AWorkbook on Bank Reserves and Deposit Expansion
Federal Reserve Bank of Chicago
Modern Money Mechanics
Thepurpose ofthisbookletis to desmmbethe basic
process ofmoneycreation in a ~actionalreserve"bank-
ingsystem. l7zeapproachtaken illustratesthe changes
in bank balancesheets that occurwhen depositsin banks
changeasa result ofmonetaryactionby theFederal
Reserve System-the centralbank ofthe UnitedStates.
Therelationshipsshown are based onsimplil5ring
assumptions. For thesake ofsimplicity,the relationships
areshown as iftheywere mechanical,but theyare not,
as isdescribed laterin the booklet. Thus,theyshould not
be intwreted to implya closeandpredictable relation-
ship betweena specificcentral bank transactionand
Theintroductorypages containa briefgeneral
desm'ptionofthe characte*ics ofmoneyand how the
US. moneysystem works. m e illustrationsin thefbl-
lowingtwosections describe twoprocesses: fijirst, how
bank akposits expand orcontractin responsetochanges
in theamountofreservessupplied by thecentml bank;
and second, how thosereservesareafected by both
FederalReserve actionsand otherjizctm. Afinal sec-
tion deals withsome ofthe elementsthat modifi,at least
i~theshort Tun,thesimple mechanical relationship
between bank reservesand depositmoney.
Moneyis sucha routinepart of everydaylivingthat
itsexistenceand acceptanceordinarilyare taken forgrant-
ed. A user may sensethat money must comeinto being
either automaticallyasa resultof economicactivityor as
an outgrowth of somegovernmentoperation. Butjust how
this happens alltoo often remainsa mystery.
What Is Money?
If moneyisviewed simplyasa tool used to facilitate
transactions,onlythose media that are readily acceptedin
exchangeforgoods,services,and otherassetsneed to be
considered. Manythings-from stonesto baseballcards
-have servedthis monetaryfunctionthrough the ages.
Today,in the United States,money used in transactionsis
mainly of threekinds-currency (papermoney and coins
in the pocketsand purses of the public);demand deposits
includingcommercialand savingsbanks, savingsandloan
associations,andcreditunions. Travelerschecksalso are
included in the definition of transactionsmoney. Since$1
in currencyand $1in checkabledeposits arefreelycon-
vertible intoeach otherand both canbe used directlyfor
expenditures,they are moneyin equaldegree. However,
onlythe cash and balances held by the nonbank public are
countedin the money supply. Depositsof the U.S. Trea-
institutions,aswell asvault cash in depositoryinstitutions
Thistransactionsconceptof money is the onedesig-
nated asM1in the FederalReserve's money stock statis-
tics. Broaderconceptsof money (M2 and M3) includeM1
aswell ascertainotherhancial assets (such assavings
and time depositsatdepositoryinstitutionsand sharesin
moneymarket mutual funds) which are relativelyliquid
but believed to representprincipallyinvestmentsto their
holdersrather than mediaof exchange. While fundscan
be shiftedfairlyeasilybetween transaction balances and
these otherliquid assets,the moneycreationprocesstakes
placeprincipallythrough transaction accounts. In the
remainderof thisbooklet, "money"meansMI.
The distributionbetween the currencyand deposit
componentsof money dependslargelyonthe preferences
of the public. When a depositorcashesa checkor makes
a cashwithdrawal through an automaticteller machine,he
or shereducesthe amountof depositsand increasesthe
amountof currencyheld by the public. Conversely,when
people have morecurrencythan is needed, someisre-
turned to banks in exchangefor deposits.
While currencyisused for a greatvariety of small
transactions,most of the dollaramount of moneypay-
mentsin our economyare made by checkorby electronic
transferbetween depositaccounts. Moreover,currency
is a relatively smallpart of the moneystock. About 69
percent,or$623biion, of the $898 biion totalmoney
stockin December 1991,wasin the formof transaction
deposits,of which$290billion were demand and $333
billion were other checkabledeposits.
What Makes MoneyValuable?
In the United Statesneitherpaper currencynor
depositshavevalue ascommodities. Intrinsically,a dollar
bii isjust a pieceof paper, depositsmerelybook entries.
Coinsdo have someintrinsicvalue asmetal,but generally
farlessthan their facevalue.
paper money,and coins-acceptableatfacevalue in
payment of alldebtsandfor othermonetary uses? Mainly,
itisthe confidencepeoplehave that theywillbe ableto
exchangesuchmoneyfor otherfinancialassets and for
real goodsand serviceswhenever theychooseto do so.
