iimits 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 sufticient to keep the nation's productive resources fully employed without price inflation? Like its predecessor, the modem bank must keep available, to make payment on demand, a considerable amount of currency and funds on depositwith 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. Oust 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 ex-
pansion 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 $50million. 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 canbe used to support a much larger volume of deposit liabilities of banks, currency in
circulation 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 not counted as part of the money stock held by the public.

Modem Money Mechanics

For individual banks, reserve accounts also serve as working balances? Banks may increase the balances in their reserve accounts by depositing checks and proceeds from electronic funds transfers as well as 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 the 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, Wities 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 abiity 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 consistentwith 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 demands 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 marketplace 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 ZPartof an individual bank's reserve account may represent its reserve
balance usedto meet its reserve requirements while another part may be its requiredclearing balance on which earnings credits are generated to
pay for Federal Reserve Bank services.

Money will vary, depending upon the reactions of the banks and the public. A number of slippages may occur. What amount of resmes 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 liabiities not defined as money but against which banks might alsohave to hold reserves? How sensitive are the banks to policy
actions of the central bank? The significance of these questionswill be discussed later in this booklet. The answers indicate why changes in the money supply may be differentthan expected or may respond to policy action only after considemble 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 account, which provides a simple means of tracing, step by step, the effects of these transactions on both the asset and liabity sides of bank balance sheets. Changes in asset items are entered on the left half of the and changes in liabiities 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 liabiities.


Bank Deposits-How

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 security. In today's world of computerized financial transactions, the Federal Reserve Bank pays for the securities with an "electronic" check drawn
on itself! Via its "Fedwire" transfer network, the Federal Reserve notifies the dealer's designated bank (Bank 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 percent5 Assuming, for simplicity, a uniform 10 percent reserve requirement against all transaction deposits, and further assuming that all banks attempt to remain fullyinvested, we cannow trace the process of expansion in deposits which cantake 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.

Expand or Contract

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 resenre requirement, is $1,000. The remaining $9,000 is "excess reserves." This amount can be loaned or invested. See illustration 2.

If business is active, the banks with excess reserves probably will have opportunities to loan the $9,000. Of course, they do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts. Loans (assets) and deposits (liabilities) both rise by $9,000. Reserves are unchanged by the loan transactions. But the deposit credits constitute new additions to the total deposits of the banking system. See illustration 3.

Dollar 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. 'Indeed, many transactions today are accomplished through an electronic transfer of funds between accounts rather than through issuance of a paper check. Apart from the timing 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.

For 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 changeannuallyin 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 modiied these requirements by exempting the first $2 million of reservable liabilities from reserve require
ments. Like the low reserve tranche, the exempt level is adjusted each year to reflect growth in reservable liabilities. The exempt level was $3.4 million in 1991 and $3.6million in 1992.

Deposit Expansion

When the Federal Reserve Bank purchases government securities, bank reserves increase. This happens

1 - 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 Assets Liabilities Assets Liabilities U.S.government Reserve accounts: Reserves with Customer securities + 10,000 Bank A + 10,000 WF.R. Banks + 10,000 deposit + 10,000 The customer deposit at Bank A likely will be transfeerred, in part, to other banks and quickly loses its identity amid the huge interbank flow of deposits. AS a result, all banks taken together now have Total reservesgainedfrom new deposits ..................... 10.000

2 - "excess" reserves on which deposit expansion less: Required against new deposits can take place. (at 10 percent) ........................................ 1,000 equals Excess reserves ................................................ 9,000

Expansion takes place only if the banks that hold these excess reserves (Stage 1banks) increase their loans or investments. Loans are made by Assets Liabilities crediting the borrower's deposit account, i.e., Loans + 9,000 Borrower by creating additional deposit money. Deposits + 9,000


Deposit Expansion and Contraction

This is the beginning of the deposit expansion pocess. 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 1banks). See illustration 4. However, only $900 (10 percent of $9,OOO) 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 1banks) and credit those of the receiving banks. See illustration 6.

Whether Stage 1banks actually do lose the deposits to other banks or whether any or all of the borrowers' checks are redeposited in these same banks makes no difference in the expansion process. If the lending banks expect to lose these deposits -and an equal 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 loanaeated 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 1in 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 pages 10and 1I.)

The individual bank, of course, is not concerned as to the stages of expansion in which it may be participating. Mows 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 cantake 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 total reserves.

Expansion through Bank Investments

Deposit expansion can proceed 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 liabiities 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 eithercase,the net effects on the banking system are identicalwith those resulting from loan operations.

As a result of the process so far, total assets and total liabiities of all banks together have risen

Assets Liabilities Reserves with Deposits:

F.R. Banks + 10,000

Initial + 10,000
Stage I Loans + 9,000
Total + 19.000 + 19,000

Excess reserves have been reduced by the Total reserves gained from initial deposit........................... 10,000

amount required against the deposits created less:

Required against initial deposits ............. 1,000 by the loans made in Stage 1.


Required against Stage I deposits ............ 900 ......1,900

Excess reserves........................................................ 8,100

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

...because borrowers write checks on their accounts at the lending banks. As these checks are deposited in the payees' banks and cleared,


the deposits created by Stage 1loans and an

Reserves with Borrower

equal amount of reserves may be transferred rF.R. Banks -

9,000 deposits 9,000

to other banks.

Assets Liabilities
Assets Liabilities

Reserve accounts: Reserves with Deposits + 9,000

Stage I banks -9,000 2F.R. Banks + 9,000


Other banks + 9,000

Deposit expansion hasjust begun!

Deposit Erpansionand Contmctwn 9

Expansion continues as the banksthat have


excess reserves increase their loans by that
amount, crediting borrowers' deposit accounts Assets Liabilities
in the process, thus creating still more money.

Loans + 8,100
deposits + 8,100

NOW the banking system's assets and liabilities


have risen by 27,100.


Reserves with

F.R Banks + 10,000 Initial + 10,000
Stage I + 9,000

Stage 2 + 8,100

Stage I + 9,000
Stage 2 + 8,100

Total + 27,100
Total + 27,100

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

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

less: Required against initial deposits ............ 1,000

banking system.

less: Required against Stage I deposii ............ 900
less: Required against Stage 2 deposits ............ 8 10 .... a
eq& Excess reserves ...................................................... 7,290

Stage 3

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 11, 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 deimed above. Some banks use their resmes incompletely or only after a considerable time lag, while others expand assets on the basis of expected reseme growth. me process is, infact,continuous and may never reach its theoretical limits.


Initial reserves provided ...................
Expansion -Stage l .....................
Stage 2 .....................
Stage3 .....................
Stage 4 .....................
Stage 5 .....................
Stage 6 .....................
Stage 7 .....................
Stage 8 .....................
Stage 9 .....................
Stage I0 ...................
10. 000
10. 000
10, 000
10, 000
10, 000
1. 000
1, 900
2. 710
4, 095
4. 686
5,2 17
5, 695
6. 126
6. 513
6. 862
9. 000
8. 100
7. 290
6, 56 1
5. 905
5.3 14
4. 783
Loans and
Investments Deposits
10. 000
Stage 20 ................... 10. 000 8.906 1. 094
Final stage ................ 10,000 / 0. 000 0

Deposit wowtar a& Corfmctiopz

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 hawed 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 previde 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 bis to a U.S. government securities dealer and
receives in payment an "electronic" check drawn on Bank
A As this payment is made, Bank A's reserve account at
a Federal Reserve Bank is reduced by $10,000. As a result,
the Federal Reserve System's holdings of securities and
the reserve accounts of banks are both reduced $10,000.
The $10,000 reduction in Bank A's deposit liabilities consti-
tutes a decline in the money stock. See illustration 11.

Contraction Also Is a Cumulative Process
While Bank A may have regained part of the initial
reduction in deposits from other banks as a result of inter-
bank deposit flows, all banks taken together have $10,000
less in both deposits and reserves than they had before
the Federal Reserve's sales of securities. The amount of
reserves freed by the decline in deposits, however, is only
$1,000 (10 percent of $10,000). Unless the banks that lose
the reserves and deposits had excess reserves, they are
left with a reserve deficiency of $9,000. See illustration 12.
Although they may borrow from the Federal Reserve
Banks to cover this deficiency temporarily, sooner or later
the banks will have to obtain the necessary reserves in
some other way or reduce their needs for reserves.

