MODERN MONEY MECHANICS
A Workbook on Bank
Reserves and Deposit Expansion
Introduction
The purpose of this booklet is to describe the basic process
of money creation in a "fractional reserve" banking system. The
approach taken illustrates the changes in bank balance sheets that
occur when deposits in banks change as a result of monetary action
by the Federal Reserve System - the central bank of the United
States. The relationships shown are based on simplifying
assumptions. For the sake of simplicity, the relationships are shown
as if they were mechanical, but they are not, as is described later
in the booklet. Thus, they should not be interpreted to imply a
close and predictable relationship between a specific central bank
transaction and the quantity of money.
The introductory pages contain a brief general description of
the characteristics of money and how the U.S. money system works.
The illustrations in the following two sections describe two
processes: first, how bank deposits expand or contract in response
to changes in the amount of reserves supplied by the central bank;
and second, how those reserves are affected by both Federal Reserve
actions and other factors. A final section deals with some of the
elements that modify, at least in the short run, the simple
mechanical relationship between bank reserves and deposit money.
Money is such a routine part of everyday living that its
existence and acceptance ordinarily are taken for granted. A user
may sense that money must come into being either automatically as a
result of economic activity or as an outgrowth of some government
operation. But just how this happens all too often remains a
mystery.
What is Money?
If money is viewed simply as a tool used to facilitate
transactions, only those media that are readily accepted in exchange
for goods, services, and other assets need to be considered. Many
things - from stones to baseball cards - have served this monetary
function through the ages. Today, in the United States, money used
in transactions is mainly of three kinds - currency (paper money and
coins in the pockets and purses of the public); demand deposits
(non-interest bearing checking accounts in banks); and other
checkable deposits, such as negotiable order of withdrawal (NOW)
accounts, at all depository institutions, including commercial and
savings banks, savings and loan associations, and credit unions.
Travelers checks also are included in the definition of transactions
money. Since $1 in currency and $1 in checkable deposits are freely
convertible into each other and both can be used directly for
expenditures, they are money in equal degree. However, only the cash
and balances held by the nonbank public are counted in the money
supply. Deposits of the U.S. Treasury, depository institutions,
foreign banks and official institutions, as well as vault cash in
depository institutions are excluded.
This transactions concept of money is the one designated as M1 in
the Federal Reserve's money stock statistics. Broader concepts of
money (M2 and M3) include M1 as well as certain other financial
assets (such as savings and time deposits at depository institutions
and shares in money market mutual funds) which are relatively liquid
but believed to represent principally investments to their holders
rather than media of exchange. While funds can be shifted fairly
easily between transaction balances and these other liquid assets,
the money-creation process takes place principally through
transaction accounts. In the remainder of this booklet, "money"
means M1.
The distribution between the currency and deposit components of
money depends largely on the preferences of the public. When a
depositor cashes a check or makes a cash withdrawal through an
automatic teller machine, he or she reduces the amount of deposits
and increases the amount of currency held by the public. Conversely,
when people have more currency than is needed, some is returned to
banks in exchange for deposits.
While currency is used for a great variety of small transactions,
most of the dollar amount of money payments in our economy are made
by check or by electronic transfer between deposit accounts.
Moreover, currency is a relatively small part of the money stock.
About 69 percent, or $623 billion, of the $898 billion total stock
in December 1991, was in the form of transaction deposits, of which
$290 billion were demand and $333 billion were other checkable
deposits.
What Makes Money Valuable?
In the United States neither paper currency nor deposits have
value as commodities. Intrinsically, a dollar bill is just a piece
of paper, deposits merely book entries. Coins do have some intrinsic
value as metal, but generally far less than their face value.
What, then, makes these instruments - checks, paper money, and
coins - acceptable at face value in payment of all debts and for
other monetary uses? Mainly, it is the confidence people have that
they will be able to exchange such money for other financial assets
and for real goods and services whenever they choose to do so.
Money, like anything else, derives its value from its scarcity
in relation to its usefulness. Commodities or services are more or
less valuable because there are more or less of them relative to the
amounts people want. Money's usefulness is its unique ability to
command other goods and services and to permit a holder to be
constantly ready to do so. How much money is demanded depends on
several factors, such as the total volume of transactions in the
economy at any given time, the payments habits of the society, the
amount of money that individuals and businesses want to keep on hand
to take care of unexpected transactions, and the forgone earnings of
holding financial assets in the form of money rather than some other
asset.