Money,like anythingelse,derivesitsvaluefrom its
scarcity in relation to itsusefulness. Commoditiesor ser-
vices aremore orlessvaluablebecause there are more or
lessof them relative to the amountspeoplewant. Money's
usefulnessisitsunique abilityto commandothergoods
and servicesandto permit aholder to be constantlyready
to do so. How much money is demanded dependson
severalfactors,suchasthe totalvolumeof transactions
in the economyat anygiven time,the paymentshabits of
the society,the amount of moneythat individualsand
businesseswantto keep on hand to take care of unexpect-
ed transactions, and the foregoneearningsof holding
tinancialassetsin the form of moneyrather than some
Control of the quantity of moneyisessentialif its
valueis to be kept stable. Money's real value canbe mea-
sured onlyin termsof what itwillbuy. Therefore,itsvalue
variesinverselywith the generallevelof prices. Assuming
a constant rate of use,if the volume of money growsmore
rapidlythan the rate atwhich the outputof realgoodsand
servicesincreases,priceswill rise. Thiswill happen b e
causetherewill be more money than therewillbe goods
and servicesto spend it on at prevailingprices. But if, on
the otherhand, growthin the supplyof money does not
keeppacewith the economy'scurrentproduction,then
priceswillfall,the nation's laborforce,factories,and other
production facilitieswillnot be fully employed,or both.
Just how largethe stockof moneyneeds to be in
ordertohandlethe transactionsof the economywithout
exertingundueiduence on the price level dependson
how intensivelymoney isb e i iused. Everytransaction
depositbalanceand everydollarbill isa part of some-
body's spendablefundsat anygiventime, ready to move
to otherownersastransactionstake place. Someholders
spend money quicklyaftertheyget it, makingthese funds
availablefor otheruses. Others,however,hold moneyfor
longerperiods. Obviously,when somemoney remains
idle,a largertotalis needed to accomplish anygiven
volume of transactions.
Who Creates Money?
Changesin the quantityof money may originatewith
actionsof the FederalReserve System (thecentralbank),
the public. The majorcontrol,however,rests with the
The actualprocessof money creation takesplace
primarilyin banks.' As noted earlier,checkableliabilities
of banksare money. These liabilitiesare customers'ac-
counts. Theyincreasewhen customersdepositcurrency
and checksandwhen the proceedsof loansmade by the
In the absenceof legalreserve requirements,banks
canbuild up depositsby increasingloansand investments
solongastheykeepenoughcurrencyon hand to redeem
whatever amountsthe holders of depositswantto convert
intocurrency. Thisunique attributeof the bankingbusi-
nesswas discoveredmany centuriesago.
It startedwith goldsmiths. As earlybankers,they
initiallyprovided safekeepingservices,makinga profit from
vaultstoragefeesforgold and coinsdepositedwith them.
Peoplewould redeemtheir "depositreceipts"whenever
they needed gold orcoinsto purchase something,and
physicallytake the gold or coinsto the sellerwho,in turn,
would depositthem for safekeeping,oftenwith the same
banker. Everyone soonfoundthat itwasa loteasier simply
to use the deposit receiptsdirectlyasa meansof payment.
These receipts,which became known asnotes,were ac-
ceptableasmoney sincewhoeverheld them couldgo to
the banker and exchangethem for metallicmoney.
Then,bankers discoveredthat they could make loans
merelyby giving their promisesto pay, orbank notes, to
borrowers. In thisway,banksbegan to create money.
More notes couldbe issuedthan the gold and coinon hand
because only a portionof the notesoutstandingwould be
presented forpaymentat anyonetime. Enough metallic
moneyhad to be kept on hand, of course,to redeemwhat-
evervolumeof noteswas presented for payment.
Transactiondepositsare the modem counterpartof
bank notes. Itwas a small stepfromprintingnotesto mak-
ingbook entriescreditingdepositsof borrowers,which the
borrowersin turncould "spend"by writingchecks,thereby
"printing"their own money.
term Bank"used in this bookletshouldbe understoodto encompassall
ted to offer interest-bearing transaction accounts to certain customers.
Transaction accounts (interest-bearing as well as demand deposits on
which payment of interest is still legally prohibited) at all depository
institutions are subject to the reserve requirements set by the Federal
Reserve. Thus an such institutions, notjust commercialbanks,havethe
potential for creatingmoney.
What Iimits the Amount of Money Banks
If depositmoney canbe createdsoeasily,what isto
preventbanksfrommaking too much -more than sufti-
cient to keep the nation's productiveresourcesfullyem-
ployedwithoutprice inflation? Likeitspredecessor,the
modem bank must keep available,to makepayment on
demand,a considerableamountof currency andfundson
depositwith the centralbank. Thebank mustbe prepared
to convertdepositmoneyintocurrencyforthose deposi-
torswho requestcurrency. It must make remittanceon
checkswritten by depositorsand presented for payment
by otherbanks (settleadverseclearings). Finally,it must
maintain legallyrequired reserves,in theformof vaultcash
and/or balances atitsFederal ReserveBank,equalto a
prescribedpercentage of itsdeposits.