One way for a bank to obtain the reserves it needs
is by selling securities. But, as the buyers of the securities
pay for them with funds in their deposit accounts in the
same or other banks, the net result is a $9,000 decline in
securities and deposits at all banks. See illustration 13.
At the end of Stage 1of 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 1banks. As the new
group of reservedeficient 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 anoth-
er until total deposits have been reduced to the point

where the smaller volume of reserves is adequate to sup
port them. The contraction multiple is the same as that
which applies in the case of expansion. Under a 10 percent
reserve requirement, a $10,000 reduction in reserves would
ultimately entail reductions of $100,000 in deposits and
$90,000in loans and investments.

As in the case of deposit expansion, contraction of
bank deposits may take place as a result of either sales of
securities or reductions of loans. While some adjustments
of both kinds undoubtedly would be made, the initial im-
pact probably would be reflected in sales of government
securities. Most types of outstanding loans cannot be
called for payment prior to their due dates. But the bank
may cease to make new loans or refuse to renew outstand-
ing ones to replace those currently maturing. Thus, depos
its built up by borrowers for the purpose of loan retirement
would be extinguished as loans were repaid.

There is one important difference between the expan-
sion and contraction processes. When the Federal Reserve
System adds to bank reserves, expansion of credit and
depositsmay 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 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 earning
assets (loans and investments).

12 Modem MoneyMnhanics


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 A's reserve account at the Federal Reserve Bank.

Assets Liabilities Liabilities

U.S. government Reserve accounts: Reserves with 1 Customer
securities -10,000 BankA -10,000 WF.R Banks -10,000 deposit -10,000
lXis reduction in the customer deposit at Bank A may be spread among a number of banks through htedank depositflows

The loss of reserves means that allbanks taken Total reserves lostfrom deposawithdrawal ...................... 10,000

I 12

together now have a reserve deficiency. less Reservesfreed by deposii decline

(at 10 percent) ..................................................... 1,000
equals Mciency in reservesagainst remaining depostts. 9,000

Contraction-Stage 1
1 I
The banks with the reserve deficiencies (Stage 1
banks) cansellgovernment securities to acauire
reserves, but this causes a decline in the debsits
and reserves of the buyers' banks.
U.S. government
Reserves with
Assets Liabilities AssetsJReserve accounts: Reserves with
Stage I banks + 9,000 9F.R. Banks
Other banks -9,000
Deposits -9,000
As a result of the process so far, assets and total
deposits of all banks together have declined 19,000.
Stage 1contraction has freed 900 of reserves, but
there is still a reserve deficiency of 8,100. Reserves with
F.R. Banks
Stage I

I Futthn contraction must take #lace!

Deposit E*palrtion and Contraction 13

Bank Reserves-How l%ey Change

Money has been detined as the sum of transaction
accounts in depository institutions, and currency and trav-
elers checks in the hands of the public. Currency is some
thing almost everyone uses every day. Therefore, when
most people thii of money, they think of currency. Con-
trary to this popular impression, however, tmtlsactiolr
deposits are the most signiscant part of the money stock
People keep enough currency on hand to effect small face
teface transactions, but they write checks to cover most
large expenditures. Most businesses probably hold even
smaller amounts of currency in relation to their total trans
actions than do individuals.

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

The preceding illustrations of 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 Depart-
ment, by the banks, or by foreign and international institu-
tions. Other changes arise from the service functions and
operating needs of the Reserve Banks themselves.

The various factors that provide and absorb bank
reserve balances, together with symbols indicating the
effects of these developments, are listed on the opposite
page. This tabulation also indicates the nature of the bal-
ancing entries on the Federal Reserve's books. Co the
extent that the impactis absorbed by changes in banks'
vault cash, the Federal Reserve's books are unaffected.)

Independent Fadors Versus Policy Action

It is apparent that bank reserves are affected in sev-
eral ways thatare 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 beiig reversed automatically.
This happens, for instance, when bad weather slows up the
check collection process, giving rise to an automatic in-
crease in Federal Reserve credit in the form of "float."
Other influences, such as changes in the public's currency
holdings, may persist for longer periods of time.

Still other variations in bank reserves result solely
from the mechanics of institutional arrangements among
the Treasury, the Federal Reserve Banks, and the deposi-
tory institutions. The Treasury, for example, keeps part of
its operating cash balance on deposit with banks. But
virtually all disbursements are made from its balance in

I4 Modern Money Mechanics

the Reserve Banks. As is shown later, any buildup in bal-
ances at the Reserve Banks prior to expenditure by the
Treasury causes a dollar-fordollar drain on bank reserves.

In contrast to these independent elements that affect
reserves are the policy actions taken by the Federal Re
serve System. The way System open market purchases and
sales of securities affect reserves has already been de
scribed. In addition, there are two other ways in which the
System can affect bank reserves and potential deposit vol-
ume directly: first,through loans to depository institutions;
and second, through changes in reserve requirement per-
centages. A change in the required reserve ratio, of course,
does not alter the dollar volume of reserves directly but
does change the amount of deposits that a given amount of
reservescan 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 Sys
tern'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 availabiity. In addition, Federal Reserve
purchases and/or sales of securities are made to provide
the reserves needed to support the rate of money growth
consistentwith monetary policy objectives.

In this section of the booklet, several kinds of trans-
actions that can have important week-to-week effects on
bank reserves are traced in detail. Other factors that nor-
mally have only a small influence are described briefly on
page 35.

Facton Changing Reserve Balances-lndefiendent and

Assets Liabilities

Public actions
lncrease in currency holdings ....................................................................
Decrease in currency holdings ..................................................................

Treasury, bank, and foreign actions
Increase in Treasury deposits in F.R. Banks ...........................................
Decrease in Treasury deposits in F.R. Banks .........................................
Gold purchases (inflow) or increase in official valuation* ...................
Gold sales (outflow)* ..................................................................................
Increase in SDR certificates issued* .........................................................
Decrease in SDR certificates issued* ......................................................
Increase in Treasury currency outstanding* ..........................................
Decrease in Treasury currency outstanding* ........................................
Increase in Treasury cash holdings* .........................................................
Decrease in Treasury cash holdings* ......................................................
increase in service-related balancesladjustments ..................................
Decrease in service-related balancesladjustments ...............................
Increase in foreign and other deposits in F.R. Banks ...........................
Decrease in foreign and other deposits in F.R. Banks .........................

Federal Reserve actions

Increase in Federal Reserve float .............................................................

Decrease in Federal Reserve float ...........................................................

lncrease in assets denominated in foreign currencies ..........................

Decrease in assets denominated in foreign currencies .......................

increase in other assets** ..........................................................................

Decrease in other assets** ........................................................................

Increase in other liabilities** .....................................................................

Decrease in other liabilities** ...................................................................

Increase in capital accounts** ...................................................................

Decrease in capital accounts** .................................................................

These factors represent assets and liabilities of the Treasury. Changes in them typically affect reserve 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.

Facton flfectitzg Balk Reserves 15

Changes in the Amount of
CuvmcyHeld 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 cash-
ing checks6 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 cansupport
deposits ten times as great,but when drawn upon to meet
currency demand, the exchange is one to one. A $1 in-
crease in currency uses up $1 of reserves.

Suppose a bank customer cashed a $100 check to
obtain currency needed for a weekend holiday. Bank
deposits decline $100 because the customer pays for the
currencywith a check on his or her transaction deposit;
and the bank's currency (vault cash reserves) is also re
duced $100. See illustration 15.

Now the bank has less currency. It may replenish
its vault cash by ordering currency from its Federal Re
serve Bank -making payment by authorizing a charge
to its reserve account. On the Reserve Bank's books, the
charge against the bank's reserve account is 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 US. 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 ship
ments of cash to banks are in the form of coin, the offset-
ting entry on the Reserve Bank's books is a decline in its
asset item "coin."

The public now has the same volume of money as
before, except that more is in the form of currency and
less is in the form of transaction deposits. Under a 10
percent reserve requirement, the amount of reserves re-
quired against the $100 of deposits was only $10, while a
full$100 of reserves have been drained away by the dis
bursement of $100 in currency. Thus, if the bank had no
excess reserves, the $100 withdrawal in currency causes a
reserve deficiency of $90. Unless new reserves are pro-
vided from some other source, bank assets and deposits
will have to be reduced (according to the contraction pro-
cess described on pages 12 and 13) by an additional $900.
At that point, the reserve deficiency caused by the cash
withdrawal would be eliminated.