Control of the quantity of money is essential if its value
is to be kept stable. Money's real value can be measured only in
terms of what it will buy. Therefore, its value varies inversely
with the general level of prices. Assuming a constant rate of use,
if the volume of money grows more rapidly than the rate at which the
output of real goods and services increases, prices will rise. This
will happen because there will be more money than there will be
goods and services to spend it on at prevailing prices. But if, on
the other hand, growth in the supply of money does not keep pace
with the economy's current production, then prices will fall, the
nations's labor force, factories, and other production facilities
will not be fully employed, or both.
Just how large the stock of money needs to be in order to handle
the transactions of the economy without exerting undue influence on
the price level depends on how intensively money is being used.
Every transaction deposit balance and every dollar bill is part of
somebody's spendable funds at any given time, ready to move to other
owners as transactions take place. Some holders spend money quickly
after they get it, making these funds available for other uses.
Others, however, hold money for longer periods. Obviously, when some
money remains idle, a larger total is needed to accomplish any given
volume of transactions.
Who Creates Money?
Changes in the quantity of money may originate with actions of
the Federal Reserve System (the central bank), depository
institutions (principally commercial banks), or the public. The
major control, however, rests with the central bank.
The actual process of money creation takes
place primarily in banks.(1)
As noted earlier, checkable liabilities of banks are money. These
liabilities are customers' accounts. They increase when customers
deposit currency and checks and when the proceeds of loans made by
the banks are credited to borrowers' accounts.
In the absence of legal reserve requirements, banks can build up
deposits by increasing loans and investments so long as they keep
enough currency on hand to redeem whatever amounts the holders of
deposits want to convert into currency. This unique attribute of the
banking business was discovered many centuries ago.
It started with goldsmiths. As early bankers, they initially
provided safekeeping services, making a profit from vault storage
fees for gold and coins deposited with them. People would redeem
their "deposit receipts" whenever they needed gold or coins to
purchase something, and physically take the gold or coins to the
seller who, in turn, would deposit them for safekeeping, often with
the same banker. Everyone soon found that it was a lot easier simply
to use the deposit receipts directly as a means of payment. These
receipts, which became known as notes, were acceptable as money
since whoever held them could go to the banker and exchange them for
metallic money.
Then, bankers discovered that they could make loans merely by
giving their promises to pay, or bank notes, to borrowers. In this
way, banks began to create money. More notes could be issued than
the gold and coin on hand because only a portion of the notes
outstanding would be presented for payment at any one time. Enough
metallic money had to be kept on hand, of course, to redeem whatever
volume of notes was presented for payment.
Transaction deposits are the modern counterpart of bank notes. It
was a small step from printing notes to making book entries
crediting deposits of borrowers, which the borrowers in turn could
"spend" by writing checks, thereby "printing" their own money.
What Limits the Amount of Money Banks Can Create?
If deposit money can be created so easily, what is to prevent
banks from making too much - more than sufficient to keep the
nation's productive resources fully employed without price
inflation? Like its predecessor, the modern bank must keep
available, to make payment on demand, a considerable amount of
currency and funds on deposit with the central bank. The bank must
be prepared to convert deposit money into currency for those
depositors who request currency. It must make remittance on checks
written by depositors and presented for payment by other banks
(settle adverse clearings). Finally, it must maintain legally
required reserves, in the form of vault cash and/or balances at its
Federal Reserve Bank, equal to a prescribed percentage of its
deposits.
The public's demand for currency varies greatly, but generally
follows a seasonal pattern that is quite predictable. The effects on
bank funds of these variations in the amount of currency held by the
public usually are offset by the central bank, which replaces the
reserves absorbed by currency withdrawals from banks. (Just how this
is done will be explained later.) For all banks taken together,
there is no net drain of funds through clearings. A check drawn on
one bank normally will be deposited to the credit of another
account, if not in the same bank, then in some other bank.
These operating needs influence the minimum amount of reserves an
individual bank will hold voluntarily. However, as long as this
minimum amount is less than what is legally required, operating
needs are of relatively minor importance as a restraint on aggregate
deposit expansion in the banking system. Such expansion cannot
continue beyond the point where the amount of reserves that all
banks have is just sufficient to satisfy legal requirements under
our "fractional reserve" system. For example, if reserves of 20
percent were required, deposits could expand only until they were
five times as large as reserves. Reserves of $10 million could
support deposits of $50 million. The lower the percentage
requirement, the greater the deposit expansion that can be supported
by each additional reserve dollar. Thus, the legal reserve ratio
together with the dollar amount of bank reserves are the factors
that set the upper limit to money creation.