Thepublic's demandfor currencyvariesgreatly,but
generallyfollowsa seasonalpattern that isquitepredict-
able. Theeffectsonbank fundsof thesevariations in the
amountof currencyheld by the public usuallyareoffsetby
the centralbank, which replacesthe reservesabsorbedby
willbe explainedlater.) For allbankstaken together,there
isno net drainof fundsthroughclearings. Acheckdrawn
on onebank normallywillbe depositedto the creditof
anotheraccount,if not in the samebank, then in some
Theseoperatingneeds influencethe minimum
amountof reservesan individualbankwillhold voluntarily.
However, aslongasthis minimum amountislessthan
what islegallyrequired, operatingneeds areof relatively
minor importanceasa restrainton aggregatedepositex-
pansion in thebankingsystem. Such expansioncannot
continuebeyond the pointwherethe amountof reserves
that allbankshave isjust sufficientto satisfylegal require-
ments under our"fractionalreserve" system. For example,
if reservesof 20 percentwere required, depositscould
expand onlyuntiltheywere fivetimes aslargeasreserves.
Reservesof $10million could supportdepositsof $50mil-
lion. Thelowerthe percentage requirement,the greater
the depositexpansionthatcanbe supportedby eachaddi-
tional reserve dollar. Thus,thelegalreserveratiotogether
with the dollaramountof bank reservesarethefactorsthat
setthe upper limitto money creation.
What Are Bank Reserves?
Currencyheld in bank vaults may be countedas
legalreservesaswell as deposits (reservebalances) atthe
FederalReserveBanks. Both areequallyacceptablein
satisfactionof reserverequirements. Abank canalways
obtain reserve balancesby sendingcurrencyto itsReserve
Bank and canobtaincurrencyby drawingon itsreserve
balance. Because eithercanbe used to supporta much
largervolumeof depositliabilitiesof banks, currencyin
circulationand reservebalancestogetherare oftenrefer-
red to as"high-poweredmoney"orthe "monetarybase."
Reservebalancesandvault cash in banks, however,arenot
counted aspart of the money stockheld by thepublic.
4 Modem Money Mechanics
For individualbanks, reserveaccountsalso serveas
workingbalances? Banksmay increase the balancesin
their reserveaccountsby depositingchecksand proceeds
fromelectronicfundstransfersaswell ascurrency. Or
they may drawdown these balancesby writingcheckson
them orby authorizinga debitto them in paymentfor
currency,customers' checks,or otherfundstransfers.
Although reserveaccountsareused asworking
balances,eachbank must maintain,on the averageforthe
the ReserveBank andvaultcashwhich together areequal
to itsrequired reserves,asdeterminedby the amountof
itsdepositsin the reservecomputationperiod.
Where Do Bank Reserves Come From?
Increasesor decreasesin bank reservescanresult
froma number of factorsdiscussed later in thisbooklet.
From the standpointof moneycreation,however,the
essentialpoint isthat the reserves of banksare,forthe
most part, Wities of the Federal ReserveBanks,and net
changesin them arelargelydeterminedby actionsof the
Federal ReserveSystem. Thus,the FederalReserve,
through itsabiityto varyboth the totalvolume of reserves
and the required ratio of reservesto depositliabilities,
influencesbanks' decisionswith respectto their assetsand
deposits. One of the major responsibilitiesof the Federal
ReserveSystemisto providethe total amountof reserves
consistentwith the monetaryneeds of the economyat
reasonablystableprices. Suchactionstake intoconsider-
ation,of course,anychangesin the pace atwhich money
isbeingused and changesin the public's demandsfor
The reader shouldbe mindfulthat depositsand
reserves tend to expand simultaneouslyand thatthe Fed-
eral Reserve's controloften is exertedthroughthe market-
place asindividualbanksfind it eithercheaperor more
expensiveto obtaintheir required reserves,dependingon
the willingnessof the Fed to supportthe currentrate of
While an individualbank can obtain reservesby
biddingthem awayfromotherbanks, this cannotbe done
by the banking systemasawhole. Exceptfor reserves
borrowed temporarily from the Federal Reserve's discount
window, asis shownlater,the supplyof reservesin the
banking systemiscontrolledby the Federal Reserve.
Moreover,a givenincreasein bank reservesisnot
necessarilyaccompaniedby an expansionin money equal
to the theoreticalpotential based on the required ratio of
reservesto deposits. Whathappensto the quantityof
ZPartof an individual bank's reserve account may representits reserve
balanceused to meetits reserverequirementswhile anotherpart may be
its requiredclearingbalance on which earningscredits are generated to
pay for Federal Reserve Bank services.
money willvary, dependingupon thereactionsof the
banks andthe public. A numberof slippagesmay occur.