When Currency Returns to Banks, Reserves Rise

After holiday periods, currency returns to the banks.
The customer who cashed a check to cover anticipated
cash expenditures may later redeposit any currency still
held thafs beyond normal pocket money needs. Most of it

16 Modern Money Mechanb


Currency held by the public
weekly averages, billions of dollars, not seasonally adjusted

probably willhave 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
currencydrain, except that the banks to which currency
is returned may not be the same banks that paid it out.
But in the aggregate, the banks gain reserves as 100
percent reserve money is converted back into fractional
reserve money.

When $100 of currency is returned to the banks,
deposits and vault cash are increased. See illustration 1 Z
The banks cankeep 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
liabiities. See illustration 18. Sice only $10 must be held
against the new $100 in deposits, $90 is excess reserves
and can give rise to $900 of additional deposits.

To avoid multiple contraction or expansion of deposit
money merely because the public wishes to change the
composition of its money holdings, the effects of changes
in the public's currency holdings on bank reserves nor-
mally are offset by System open market operations.

6The same balance sheet entries apply whether the individual physically
cashes a paper check or obtains currency by withdrawing cash through an
automati; tkller machine.

'Under current reserve accounting regulations, vault cash reserves are
used to satisfy reserve requirements in a future maintenance period while
reserve balances sati* 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.

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


Assets Liabilities

Vault cash Deposits -100

If the bank replenishes its vault cash, its account at the Reserve Bank is drawn down in exchange for notes


issued by the Federal Reserve.

Assets Liabilities Assets Liabilities
Reserve accounts: Vault cash +I00
Bank A Reserveswith
F.R. notes +I00 F.R. Banks -100

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

Assets Liabilities

Vault cash
reserves +I00

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

Assets Liabilities Assets Liabilities

Vault cash -100

Reserves with
FA. notes F.R. Banks +I00


Factors Afecting Bark Reserues 17

Changes in US. Treasury
Deposits in Federal Bank

Reserve accounts of depository institutions consti-
tute the bulk of the deposit liabilities of the Federal Re-
serve System. Other institutions, however, also m&~n
balances in the Federal Reserve Banks -mainly the U.S.
Treasury, foreign central banks, and international hancial
institutions. In general, when these balances rise, bank
reserves fall, and vice versa. 'I'his occurs because the
funds u se agencies to build up their deposits in
the Res s ultimately come from deposits in
banks. Gonvemly, recipients of payments from these
agencies normally deposit the funds in banks.
the collection process these banks receive cre
reserve accounts.

rtant nonbank depositor is the US.
Treasury. Part of the Treasury's ope
is kept in the Federal Reserve Banks,
depository institutions all over the counm, in dled
'Treasury tax and loan" m&L) note accounts.

a&) Disbursements by the Treasury, h
made against its balances at the Federal Reserve. Thus,
transfers from banks to Federal Reserve Banks are made
through regularly scheduled "calls"on TT&L balances to
assure that sufficient funds are available to cover Treasury
checks as they are presented for payment8

Calls on TT&L note accounts drain reserves frorn
the banks by the full amount of the transfer as funds move
frorn 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?

SupposeaTreasury 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 Reseme. 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.

This withdrawal of Treasury funds will
cause a reserve deficiency of $1,000 since no resemes are
released by the decline in lT&Lnote accounts at deposi-
tory institutions.

As the Treasury makes expenditures, checks hwn
on its balances in the Reserve Banks are paid to the public,
and these funds iind their way back to banks in the form of
deposits. The banks receive reserve credit equal bthe full
amount of these deposits although the corresponding
increase in their required reserves is only 10 percent of
this amount.

Modem Money Mechanics

Operating cash balance of the US. Treasury

weekly averages, billions of dollars, not seasonally adjusted

Suppose a government employee deposits a $1,000

check in Bank kThe bank sends the check to
its Federal Reserve Bank for collection. The Reserve Bank
then credits Bank ATs reserve account and charges the
Treasury's account. As a result, the bank gains both re-
serves and deposits. While there is no change in the as-
sets or total liabilities of the Reserve Banks, the funds
drawn away from the Treasury's balances have been shift-
ed to bank reserve accounts.

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 mainMng a fairly consmt balance,
large drains from or additions to bank reserves from wide
swings in the Treasury's balance that would require exten-
sive offsetting open market operations can be avoided.
Nevertheless, there are still periods when these fluctua-
tions have large reserve effects. In 1991, for example,
week-to-week changes in Treasury deposits at the Reserve
Banks averaged only $56 million, but ranged from "$4.15
biion to +$8.57 billion.

When theTreasuryk balance at the Federal Reserve rises above expected
payment needs, the Treasury my place the excess funds in lT&L note
accounts lfirough a "direct investment." The accounting entries are the
same, but of opposite signs, as those shown when funds are transferred
from 'lT&L note accounts to Treasury deposits at the Fed.

*Tmpaymenb received by institutions designated as Federal taxdepositar-
ies initially are credited to reservable demand deposits due to the U.S.
govement. Because such tax payments typically come from reservable
transaction accounts, required reserves are not materially affected on this
day, On thenext businessday, however, when thesefundsareplacedeither
in a nonreservable note account or remitted to the Federal Reserve for
credit to the Treasury's balance at the Fed, required reserves decline.

When the Treasury builds up its deposits at the Federal Reserve through "calls"on?T&L note balances,


reserve accounts are reduced.

Assets Liabilities Assets Liabilities

Reserve accounts: Reserves with Treasury tax and
Bank A -1.000 f---,F.R Banks loan note account -1,000

deposits +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.

Liabilities Assets Liabilities

Reserve accounts: Reserves with Private deposits +1.000
Bank A + 1.000 UF.R. Banks

U.S. Treasury
deposits -1.000
Facton MeetingBank RCSCNCS 19

Changes ilz Federal Reseme 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 credit-
ed immediately to the resem accounts of the depositing
b& 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,
mspomtion, or other delays.

The reserve credit given for checks not yet collected
is included in Federal Resenre On the books of
the Federal Reserve Banks, balance sheet float, or state-
ment float as it is sometimes called, is the difference be-
tween the asset account "items in process of collection,"
and the liabiity account "deferred credit items." State-
ment 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-fadof' framework rather than a balance
sheet accounting kamework. As published, Federal Re-
serve float includes statement float, as dehned above, as
well as float-related "as-of' adjustments." These adjust-
ments represent corrections for errors that arisein pro-
cessing transactions related to Federal Reserve priced
services. As-of adjustments do not change the balance
sheets of either the Federal Reserve Banks or an individ-
ual bank. Rather they are corrections to the bank's reserve
position, thereby affecting the calculation of whether or
not the bank meets its reserve requirements.

An Increase in Federal Reserve

kink 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 collec-
tion," and increases its liability account "deferred credit
items" (checks and other items not yet credited ta the
sending banks' reserve accounts). As long as these two
accounts move together, there is no change in float or in
total reserves from this source. See illustmtiotz 21.

On the next business day (assuming Banks B, C,
and D are oneday deferred availability points), the Re-
serve Bank pays Bank A. The Reserre Bank's "deferred
credit items" account is reduced, and Bank A's reserve
account is increased $100. If these items actually take
more than one business day to collect so that "items in

10 Modem Momy Mechanics


Federal Reserve float (including as-of adjustments)
annual averages, billions of dollars


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 willnot
have been commensmtely reduced.= See iEZusl.ration22.

A Decline in Fed Reserve Float Reduces
Bamk Remrves

Only when the checks are actually collected from
Banks B, C, and D does the float involved in the above ex-
ample disappear -"items in process of collectioni' 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. (Set: chant.) 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 difticdt-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.

'"Federal Reserve float also arises from other funds transfer sentices
provided by the Fed, such as wire transfers, securities transfers, and
automatic clearinghouse transfers.

"As-ofadjustments also are used asone means of pricing float, as discussed
on page 22, and for nonfloat-related corrections, as discussed on page 35.

I2If the checks received from Bank Ahad been erroneously assigned atwo-
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
asof adjustments.