What Are Bank Reserves?
Currency held in bank vaults may be counted as legal reserves as
well as deposits (reserve balances) at the Federal Reserve Banks.
Both are equally acceptable in satisfaction of reserve requirements.
A bank can always obtain reserve balances by sending currency to its
Reserve Bank and can obtain currency by drawing on its reserve
balance. Because either can be used to support a much larger volume
of deposit liabilities of banks, currency in circulation and reserve
balances together are often referred to as "high-powered money" or
the "monetary base." Reserve balances and vault cash in banks,
however, are not counted as part of the money stock held by the
public.
For individual banks, reserve accounts
also serve as working balances.(2)
Banks may increase the balances in their reserve accounts by
depositing checks and proceeds from electronic funds transfers as
well as currency. Or they may draw down these balances by writing
checks on them or by authorizing a debit to them in payment for
currency, customers' checks, or other funds transfers.
Although reserve accounts are used as working balances, each bank
must maintain, on the average for the relevant reserve maintenance
period, reserve balances at their Reserve Bank and vault cash which
together are equal to its required reserves, as determined by the
amount of its deposits in the reserve computation period.
Where Do Bank Reserves Come From?
Increases or decreases in bank reserves can result from a number
of factors discussed later in this booklet. From the standpoint of
money creation, however, the essential point is that the reserves of
banks are, for the most part, liabilities of the Federal Reserve
Banks, and net changes in them are largely determined by actions of
the Federal Reserve System. Thus, the Federal Reserve, through its
ability to vary both the total volume of reserves and the required
ratio of reserves to deposit liabilities, influences banks'
decisions with respect to their assets and deposits. One of the
major responsibilities of the Federal Reserve System is to provide
the total amount of reserves consistent with the monetary needs of
the economy at reasonably stable prices. Such actions take into
consideration, of course, any changes in the pace at which money is
being used and changes in the public's demand for cash balances.
The reader should be mindful that deposits and reserves tend to
expand simultaneously and that the Federal Reserve's control often
is exerted through the market place as individual banks find it
either cheaper or more expensive to obtain their required reserves,
depending on the willingness of the Fed to support the current rate
of credit and deposit expansion.
While an individual bank can obtain reserves by bidding them away
from other banks, this cannot be done by the banking system as a
whole. Except for reserves borrowed temporarily from the Federal
Reserve's discount window, as is shown later, the supply of reserves
in the banking system is controlled by the Federal Reserve.
Moreover, a given increase in bank reserves is not necessarily
accompanied by an expansion in money equal to the theoretical
potential based on the required ratio of reserves to deposits. What
happens to the quantity of money will vary, depending upon the
reactions of the banks and the public. A number of slippages may
occur. What amount of reserves will be drained into the public's
currency holdings? To what extent will the increase in total
reserves remain unused as excess reserves? How much will be absorbed
by deposits or other liabilities not defined as money but against
which banks might also have to hold reserves? How sensitive are the
banks to policy actions of the central bank? The significance of
these questions will be discussed later in this booklet. The answers
indicate why changes in the money supply may be different than
expected or may respond to policy action only after considerable
time has elapsed.
In the succeeding pages, the effects of various transactions on
the quantity of money are described and illustrated. The basic
working tool is the "T" account, which provides a simple means of
tracing, step by step, the effects of these transactions on both the
asset and liability sides of bank balance sheets. Changes in asset
items are entered on the left half of the "T" and changes in
liabilities on the right half. For any one transaction, of course,
there must be at least two entries in order to maintain the equality
of assets and liabilities.
1In order to
describe the money-creation process as simply as possible, the term
"bank" used in this booklet should be understood to encompass all
depository institutions. Since the Depository Institutions
Deregulation and Monetary Control Act of 1980, all depository
institutions have been permitted to offer interest bearing
transaction accounts to certain customers. Transaction accounts
(interest bearing as well as demand deposits on which payment of
interest is still legally prohibited) at all depository institutions
are subject to the reserve requirements set by the Federal Reserve.
Thus all such institutions, not just commercial banks, have the
potential for creating money.
back
2Part of an
individual bank's reserve account may represent its reserve balance
used to meet its reserve requirements while another part may be its
required clearing balance on which earnings credits are generated to
pay for Federal Reserve Bank services.
back
Modern Money
Mechanics
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