Whatamountof resmeswillbe drainedintothe public's
currencyholdings? Towhatextentwill the increase in
totalreservesremain unused asexcessreserves? How
much will be absorbedby depositsor otherliabiitiesnot
definedasmoneybut againstwhichbanksmight alsohave
to hold reserves? How sensitivearethe banksto policy
actionsof thecentralbank? The significanceof these
questionswillbe discussedlater in thisbooklet. The an-
swersindicatewhy changesinthe money supplymay be
differentthan expectedormay respond to policyaction
In the succeedingpages,the effectsof varioustrans-
actionsonthe quantityof money aredescribed and illus-
trated. Thebasic workingtool isthe Taccount, which
providesa simplemeans of tracing,stepby step,the effects
of these transactionson both the asset and liabity sidesof
bankbalance sheets. Changesin asset itemsareentered
on thelefthalf of the Tand changesin liabiitiesonthe
righthalf. For anyonetransaction,of course,there must
be atleasttwo entriesin orderto maintainthe equalityof
Bank Deposits-How l%ey Expand or Contract
Let us assumethat expansionin the money stockis
desiredby the FederalReserveto achieveitspolicy objec-
tives. Oneway the centralbank can initiate suchan expan-
sionisthrough purchasesof securitiesin the open market
Paymentforthe securitiesaddstobank reserves. Such
purchases (and sales) arecalled"open market operations."
How doopen market purchasesadd to bank reserves
and deposits? Supposethe Federal ReserveSystem,
through itstrading desk at the FederalReserveBank of
New York,buys$10,000of Treasurybillsfroma dealerin
U.S. governmentsecuritie~.~In today's world of computer-
ized financialtransactions,the FederalReserveBank
pays forthe securitieswith an "electronic"checkdrawn
on itself! Via its"Fedwire" transfer network, the Federal
Reserve notifiesthe dealer's designatedbank (BankA)
that payment for the securitiesshouldbe credited to (de-
posited in) the dealer'saccountat BankA At the same
time, BankA's reserveaccountatthe FederalReserve
iscreditedforthe amountof the securitiespurchase.
The FederalReserve Systemhas added $10,000of securi-
ties to itsassets,which ithas paid for,in effect, by creating
aliabilityonitself in the formof bank reservebalances.
These reserveson BankA's books arematchedby
$10,000of the dealer's depositsthat did not existbefore.
See illustration 1.
How the Multiple Expansion ProcessWorks
If the processendedhere,therewould be no "multi-
ple" expansion,i.e., depositsandbank reserveswould
havechangedby the sameamount However,banksare
requiredto maintainreservesequalto onlya fraction of
their deposits. Reservesin excessof this amountmaybe
used to increase earningassets-loansand investments.
Unused orexcessreservesearnno interest Undercurrent
regulations,the reserverequirementagainstmost transac-
tion accountsis 10percent5 Assuming,for simplicity,a
uniform 10percent reserverequirementagainstalltransac-
tion deposits,andfurther assumingthat allbanksattempt
to remain fullyinvested,we cannowtracethe processof
expansionin depositswhich can take place on the basisof
the additionalreservesprovided by the Federal Reserve
System's purchaseof U.S. governmentsecurities.
Theexpansionprocessmay ormay not begin with
BankA, dependingonwhat the dealerdoeswith the mon-
eyreceivedfromthe saleof securities. If the dealerimme-
diatelywriteschecksfor$10,000and allof them are
depositedin otherbanks, BankAlosesboth depositsand
reservesand showsno net changeasa result of the Sys-
tem's openmarketpurchase. However,otherbankshave
receivedthem. Mostlikely,a part of the initialdepositwill
remain with BankA, and a partwillbe shifted to other
banks asthe dealer'schecksclear.
6 Modem Money Mechanics
It doesnot reallymatterwherethismoney is atany
giventime. The importantfactisthat thesedeposits do not
disappear. Theyarein somedepositaccountsatalltimes.
All bankstogether have $10,000of depositsand reserves
thatthey did nothave before. However,they arenot
requiredto keep $10,000of reservesagainstthe $10,000
of deposits. All they need to retain,under a 10percent
resenrerequirement, is$1,000. The remaining$9,000is
"excessreserves." Thisamountcan be loaned or invested.
See illustration 2.
If businessisactive,the bankswith excessreserves
probablywillhave opportunitiesto loan the $9,000. Of
course,they donot reallypay outloansfromthe money
theyreceiveasdeposits. If they did this,no additional
moneywould be created. Whatthey dowhen they make
loansisto acceptpromissorynotesin exchangeforcredits
to the borrowers' transactionaccounts. Loans (assets)
anddeposits (liabilities) both riseby $9,000. Reservesare
unchanged by the loan transactions. Butthe depositcred-
itsconstitutenewadditionsto the totaldepositsof the
banking system. See illustration 3.