When a bank receives deposits in the form of checks drawn on other banks, it can send them to the Federal

Reserve Bank for collection. (Required reserves are not affected immediately because requirements apply to

net transaction accounts, i.e., total transaction accounts minus both cash items in process of collection and

deposits due from domestic depository institutions.)

Assets Liabilities Assets Liabilities

Items in process Deferred Cash items in Deposits +I00
of collection +I00 credit items +I00 process
of collection +I00

Ifthe reserve account of the payee bank is credited before the reserve accounts of the paying banks are debited,
total reserves increase.

Assets Liabilities Assets Liabilities
Deferred Cash items in
credit items -100 process of
Reserve accounts: collection -100
Bank A Reserves with
F.R. Banks +I00

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

Assets Liabilities Assets Liabilities

Items in process Reserve accounts:
of collection -100

Bank B

Bank D

Facton qdFecting Bank R-LS 21

Changes in Service-Related Balances
and A&&ments

In order to foster a safe and efficient payments system,
the Federal Reserve offers banks a variety of payments ser-
vices, Prior to passage of the Monetary Control Act in 1980,
the Federal Reserve offered its services free, but only to
banks that were members of the Federal Reserve System.
The Monetary Control Act directed the Federal Reserve to
offer its services to all depository institutions, to charge for
these services, and to reduce and price Federal Reserve
float.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' re-
serve accounts. As a result, only part of the total balances in
bank reserve accounts is identified as "reserve balances"
available to meet reserve requirements. Other balances held
in reserve accounts represent "service-related balances and
adjustments (to compensate for float) ." Service-related bal-
ances are "required clearing balances" held by banks that use
Federal Reserve services while "adjustments" represent bal-
ances held by banks that pay for float with as-of adjustments.

An Increase in Required Clearing Bbces
Reduces Reserve Balances

Procedures for establishing and maintaining clearing
balances were approved by the Board of Governors of the
Federal Reserve System in February 1981. A bank may be
required to hold a clearing balance if it has no required re-
serve balance or if its required reserve balance (held to satis-
fy reserve requirements) is not large enough to handle its
volume of clearings. Tmically a bank holds both reserve bal-
ances 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 identi-
fied as reserve balances declines.

Suppose Bank A wants to use Federal Reserve services
but has a reserve balance requirement that is less than its
expected operating needs. With its Reserve Bank, it is deter-
mined that Bank A must maintain a required clearing balance
of $1,000. If BankA 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 illrkstration 24.

Banks are billed each month for the Federal Reserve
services they have used with payment collected on a speci-
fied 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 illustrafian25.

22 Mudai Money M~ckanlo

Service-related balances and adjustments
weekly averages, billions of dollars, not seasonally adjusted

-Of Adjushents Reduce

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 Re-
serve Bank but hwn 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 op
tion 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 re-
quirements. Float pricing as-of adjustments are applied two
weeks after the related float is generated. Thus, an individual
bank has sufticient 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.

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

'The Act specified that fee schedules cover services such as check
clearing and collection, wire transfer, automated clearinghouse, settle-
ment, securities safekeeping, noncash collection, Federal Reserve float,
and any new services offered.

M"Eamings creditsn are calculated by multiplying the actual average
clea~gbalance 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.

*While 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.

When Bank A establishes a required clearing
balance at a Federal Reserve Bank by selling
securities, the reserve balances and deposits of Assets Liabilities
other banks decline.

U.S. government
securities -1,000
Reserve account
with F.R. Banks:
Required clearing


balance +1.000

Assets Liabilities Liabilities

Reserve accounts: Reserve accounts Deposits .. -1,000Required clearing with F.R Banks:
Bank A +1,000 4-
Reserve balances:
Other banks -1,000

When Bank A is Vied monthly for Federal Reserve services used, it can pay for these services by having
earnings credits applied and/or by authorizing a directcharge to its reserve account Suppose Bank A has
accrued earnings credits of $100but incurs fees of $125.Then both methods would be used. On the Federal
Reserve Bank's books, the liabiity 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'sbooks, the accounting entries might be a $100reduc-
tion to its asset account "earnings credit due from Federal Reserve Banks "and a $25reduction in its reserve
account, which are offset by a $125decline in its liabiity '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 directcharge to Bank A's reserve account

Assets Liabilities Assets Liabilities

Accrued service Earnings credits Earnings credits Accounts
income -125 due to depository due from payable -125
institutions F.R Banks -100

Reserve accounts: Reserves with

-25 HF.RBanks -25
Facfon metingBark Rmes 23


Changes in Loans to
Depository Institutions

Prior to passage of the Monetary Control Act of 1980,
only banks that were members of the Federal Reserve Sys-
tem had regular access to the Fed's "discount window."
Since then, all institutions having deposits reservable under
the Act also have been able to borrow from the Fed. Under
conditions set by the Federal Reserve, loans are available
under three credit programs: adjustment, seasonal, and ex-
tended credit.16 The average amount of each type of discount
window credit provided varies over time. (See rlrn~-fi

When a bank borrows from a Federal Reserve Bank, it
borrows reserves. The acquisition of reserves in this manner
diem in an important way from the cases already illustrated.
Banks normally borrow adjustment credit only to avoid re-
serve deficiencies or overdrafts, not to obtain excess re-
serves. Adjustment credit borrowings, therefore, are
reserves on which expansion has already taken place. How
can this happen?

In their efforts to accommodate customers as well as to
keep fully invested, banks frequently make loans in anticipa-
tion of inflows of loanable funds from deposits or money
market sources. Loans add to bank deposits but not to bank
reserves. Unless excess reserves can be tapped, banks will
not have enough reserves to meet the reserve requirements
against the new deposits. Likewise, individual banks may
incur deficiencies through unexpected deposit outflows and
corresponding losses of reserves through clearings. Other
banks receive these deposits and can increase their loans
accordingly, but the banks that lost them may not be able to
reduce outstanding loans or investments in order to restore
their reserves to required levels within the required time
period. In either case, a bank may borrow reserves tempo-
rarily from its Reserve Bank.

Suppose a customer of Bank A wants to borrow $100.
On the basis of the management's judgment that the bank's
reserves will be sufticient to provide the necessary funds, the
customer is accommodated. The loan is made by increasing
"loans" and crediting the customer's deposit account. Now
Bank A's deposits have increased by $100. However, if re-
serves are insufticient to support the higher deposits, Bank A
will have a $10 reserve deficiency, assuming requirements of
10 percent. See zllustratlo~z26. Bank A may temporarily
borrow the $10 from its Federal Reserve Bank, which makes
a loan by increasing its asset item "loans to depository institu-
tions" and crediting Bank A's reserve account. Bank A
gains reserves and a corresponding liability "borrowings from
Federal Reserve Banks." See tlitutruiito~z27

To repay borrowing, a bank must gain reserves through
either deposit growth or asset liquidation. 3cr ~llrrstrntio~z


A bank makes payment by authorizing a debit to its reserve

account at the Federal Reserve Bank. Repayment of borrow-

ing, therefore, reduces both reserves and "borrowings from

Federal Reserve Banks." S~P

ziiustmtzon 29

Unlike loans made under the seasonal and extended
credit programs, adjustment credit loans to banks generally

Loans to depository institutions

monthly averages, billions of dollars, not seasonally adjusted
Extended credit

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 borrow-

ing. In the aggregate, adjustment credit borrowing usually

increases in periods of rising business activity when the

public's demands for credit are rising more rapidly than

nonborrowed reserves are being provided by System open

market operations.

Although reserve expansion through borrowing is initi-
ated by banks, the amount of reserves that banks can acquire
in this way ordinarily is limited by the Federal Reserve's ad-
ministration 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 ad-
justment 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.


'fiAdjustment credit is short-term credit available to meet temporary needs
for funds. Seasonal credit is available for longer periods to smaller institu-
tions having regular seasonal needs for funds. Extended credit may be made
available to an institution or group of institutions experiencing sustained
liquidity pressures. The reserves provided through extended credit borrow-
ing typically are offset by open market operations.

';Flexible discount rates related to rates on money market sources of funds
currently arecharged for seasonalcredit and for extendedcredit outstanding
more than 30 days.

24 1 Modem Money Mechanrcs

A bank may incur a reserve deficiency if it makes

26 loans when it has no excess reserves.

3 I

Assets Liabilities

no change

1 Borrowing from a Federal Reserve Bank to cover such a deficit is accompanied by a direct credit to the27 bank's reserve account.

I ~ssets Liabilities Assets Liabilities

Loans to depository Reserve accounts: Reserves with Borrowings from

Bank A + 10-F.R Banks F.R. Banks + 10
1 + 10


Nofirher expansion can take phce on the new reserves because thy an all needed against the deposits created in (26).

Assets Liabilities
Securities -10
Reserves with

F.R Banks
Repayment of borrowings from the Federal Reserve Bank reduces reserves.


Assets Liabilities Assets Liabilities

Loans to depository Reserve accounts: Reserves with Borrowings from
institutions: Bank A -10-F.R.Banks -10
Bank A -10

Factors metingEank Resewes 25

Changes in Resave Reqzkments

Thusfar 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 iduence deposit expan-
sion 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 Fed-
eral Reserve Board of Governors in 1933. The ranges within
which this authority canbe exercised have been changed
several times, most recently in the Monetary Control Actof
1980, which provided for the establishment of reserve re
quirements that apply uniformly to all depository institutions.
?he 1980 statute established the following limits:

On transadon accounts
first$25 million 3%
above $25 million 8%to 14%
On nonpmonal 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 3percent The initial $25 mik
lion "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 liabiitie~?~

(Initially the Board set a 3percent
requirement on Eurocurrency liabiitiea)

The Garn-St GermainActof 1982 modiied these provi-
sions somewhat by exempting from reserve requirements
the first $2 million of total resemble liabiities at each depos
itory institution. Similar to the low reserve tranche adjust-
ment for transaction accounts, the $2 million "resemble
liabiities exemption amount" was indexed to 80 percent of
annual increases in total resemble liabiities. (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 withii the ranges indicated above. In addition,
the Board may impose differing reserve requirements on
nonpersonal time deposits based on the maturity of the de-
posit. me Board initially imposed the 3percent nonper-
sonal time deposit requirement only on such deposits with
original maturities of under four years.)

During the phasein period, which ended in 1984 for
most member banks and in 1987 for most nonmember insti-
tutions, requirements changed according to a predetermined
schedule, without any action by the Federal Reserve Board.
Apart from these legally prescribed changes, once the Mone-
tary Control Act provisions were implemented in late 1980,

the Board did not change any reserve requirement ratios until
late 1990. me 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 3percent to
zero. Effective in April 1992, the reserve requirement on
transaction accounts above the low reserve tranche was low-
ered 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 illustration30. But a reduc-
tion in the legal requirement to 8 percent would tie up only $8,
freeii $2 out of each $10 of reserves for use in creating addi-
tional bank credit and deposits. See illustration 31.

An increase in reserve requirements, on the other hand,
absorbs additional reserve funds, and banks which have no
excess reserves must acquire reserves or reduce loans or
investmentsto 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 onesixth less than before.
See illustration 32.

Reserve Requirements and Monetary Policy

The power to change reserve requirements, like pur-
chases and sales of securities by the Federal Reserve, is an
instrument of monetary policy. Even a small change in re
quirements-say, onehalf 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 expan-
sion power of every reserve dollar. Thus, such changes affect
the leverage of all subsequent increases or decreases in re-
serves from any source. For this reason, changes in the total
volume of bank reserves actually held between points in time
when requirements diier do not provide an accurate indica-
tion of the Federal Reserve's policy actions.

Both reserve balances and vault cash are eligible to
satisfy reserve requirements. To the extent some institutions
normally hold vault cash to meet operating needs in amounts
exceeding their required reserves, they are unlikely to be
affected by any change in requirements.

I8The1980statute 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.

Under a 10 percent reserve requirement,
$10 of reserves are needed to support each
$100 of deposits. Assets Liabilities

Loans and


With a reduction in requirements from 10
percent to 8percent, fewer reserves are
required against the same volume of deposits Assets Liabilities
so that excess reserves are created. These can

Loans and Deposits 100

be loaned or invested.

investments 90

Reserves 10

Assets Liabilities

NO CHANGE There is no change in the total amount of bank reserves.


With an increase in requirements from 10
percent to 12 percent, more reserves are
required against the same volume of deposits. Assets Liabilities
The resulting deficiencies must be covered by

Loans and Deposits

liquidation of loans or investments. . .

investments 90

Reserves 10


Assets Liabilities


...because the total amount of bank reserves remains

Factors mctirrg Bank Resemes 27

The Federal Reserve has engaged in foreign currency

operations for its own account since 1962. In addition,

it acts as the agent for foreign currency transactions of the

U.S. Treasury, and since the 1950s has executed transac-
tions for customers such as foreign central banks. Perhaps
the most publicized type of foreign currency transaction
undertaken by the Federal Reserve is intervention in the
foreign exchange markets. Intervention, however, is only
one of several foreign-related transactions that have the
potential for increasing or decreasing reserves of banks,
thereby affecting money and credit growth.
Several foreign-related transactions and their effects
on U.S. bank reserves are described in the next few pages.
Included are some but not all of the types of transactions
used. The key point to remember, however, is that the
Federal Reserve routinely offsets any undesired change in

U.S bank reserves resulting from foreign-related transac-
tions. As a result, such transactions do not affect money
and credit 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 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 assek
to pay for the dollars purchased and reserves of US. banks

Consider the example where the Federal Reserve
intervenes in the foreign exchange markets to sell $100 of

U.S. dollars for its own account. In this transaction, the
Federal Reserve buys a foreignarrencydenominated
deposit of a U.S. bank held at a foreign commercial barkz0
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 ac-
count at a Foreign Central Bank, and as this transaction
clears, the foreign bank's reserves at the Foreign Central
Bank decline. See illustration 33 on pages 3031. Initially,
then, the Fed's intervention sale of dollars in this example
leads to an increase in Federal Reserve Bank assetsdenom-
inated in foreign currencies and an increase in reserves of
U.S. banks.
Suppose instead that the Federal Reserve intervenes
in the foreign exchange markets to buy $100 of US. dollars,
again for its own account. The Federal Reserve purchases a
dollardenominated deposit of a foreign bank held at a US.
bank, and pays for this dollar deposit by drawing on its
foreign currency deposit at a Foreign Central Bank. me
Federal Reserve might have to sell some of its foreign cur-
rency investments to build up its deposits at the Foreign
Central Bank, but this 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

28 M& Money Mechanics

Federal Reserve Bank assets denominated
in foreign currencies

end of month, billions of dollars, not seasonally adjusted

via a $100 charge to its reserve account at the Federal Re
serve. See illustration 34 on pages 3031. Initially, then, the
Fed's intervention purchase of dollars in this example leads
to a decrease in Federal Reserve Bank assets denominated in
foreign currencies and a decrease in reserves of U.S. banks.

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

Monthly Revaluation of Foreign Currency Assets
Another set of accounting transactions that affects
Federal Reserve Bank assets denominated in foreign curren-
cies is the monthly revaluation of such assets. Two business
days prior to the end of the month, the Fed's foreign currency
assetsare increased if their market value has appreciated or
decreased if their value has depreciated. The offsettine; ac-
counting entry on the Fed's balance sheet is to the "exchange
translation account" included in "other F.R liabiities." 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 af-
fects the amount of the Fed's payment to the Treasury, which
in turn iniluences the size of 'IT&L calls and bank reserves.
(Seeexplanation on pages 18 and 19.)

'gOverall responsibiity 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 withiithe general framework
of exchange rate policy established by the US. 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
theTreasuryls Exchange Stabilization Fund.

2oAmericans 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 US. banks and foreign banks
are the market participants in the intervention transactions, but the impact
on reserves would be the same if the U.S. or foreign public were involved.

Foreign-Related Transactions for the Treasury

U.S. intervention in foreign exchange markets by the
Federal Reserve usually is divided between its own account
and the Treasury's Exchange Stabilization Fund (ESF') ac-
count. The impact on U.S. bank reserves from the interven-
tion transaction is the same for both -sales of dollars add
to reserves while purchases of dollars drain reserves. See
illustration 35 on pages 3@31. Depending upon how the
Treasury pays for, or hances, its part of the intervention,
however, the Federal Reserve may not need to conduct
offsetting open market operations.
The Treasury typically keeps only minimal balances
in the ESFs account at the Federal Reserve. Therefore,
the Treasury generally has to convert some ESF assets into
dollar or foreign currency deposits in order to pay for its part
of an intervention transaction. Likewise, the dollar or for-
eign currency deposits acquired by the ESF in the interven-
tion typically are drawn down when the ESF invests the
proceeds in earning assets.