3Dollaramountsused in the variousillustrationsdo not necessarilybear
any resemblancetoactualtransactions. Forexample,openmarketopera-
tions typically are conductedwith many dealers and in amountstotaling
check. Apart from the timing of posting, the accounting entries are the
samewhetheratransferismadewith apapercheckorelectronically. The
term "check,"therefore,is usedfor both typesof transfers.
SForeachbank, the reserverequirementis 3 percent on a specifiedbase
amountof transactionaccountsand 10percent on the amountabovethis
"low reserve tranche"-at $25 million, and provided for it to change
reserve tranchewas $41.1million in 1991and $42.2millionin 1992. The
Garn-St Germain Act of 1982 further modiied these requirements by
in 1991and $3.6millionin 1992.
Thecustomerdepositat Bank A likely will be transfeerred,in part, to otherbanks and quickly loses its identity amid the huge
When the FederalReserveBankpurchasesgovernmentsecurities,bank reservesincrease. Thishappens
becausethe sellerof the securitiesreceivespaymentthrough a creditto a designateddeposit account
ata bank (BankA) which the FederalReserveeffectsby creditingthe reserve account of BankA
Assets Liabilities Assets Liabilities
securities + 10,000
Expansion takesplace onlyif the banksthat hold
these excessreserves (Stage1banks) increase
I their loansorinvestments. Loansaremade by Assets Liabilities
Reserve accounts: Reserveswith
Bank A + 10,000 W F.R. Banks + 10,000
ASa result, allbankstaken togethernow have Total reservesgainedfrom new deposits ..................... 10.000
"excess"reservesonwhich depositexpansion less: Requiredagainstnew deposits
can take place. (at 10 percent)........................................ 1,000
equals Excessreserves ................................................ 9,000
crediting the borrower's deposit account, i.e.,
by creatingadditionaldeposit money.
deposit + 10,000
Deposit Expansion and Contraction
Loans + 9,000
deposits + 9,000
ntisisthe beginningof the dejPosit expansionpmcess.
In thefirst stageof the process, totalloansand depositsof
the banksrise by an amountequalto the excessreserves
existingbefore anyloanswere made (90percent of the
initialdepositincrease). At the end of Stage 1,deposits
have risen a total of $19,000 (theinitial$10,000provided
by the FederalReserve's action plus the $9,000in deposits
createdby Stage1banks). See illustration 4. However,
only$900 (10percent of $9,OOO) of excessreserveshave
been absorbedby the additionaldepositgrowth at Stage 1
banks. See illustration 5.
Thelendingbanks,however, donot expectto retain
the depositstheycreatethrough theirloan operations.
Borrowerswrite checksthatprobablywillbe depositedin
otherbanks. As thesechecksmovethroughthe collection
process,the FederalReserveBanks debitthe reserve
accountsof thepayingbanks (Stage 1banks) and credit
those of the receivingbanks. See illustration 6.
Whether Stage1banks actually dolosethe deposits
to otherbanks orwhetheranyor allof theborrowers'
checksareredepositedin thesesame banksmakesno
differencein the expansionprocess. If thelendingbanks
expect to losethese deposits-and an equalamountof
reserves-asthe borrowers' checksarepaid,theywill not
lend more than theirexcessreserves. Likethe original
$10,000deposit,the loanaeated depositsmaybetrans
ferred to otherbanks, but they remain somewherein the
banking system. Whicheverbanksreceivethem also
acquireequalamountsof reserves,of which allbut 10
Assuming thatthe banksholdingthe $9,000of d e
posits created in Stage1in turn makeloansequalto their
excessreserves,then loansand depositswill rise by a
further$8,100in the secondstage of expansion. This
processcan continueuntil depositshave risen to the point
whereallthe reservesprovided by the initialpurchaseof
governmentsecuritiesby the Federal ReserveSystemare
just sufficientto satisfyreserverequirementsagainstthe
newly created deposits. (Seepages 10and 1I.)
Theindividualbank, of course,isnot concerned as
to the stagesof expansionin which itmay be participating.
Mows and outflowsof depositsoccurcontinuously. Any
depositreceived isnew money,regardlessof itsultimate
source. Butif bank policyisto makeloansand invest-
ments equaltowhatever reservesarein excessof legal
requirements,the expansionprocesswill be carriedon.
How Much Can Deposits Expand
in the Banking System?
Thetotalamountof expansionthat cantakeplace
is illustrated onpage 11. Carriedthrough to theoretical
limits,the initial$10,000of reserves distributedwithinthe
banking systemgivesrise to an expansion of $90,000in
bank credit (loans and investments) and supportsa total of
$100,000in new depositsunder a 10percent reserver e
quirement. The depositexpansionfactorfor a given
8 Modern Monqr Mechanics
amountof new reservesisthus the reciprocal of the r e
quiredreservepercentage (1/.10 = 10). Loan expansion
willbe lessby the amountof the initialinjection. Themulti-
ple expansionispossible becausethe banksasa group
arelike onelargebank inwhich checks drawnagainst
borrowers' depositsresult in creditsto accountsof other
depositors,with no net changein total reserves.
Expansion through Bank Investments
aswell asloans. Supposethatthe demandforloansat
someStage 1banks isslack Thesebankswould then
probablypurchasesecurities. If the sellersof the securities
were customers,the bankswould makepaymentby credit-
ingthe customers'transaction accounts;depositliabiities
would risejust asif loanshad been made. Morelikely,
thesebankswould purchasethe securitiesthrough deal-
ers,paying forthem with checkson themselvesor ontheir
reserveaccounts. Thesecheckswould be depositedin
the sellers'banks. In eithercase,the net effectsonthe
banking systemareidenticalwith those resultingfrom
As a result of theprocess sofar, totalassetsand
totalliabiitiesof allbankstogetherhave risen
F.R. Banks + 10,000
Loans + 9,000
Total + 19.000
Initial + 10,000
Excessreserveshave been reduced by the Total reservesgainedfrom initialdeposii............................ 10,000
.............amountrequiredagainstthe depositscreated less: Requiredagainstinitialdeposits 1,000
............ ......by the loansmade in Stage 1. lets: RequiredagainstStage I deposits 900 1,900
eq& Excess reserves........................................................ 8,100
and depositswhentheystill have excessreserves?
accountsatthe lendingbanks. As these checks
I I are depositedin thepayees' banksand cleared, Assets Liabilities
the depositscreatedby Stage 1loansand an Reservesv
equalamountof reservesmay be transferred
Deposit expansion hasjust begun!
deposits - 9,000
Assets Liabilities Assets Liabilities
Deposit Erpansionand Contmctwn 9
Stage I banks - 9,000 2 F . R . Banks + 9,000
Other banks + 9,000
Deposits + 9,000
amount, creditingborrowers' depositaccounts Assets Liabilities
in the process, thus creatingstillmore money.
Loans + 8,100
have risen by 27,100.
..........................Butthere arestill7,290of excessreservesin the Total reservesgainedfrom initialdeposits 10,000
............bankingsystem. less: Requiredagainst initialdeposits 1,000
less: Requiredagainst Stage I deposii............ 900
less: Requiredagainst Stage2 deposits ............ 810.... a
It should be understood that thestages ofexpansionoccurneithersimultaneously nor in
thesequence demibed above. Some banks use theirresmes incompletelyor only aftera
considerable time lag, whileothersexpand assetson the basis of expected resemegrowth.
m eprocess is, infact,continuousand may neverreach its theoretical limits.
deposits + 8,100
F.R Banks + 10,000
Stage I + 9,000
Stage 2 + 8,100
Total + 27,100
......................................................eq& Excessreserves 7,290
10 1 Modem M m q Mahatub
Initial + 10,000
Stage I + 9,000
Stage 2 + 8,100
Total + 27,100
As borrowersmake payments,these reserveswill be furtherdispersed,andthe processcan continuethrough
manymore stages,in progressivelysmallerincrements,until the entire 10,000of reserveshave been absorbed
by depositgrowth. Asisapparentfromthe summarytableonpage 11,more than tw&hiidsof the deposit
expansionpotential isreached afterthe firstten stages.
How Open Market Sales Reduce Bank Reserves
Now supposesomereductionin the amountof
money isdesired. Nonnally thiswould reflecttemporary
or seasonalreductionsin activityto be hawed since,on
ayear-to-yearbasis, agrowing economyneeds atleast
somemonetary expansion. Just aspurchasesof govern-
ment securitiesby the pederal ReserveSystemcan pre
vide thebasisfor depositexpansionby addingto bank
reserves, salesof securitiesby the Federal ReserveSystem
reduce the money stockby absorbingbank reserves. The
processisessentiallythe reverseof the expansionsteps
Treasuryb i s to a U.S. governmentsecuritiesdealerand
A Asthispaymentismade,BankA's reserveaccountat
a FederalReserveBank isreduced by $10,000. As a result,
the FederalReserveSystem's holdingsof securitiesand
the reserve accountsof banks areboth reduced $10,000.
The$10,000reductionin BankA's depositliabilitiesconsti-
tutes a declinein the money stock. Seeillustration 11.