For example, to hance 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
ESFs account at the Fed. (On the Federal Reserve's bal-
ance sheet, the ESFs account is included in the liability
category "other deposits.") The Treasury, however, would
need to replenish its Fed balances to desired levels, perhaps
by increasing the size of ?T&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 ?T&L
call. See illustrations 35 and 36 on pages 3@31. Thus, no
Federal Reserve offsetting actions would be needed if the
Treasury hced the intervention sale of dollars through
a ?T&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 transac-
tions involving the Federal Reserve. These include the
Treasury's issuance of SDR or gold certificates to the Feder-
al Reserve and the "warehousing" of foreign currencies by
the Federal Reserve.

SDR certtj5cate.s. Occasionally the Treasury acquires
dollar deposits for the ESFs account by issuing certificates
to the Federal Reserve against allocations of Special Draw-
ing Rights (SDRs) received from the International Monetary
Fund.21 For example, $3.5 biion of SDR certificates were
issued in 1989, and another $1.5 billion in 1990. This "mone-
tization" of SDRs is reflected on the Federal Reserve's bal-
ance sheet as an increase in its asset "SDR certificate
account" and an increase in its liability "other deposits
(ESF account) ."

If the ESFuses these dollar deposits directly in an
intervention sale of dollars, then the intervention-induced
increase in U.S. bank reserves is not altered. See illustra-
tions 35 and 370n pages 3@31. If not needed immediately
for an intervention transaction, the ESF might use the dollar
deposits from issuance of SDR certificates to buy securities

USgold stock, gold certificates and SDR certificates
end of year, billions of dollars



from the Treasury, resulting in a transfer of funds from the
ESFs account at the Federal Reserve to the Treasury's ac-
count at the Fed. U.S. bank reserves would then increase as
the Treasury spent the funds or transferred them to banks
through a dii investment to ?T&L note accounts.

Gold stock andgold certtj5cates. Changes in 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 on
this page.)

Prior to August 1971, the Treasury bought and sold
gold for a fixed price in terms of U.S. dollars, mainly at the
initiative of foreign central banks and governments. Gold
purchases by the Treasury were added to the U.S. monetary
gold stock, and paid for from its 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 Buy-
ers' checks are credited to the Treasury's account and re-
serves decline. Because the official U.S. gold stock is now
fully "monetized," the 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. We
official gold price was last raised, from $38.00 to $42.22 per
troy ounce, in 1973.)

Warehousing. The Treasury sometimes acquires dol-
lar deposits at the Federal Reserve by "warehousing" foreign
currencieswith the Fed. (For example, $7 billion of foreign

21SDRswere created in 1970 for use by governments in official balance of
payments transactions.

When the Federal Reserve intervenes to sell dollars for its own
account, it pays for a foreignarrencydenominateddeposit of a U.S.
bank at a foreign commercial bank by crediting the reserve account of Liabilities
the U.S. bank, and acquires a foreign currency asset in the form of a

Deposits at Reserves:

deposit at a Foreign Central Bank. The Federal Reserve, however, will Foreign Central US. bank + 100-offset the increase in U.S. bank reserves if it is inconsistent with
domestic policy objectives.

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 dollardenominated deposit of a foreign bank Liabilities
at a U.S. bank, which leads to a contraction in reserves of the US.

Deposits at Reserves:

bank. This reduction in reserves will be offset by the Federal Reserve Foreign Central U.S. bank -100 -if it is inconsistent with domestic policy objectives.

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 US. 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.

Assets Liabilities Assets Liabilities Assets Liabilities

Deposits at Other deposits:
Foreign Central

Concurrently, the Treasury must hce the intervention transaction in (35). ?he Treasury might build up deposits in
the ESFs 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 ?T&L note accounts. This set of transac-
tions drains reserves of U.S. banks by the same amount as the intervention in (35) added to U.S. bank reserves.

Assets Liabilities Assets Liabilities Assets Liabilities

US. govt

Deposits at Treas. deps.: net 0

F.R. Banks
Other deposits:

+ 100
Alternatively, the Treasury might hnce the intervention in (35) by issuing SDR certificates to the Federal
Reserve, a transaction that would not disturb the addition of US. bank reserves in intervention (35). The Federal
Reserve, however, would offset any undesired change in U.S. bank reserves.

Assets Liabilities Assets Liabilities
Deposits at SDR certificates SDR certificate Other deposits:

FA. Banks + 100 issued to account + I00 ESF + 100

30 Modem Monq Mechanics


Assets Liabilities Assets Uabiliti~ Assets Liabilities

Deposits at Reserves of
foreign bank -100 foreign bank -100

Assets Liabilities Assets Liabilities Assets Liabilities

,-b F.R. Banks foreign bank -100

Reserves with Reserves of
Foreign Central foreign bank + 100

+ 100
Assets Liabilities Assets Liabilities Assets Liabilities

Foreign Central
Deposits at Reserves of
foreign bank -100 foreign bank -100

Assets Liabilities

Reserves with TT&Laccts. -I00

-F.R. Banks -1007
Assets Liabilities




Factots Mxfing Bank Rcsmes 31

currencies were warehoused in 1989.) The Treasury or
ESF acquires foreign currency assets as a result of transac-
tions such as intervention sales of dollars or sales of U.S.
government securities denominated in foreign currencies.
When the Federal Reserve warehouses foreign currencies
for the Trea~ury,~

"Federal Reserve Bank assets denomi-
nated in foreign currencies" increase as do Treasury depos-
its at the Fed. As these deposits are spent, reserves of U.S.
banks rise. In contrast, the Treasury likely will have to
increase the size of lT&L calls -a transaction that drains
reserves -when it repurchases warehoused foreign cur-
rencies from the Federal Reserve. (In1991,$2.5 billion of
warehoused foreign currencies were repurchased.) The
repurchase transaction is reflected on the Fed's balance
sheet as declines in both Treasury deposits at the Federal
Reserve and Federal Reserve Bank assets denominated in
foreign currencies.

Transactions for Foreign Customers

Many foreign central banks and governments main-
tain deposits at the Federal Reserve to facilitate dollar-
denominated transactions. These "foreign deposits" on the
liability side of the Fed's balance sheet typically are held at
minimal levels that vary little from week to week. For ex-
ample, foreign deposits at the Federal Reserve averaged
only $237 million in 1991, rangingfrom $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 mar-
ketable U.S. government securities held in custody by the
Federal Reserve for foreign customers. (See chart.) The
net effect of foreign customers' cash management transac-
tions usually is to leave U.S. bank reserves unchanged.

Managingfbreign 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 Feder-
al 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 re-
serves from the disbursement transactions. The net effect
is to leave U.S. bank reserves unchanged when U.S. govern-
ment securities of foreign customers are sold in the mar-
ket. See illustrations 38 and 39. Occasionally, however, the
Federal Reserve executes foreign customers' sell orders
with the System's account. When this is done, the rise in
reserves from the foreign customers' disbursement of funds
remains in place. See illustratiolzs 38 and 40. The Federal
Reserve might choose to execute sell orders with the Sys-
tem's account if an increase in reserves is desired for do-
mestic policy reasons.

MarketableUSgovernment securities held in
custody for foreign customers during 199 1
Wednesday outsmndings, billions of dollars

235 ~~'''1'''~'''~''''~'''~''''~'''~'''1''''1'''1'''i
Feb. Apr. June Aug. Oct. Dec.


fbreign deposits through purchases of securi-
ties. Foreign customers of the Federal Reserve also receive
a variety of dollardenominated payments, including pro-
ceeds from intervention purchases of dollars by foreign
central banks, that are drawn on U.S. banks. As these funds
are credited to foreign deposits at the Federal Reserve, re
serves of U.S. banks decline. But if receipts of dollardenom-
hated payments raise their deposits at the Federal Reserve
to levels higher than desired, foreign customers will buy U.S.
government securities. The net effedt 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" net-
work, which consists of reciprocal short-term credit arrange-
ments 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 in-
crease in the liabiity category Yoreign deposits." When the
swap line is repaid, both of these accounts decline. Reserves
of U.S. banks will rise when the foreign central bank spends
its dollar proceeds from the swap drawing. See illustration

41. In contrast, reserves of U.S. banks will fall as the foreign
central bank rebuilds its deposits at the Federal Reserve
in order to repay a swap drawing.
The accounting entries and impact on U.S. bank re
serves are the same if the Federal Reserve uses the swap
network to borrow and repay foreign currencies. However,
the Federal Reserve has not activated the swap network in
recent years.

nTechnically, warehousing consists of two parts: the Federal Reserve's
agreement to purchase foreign currency assetsfrom theTreaswy or ESF
for dollar deposits now, and the Treasury's agreement to repurchase the
foreign currencies sometime in the future.