Contraction Also Is a Cumulative Process
While BankA mayhave regainedpart of the initial
reduction in depositsfromotherbanksasa result of inter-
bank depositflows,allbankstaken togetherhave $10,000
lessin both depositsand reservesthan they had before
the FederalReserve's salesof securities. The amountof
reservesfreed by the declinein deposits,however,isonly
$1,000(10percent of $10,000). Unless thebanksthatlose
the reservesand depositshad excessreserves,they are
leftwith a reserve deficiencyof $9,000. See illustration 12.
Although they mayborrow fromthe Federal Reserve
Banksto coverthis deficiencytemporarily,soonerorlater
the bankswill have to obtainthe necessary reservesin
someotherway or reducetheir needsfor reserves.
Oneway for a bank to obtainthe reservesit needs
isby sellingsecurities. But, asthe buyersof the securities
pay forthemwith fundsin their depositaccountsin the
sameor otherbanks, the net result isa $9,000declinein
securitiesand depositsat allbanks. See illustration 13.
At the end of Stage 1of the contractionprocess, deposits
have been reduced by a totalof $19,000 (theinitial $10,000
resultingfrom the Federal Reserve's action plus the $9,000
in depositsextinguishedby securitiessalesof Stage 1
banks). See illustration 14.
However,thereisnowa reservedeficiencyof $8,100
atbankswhose depositorsdrewdown their accountsto
purchasethe securitiesfrom Stage 1banks. Asthe new
groupof reservedeficientbanks,in turn,makesup this
deficiencyby sellingsecuritiesor reducingloans,further
depositsandloansor investmentsin one stageafteranoth-
er until total depositshave been reduced to the point
12 / Modem MoneyMnhanics
wherethe smallervolume of reserves isadequateto sup
port them. The contractionmultipleisthe sameasthat
which appliesin the caseof expansion. Under a 10percent
reserverequirement,a $10,000reductionin reserveswould
ultimatelyentailreductions of $100,000in depositsand
As in the caseof depositexpansion,contractionof
bank depositsmay take place as a result of eithersalesof
securitiesorreductions of loans. While someadjustments
of both kinds undoubtedlywould be made,the initialim-
pactprobablywould be reflectedin salesof government
securities. Mosttypes of outstandingloanscannotbe
calledforpayment prior to their due dates. Butthe bank
may ceaseto make newloansor refuse to renewoutstand-
ingonesto replacethosecurrentlymaturing. Thus,depos
itsbuilt up by borrowersfor the purposeof loan retirement
would be extinguished asloanswere repaid.
There is oneimportantdifferencebetween the expan-
sion and contractionprocesses. Whenthe FederalReserve
Systemaddsto bank reserves,expansionof creditand
depositsmay take place up to the limitspermittedby the
minimum reserveratio that banksarerequired to maintain.
Butwhen the Systemactsto reducethe amountof bank
reserves,contractionof creditand depositsmust takeplace
(exceptto the extentthat existingexcessreserve balances
and/or surplusvaultcash areutilized) to the pointwhere
the required ratio of reserves to depositsisrestored. But
the signi6canceof this difference shouldnot be overempha-
sized. Becauseexcessreservebalancesdonot earninter-
est, there isa strongincentiveto convertthem into earning
assets (loansand investments).
Assets Liabilities Liabilities
U.S. government Reserve accounts: Reserveswith
securities -10,000 BankA - 10,000 W F . R Banks - 10,000 deposit - 10,000
When the Federal Reserve Bank sellsgovernment securities,bank reservesdecline. This happens because the buyer
of the securitiesmakespayment through a debitto a designated depositaccountat a bank (BankA),with the transferof
fundsbeing effectedby a debitto BankA's reserveaccountat the Federal Reserve Bank.
lXisreduction in the customerdepositat Bank A may be spread among a numberof banks throughhtedank depositflows
The bankswith the reservedeficiencies (Stage 1
banks) cansellgovernmentsecuritiesto acauire
1 I reserves,but thiscauses a declinein the debsits &sets Liabilities
The loss of reservesmeansthat allbanks taken Total reserveslostfrom deposawithdrawal...................... 10,000
together now have a reservedeficiency. less Reservesfreed bydeposiidecline
(at 10 percent) ..................................................... 1,000
equals Mciency in reservesagainst remainingdepostts. 9,000
and reservesof the buyers' banks. U.S. government
securities - 9,000
As a resultof the processsofar, assets and total
depositsof allbankstogether havedeclined 19,000.
Assets Liabilities Assets Liabilities
Stage 1contractionhas freed 900of reserves,but Liabilities
there is stilla reservedeficiencyof 8,100. Reserveswith Deposits:
US.government Stage I
Total - 19.000
Reserve accounts: Reserveswith
Stage I banks + 9,000 9 F . R . Banks - 9,000
Other banks - 9,000
I Futthncontractionmust take#lace!