When a Foreign Central Bank makes a dollardenominated payment from its account at the Federal Reserve, the


recipient deposits the funds in a U.S. bank. As the payment order clears, U.S. bank reserves rise.

Assets Liabilities Assets Liabilities Assets Liabilities

Reserves: Reserves with Deposits + 100 Deposits at Accounts

U.S. bank + 100*~.~. Banks + I00
F.R. Banks -I00 payable -100
deposits -I00

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. govemment securities for it. If the sell order is executed in the
market, reserves of U.S. banks willfall by the same amount as reserves were increased in (38).

Assets Liabilities Assets Liabilities Assets Liabilities

Reserves: Reserves with Deposits of Deposits at

U.S. bank
-100-F.R. Banks -I00 securities
buyer U.S.govt.
deposits + I00 securities

1 If the sellorder 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 sellorder with the System's
accountif an increase in reserves is desired for domestic policy reasons.

Assets Liabilities
Liabilities Assets Liabilities

US. govt. Foreign Deposits at
securities + 100 deposits + 100 F.R. Banks + I00

U.S. govt
securities -100


When a Foreign Central Bank draws on a "swap" line, it receives a credit to its dollar deposits at the Federal


Reserve in exchange for a foreign currency deposit credited to the Federal Reserve's account. Reserves of U.S.
banks are not affected by the swap drawing transaction, but will increase as the Foreign Central Bank uses the
funds as in (38).

Liabilities Assets Uabilities Assets Liabilities

Deposits at
Foreign Central
Bank + 100


Factors tlffectingBank Resewes 3 3

Federal Reserve Actim 4ffecting I&
Holdings of US. Government Securities

In discussing various factors that affect reserves, it
was often indicated that the Federal Reserve offsets unde-
sired 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 secu-
rities by the Federal Reserve in the market occur inii-equent-
ly,and typically are conducted when an increase or decrease
in another factor is expected to persist for some time. Most
market actions taken to implement changes in monetary
policy or to offset changes in other factors are accomplished
through the use of transactions that change reserves temp
rarily. In addition, there are off-market transactions the
Federal Reserve sometimes uses to change its holdings of

U.S. government securities and affect reserves. (Recallthe
example in illustrations 38and 40.) The impact on reserves
of various Federal Reserve transactions in U.S. government
and federal agency securities is explained below. (See table
fora summary..)
OutTtght transactions. Ownership of securities is
transferred permanently to the buyer in an outright transac-
tion, and the funds used in the transaction are transferred
permanently to the seller. As a result, an outright purchase
of securities by the Federal Reserve from a dealer in the
market adds reserves permanently while an outright sale of
securities to a dealer drains reserves permanently. The
Federal Reserve can achieve the same net effect on reserves
through off-market transactions where it executes outright
sell and purchase orders from customers internally with the
System account. In contrast, there is no impact on reserves
if the Federal Reserve fills customers' outright sell and pur-
chase orders in the market.

Temporary transactions. Repurchase agreements
(RF's), and associated matched sale-purchase agreements
(MSPs), transfer ownership of securities and use of funds
temporarily. In an RP transaction, one party sells securities
to another and agrees to buy them back on a specified future
date. In an MSP transaction, one party buys securities from
another and agrees to sell them back on a specified future
date. In essence, then, an RP for one party in the transaction
works like an MSP for the other party.

When the Federal Reserve executes what is referred
to as a "System RP,"it acquires securities in the market from
dealers who agree to buy them back on a specified future
date 1to 15days later. Both the System's portfolio of securi-
ties and bank reserves are increased during the term of the
RP, but decline again when the dealers repurchase the secu-
rities. Thus System RPs increase reserves only temporarily.
Reserves are drained temporarily when the Fed executes
what is known as a "System MSP." A System MSP works
like a System RP, only in the opposite direction. 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 tern of the MSP, but both increase when the Federal
Reserve buys back the securities.

34 Modem Money Mechanics


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

Federal Reserve Transaction Reserve Imcuct

Outright Purchases of Securities

-From dealer in market Permanent increase
-To fill customer sell orders internally Permanent increase
(If customer sell orders filled in market) (No impact)
OutrightWes of Securities

-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 a System RP Temporary increase

Matched Sale-Purchase Agreements (MSPr)
-With dealer in market in a System MSP Temporary decrease

-To fill customer RP orders internally No impad
(If customer RP orders passed to market as
customer-related UPS) (Temporary increase*)
Redemption of Maturing Securities

-Replace total amount maturing No impact
-Redeem part of amount maturin Permanent decrease
-Buy more than amount maturinJ* Permanent increase**
* Impact based on assumption that the amount of RP orders done
internally is the same as on the prior day.
*me 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.
Consideredin isolation, a Federal Reserve MSP transac-
tion with customers would drain reserves temporarily.
However, these transactions occur every day, with the
total amount of RP orders being fairly stable from day
to day. Thus, on any given day, the Fed both buys back
securities from customers to fulfill the prior day's MSP,
and sells them about the same amount of securities to
satisfy that day's agreement. As a result, there generally is
little or no impact on reserves when the Fed uses MSPs to
fdl customer RP orders internally with the System account.
Sometimes, however, the Federal Reserve fills some of the
RP orders internally and the rest in the market The part
that is passed on to the market is known as a "customer-
related RP." The Fed ends up repurchasing more securi-
ties from customers to complete the prior day's MSP than
it sells to them in that day's MSP. As a result, customer-
related RPs add reserves temporarily.

Maturing securities. As securities held by the Fed-
eral Reserve mature, they are exchanged for new securi-
ties. Usually the total amount maturing is replaced so that
there is no impact on reserves since the Fed's total hold-
ings remain the same. Occasionally, however, the Federal
Reservewill exchange only part of the amount maturing.
Treasury deposits decline as payment for the redeemed
securities is made, and reserves fall as the Treasury re-
plenishes its deposits at the Fed through 'IT&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.

Mkcelhneous Factors Affecting
Bank Reserves

The factors described below normally have negligi-
ble effects on bank reserves because changes in them either
occur very slowly or tend to be balanced by concurrent
changes in other factors. But at times they may require
offsetting action.

Treasury Currency Outstanding
Treasury currency outstanding consists of coins,
silver certificates and U.S. notes originally issued by the
Treasury, and other currency originally issued by commer-
cial banks and by Federal Reserve Banks before July 1929
but for which the Treasury has redemption responsibiity.
Short-run changes are small, and their effects on bank
reserves are indirect.

The amount of Treasury currency outstanding cur-
rently increases only through issuance of new coin. The
Treasury ships new coin to the Federal Reserve Banks for
credit to Treasury deposits there. These deposits will be
drawn down again, however, as the Treasury makes expen-
ditures. Checks issued against these deposits are paid out
to the public. As individuals deposit these checks in banks,
reserves increase. (Seeexplanation on pages 18 and 19.)

When any type of Treasury currency is retired, bank
reserves decline. As banks turn in Treasury currency for
redemption, they receive Federal Reserve notes or coin in
exchange or a credit to their reserve accounts, leaving
their total reserves (reserve balances and vault cash) ini-
tially unchanged. However, the Treasury's deposits in the
Reserve Banks are charged when Treasury currency is
retired. Transfers from TT&Lbalances 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 interna-
tional organizations and certain U.S. government agencies
that keep funds on deposit in the Federal Reserve Banks. In
general, balances are built up through transfers of deposits
held at U.S. banks. Such transfers may take place either
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 Re-
serve balances (say, to purchase securities), these funds
are paid to the public and deposited in U.S. banks, thus
increasing bank reserves. Just like foreign customers,
these "other" customers manage their balances at the
Federal Reserve closely so that changes in their deposits
tend to be small and have minimal net impact on reserves.

Nonfloat-Related Adjustments
Certain adjustments are incorporated into published
data on reserve balances to reflect nonfloat-related correc-
tions. Such a correction might be made, for example, if an
individual bank had mistakenly reported fewer reservable
depositsthan actually existed and had held smaller re-
serve balances than necessary in some past period. To
correct for this error, a nonfloat-related as-of adjustment
will be applied to the bank's reserve position. This essen-
tially results in the bank having to hold higher balances in
its reserve account in the current and/or future periods
than would be needed to satisfy reserve requirements in
those periods. Nonfloat-related as-of adjustments affect
the allocation of funds in bank reserve accounts but not
the total amount in these accounts as reflected on Federal
Reserve Bank and individual bank balance sheets. Pub
lished data on reserve balances, however, are adjusted to
show only those reserve balances held to meet the current
and/or future period reserve 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 secu-
rities. The same results follow from any Federal Reserve
expenditure or receipt. Every payment made by the Re
serve Banks, in meeting expenses or acquiring any assets,
affectsdeposits and bank reserves in the same way as does
the payment to a dealer for government securities. Si-
larly, Reserve Bank receipts of interest on loans and secu-
rities and increases in paid-in capital absorb reserves.

Factors metingBank ReSe~es 35

The Reserve Multiplier -Why it Varies

The deposit expansion and contraction associated
with a given change in bank reserves, asillustrated earlier
in this booklet, assumed a hed reserve-to-deposit multi-
plier. That multiplier was determined by a uniform percent-
age reserve requirement specified for transaction accounts.
Such an assumption is an oversimplifidon of the actual
relationship between changes in reserves and changes in
money, especdly in the short run. For a number of rea-
sons, as discussed in thissection, the quantity of reserves
associatedwith a given quantity of transaction deposits is
constantly changing.

One slippage affecting the reserve multiplier is varia-
tion in the amount of excess reserves. In the realworld,
reserves are not alwaysfullyutilized. There arealways
some excess reserves in the banking system, reflecting
frictions and lagsas funds flow among thousands of individ-
ual banks.

Excess reserves present a problem for monetary
policy implementation only because the amount changes.
To the extent that new reserves supplied areoffset 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.

Slippagesalsoarise from reserve requirements being
imposed on liabilities not included in money aswell as
differing reserve ratios being applied to transaction deposits
according to the size of the bank. From 1980 through 1990,
reserve requirements were imposed on certain nontransac-
tion liabiities 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 aswe11 as by shifts of
funds between transaction deposits and other liabilities
subjectto reserve requirements. ?he extension of reserve
requirements to all depository institutions in 1980 and the
elimination of reserve requirements against nonpersonal
time deposits and Eurocurrency liabiities 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 trana
action deposits between larger institutions and those either
exempt from reserve requirements or whose transaction
deposits are within the tranche subject to a 3percent
reserve requirement.

In addition, the reserve multiplier is affected by con-
versions of deposits into currency or vice versa. Thisfactor
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 shiftsbe-
tween transaction deposits included in money and other
transaction accounts that also are resemble but not includ-
ed in money, such as demand deposits due to depository

36 Modem MoneyMechanics

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 signiticantly from
week to week.

A net injection of reserves has widely different effects
depending on how it is absorbed. Only a dollar-fordollar
increase in the money supply would result if the new re-
serves were paid out in currency to the public. With a mi-
form 10 percent reserve requirement, a $1increase in
reserves would support $10 of additional transaction ac-
counts. An even 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
resemble transaction accounts that are not counted as
money. (See chart below.) Normally, an increase in re-
serves 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.

The growth potential of a $1 million reserve injection

$12.5 mil.

$10 mil.

$1 million

Money Creation and Reserve Management
Another reason for short-run variation in the amount
of reserves supplied is that credit expansion -and thus
deposit creation -is variable, reflecting uneven timing of
credit demands. Although bank loan policies normally take
account of the general availability of funds, the size and
timing of loans and investments made under those policies
depend largely on customers' credit needs.

In the real world, a bank's lending is not normally
constrained by the amount of excess reserves it has at
any given moment. Rather, loans are made, or not made,
depending on the bank's credit policies and its expectations
about its ability to obtain the funds necessary to pay its
customers' checks and maintain required reserves in a
timely fashion. In fact, because Federal Reserve regula-
tions in effect from 1968 through early 1984 specified that
average required reserves for a given week should be
based on average deposit levels two weeks earlier ("lagged"
reserve accounting), deposit creation actually preceded the
provision of supporting reserves. In early 1984, a more
"contemporaneous" reserve accounting system was imple-
mented in order to improve monetary control.

In February 1984, banks shifted to maintaining aver-
age reserves over a two-week reserve maintenance period
ending Wednesday against average transaction deposits
held over the tweweek computation period ending only
two days earlier. Under this rule, actual transaction deposit
expansion was expected to more closely approximate the
process explained at the beginning of this booklet. How-
ever, some slippages still exist because of short-run uncer-
tainties about the level of both reserves and transaction
deposits near the close of reserve maintenance periods.
Moreover, not all banks must maintain reserves according
to the contemporaneous accounting system. Smaller insti-
tutions are either exempt completely or only have to main-
tain reserves quarterly against average deposits in one
week of the prior quarterly period.

On balance, however, variabiity in the reserve multi-
plier has been reduced by the extension of reserve require-
ments to all institutions in 1980, by the adoption of
contemporaneous reserve accounting in 1984, and by the
removal of reserve requirements against nontransaction
deposits and liabilities in late 1990. As a result, short-term
changes in total reserves and transaction deposits in money
are more closely related now than they were before. (See
charts on this page.) The lowering of the reserve require-
ment against transaction accounts above the 3percent
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 (MI) and the economy deteri-
orated. Because the M1 measure of money has become
less useful as a guide for policy, somewhat greater attention
has shiid to the broader measures M2 and M3. However,
reserve multiplier relationships for the broader monetary
measures are far more variable than that for MI.

The relationship between short-term changes in
reserves and transaction deposits was quite
volatile before the Monetary Control Act of 1980.. .

21II Weekly changes. 1979
. . . and before adoption of contemporaneous
reserve accounting in 1984 . . .

Weekly changes, 1983
...but less variable afterward.

Two-week changes, 1991
Note: All data are in billions of dollars, not seasonally adusted. Scaling
approximately reflects each year's average ratio of transaction deposits
to total reserves.

Variability in the reserve multiplier 37

Although every bank must operate within the sys-
tem where the total amount of reserves is controlled by
the Federal Reserve, its response to policy action is indi-
rect. ?he 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 beiisupplied to the banking system. Re-
serves are distributed among thousands of banks, and the
individual banker cannot distinguish between inflows
originating from additions to reserves through Federal
Resenre action and shiftsof funds from other banks that
occur in the normal course of business.

To equate short-run reserve needs with available
funds, therefore, many banks turnto the money market -
borrowing funds to cover deficits or lending temporary
surpluses. When the demand for reserves is strong rela-
tive to the supply, funds obtained from money market
sources to cover deficits tend to become more expensive
and harder to obtain, which, in turn,may induce banks to
adopt more restrictive loan policies and thus slow the rate
of deposit growth.

Federal Reserve open market operations exert
control over the creation of deposits mainly through their
impacton the availability and cost of funds in the money
market. When the total amount of reserves supplied to
the banking system through open market operations falls
short of the amount required, some banks are forced to
borrow at the Federal Reserve discount window. Because
such borrowing is restricted to short periods, the need
to repay it tends to induce restraint on further deposit
expansion by the borrowing bank. Conversely, when
there are excess reserves in the banking system, individ-
ual banks find it easy and relatively inexpensive to acquire
reserves, and expansion in loans, investments, and depos-
its is encouraged.

Copies of this workbook
are available from:
Public Information Center
Federal Reserve Bank of Chicago

P.O. Box 834
Chicago. IL 60690-0834
[3 121 322-5 1 1 1
This publication originally was written
by Dorothy M. Nichols in May 196 1.
The June 1992 revision was prepared
by Anne Marie L. Gonczy


May I968

September 197 1
June 1975

October 1982
June 1992

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

@ Printed on recycled paper


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