Deposits - 9,000
Deposit E*palrtion and Contraction 13
Bank Reserves-How l%eyChange
Moneyhas been detined asthe sum of transaction
accountsin depositoryinstitutions,and currencyandtrav-
elerschecksin the hands of the public. Currencyis some
thingalmosteveryoneuses everyday. Therefore,when
mostpeoplet h i i of money,theythink of currency. Con-
traryto this popular impression,however,tmtlsactiolr
depositsarethe most signiscantpart of the moneystock
Peoplekeep enoughcurrencyon hand to effect smallface
teface transactions,but theywrite checksto covermost
largeexpenditures. Most businessesprobablyhold even
smalleramountsof currencyin relationto theirtotaltrans
actionsthan do individuals.
Sincethe mostimportantcomponentof moneyis
transactiondeposits,and sincethese depositsmustbe sup
ported by reserves,the centralbank's influenceovermon-
eyhingeson itscontroloverthe totalamountof reserves
and the conditionsunderwhich bankscan obtain them.
The preceding illustrationsof the expansionand
contractionprocesseshave demonstratedhow the central
bank, by purchasing and sellinggovernmentsecurities,
can deliberatelychangeaggregatebank reservesin order
to affectdeposits. But open market operationsare only
one of a number of kinds of transactionsor developments
that causechangesin reserves. Somechangesoriginate
from actionstakenby the public,by theTreasuryDepart-
ment, by the banks, orby foreign andinternationalinstitu-
tions. Otherchangesarisefromthe servicefunctionsand
operatingneedsof the Reserve Banksthemselves.
Thevariousfactorsthat provide and absorbbank
reserve balances,togetherwith symbolsindicatingthe
effectsof these developments,arelistedonthe opposite
page. Thistabulation alsoindicatesthe nature of the bal-
ancingentriesonthe Federal Reserve's books. Co the
extentthat the impactisabsorbedby changesinbanks'
vaultcash,the Federal Reserve's books are unaffected.)
Independent FadorsVersus PolicyAction
It isapparentthat bank reservesare affectedin sev-
eralways thatare independentof the controlof the central
bank. Most of these "independent?elementsare changing
more orlesscontinually. Sometimestheir effectsmay last
only a day or twobeforebeiig reversed automatically.
Thishappens,forinstance,when bad weatherslowsup the
checkcollectionprocess,givingrise to an automaticin-
creasein Federal Reserve creditin the form of "float."
Otherinfluences,suchaschangesin the public's currency
holdings,may persistforlongerperiodsof time.
Stillothervariationsin bank reservesresult solely
from the mechanicsof institutionalarrangementsamong
theTreasury,the FederalReserveBanks,and the deposi-
tory institutions. TheTreasury,for example,keepspart of
itsoperatingcash balanceon depositwith banks. But
virtually all disbursementsare made from itsbalancein
I4 I Modern Money Mechanics
the ReserveBanks. As is shownlater, anybuildupin bal-
ancesatthe ReserveBanksprior to expenditureby the
Treasurycausesa dollar-fordollardrainon bank reserves.
In contrastto these independentelementsthat affect
reservesare the policy actionstaken by the Federal Re
serveSystem. Theway Systemopen market purchases and
salesof securitiesaffectreserveshas alreadybeen d e
scribed. In addition,there are two otherwaysin which the
Systemcanaffectbank reservesand potentialdepositvol-
ume directly:first,through loansto depositoryinstitutions;
and second,through changesin reserve requirementper-
centages. A changein the required reserveratio,of course,
doesnot alterthe dollarvolume of reserves directlybut
doeschangethe amount of depositsthat a givenamount of
Any changein reserves,regardlessof itsorigin,has
the samepotentialto affect deposits. Therefore,in orderto
achievethe net reserve effectsconsistentwith itsmonetary
policy objectives,the FederalReserveSystemcontinuously
must take accountof what the independentfactorsare
doingto reservesand then,using itspolicytools,offsetor
supplementthem asthe situationmay require.
By farthe largestnumber and amount of the Sys
tern's gross open markettransactionsare undertaken to
offset drainsfrom or additionsto bank reservesfrom non-
changesin creditavailabiity. In addition,Federal Reserve
purchasesand/or salesof securitiesare madeto provide
the reservesneeded to supportthe rate of moneygrowth
consistentwith monetary policy objectives.
In this section of the booklet, severalkindsof trans-
actionsthat canhave importantweek-to-weekeffectson
bank reservesare traced in detail. Other factorsthat nor-
mallyhave onlya smallinfluenceare describedbrieflyon
Facton ChangingReserve Balances-lndefiendent and
....................................................................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) o r 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 balancesthrough
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
Changesin theAmount of
CuvmcyHeld by thePublic
Changesin the amountof currencyheld by the
public typicallyfollowa fairlyregularintramonthlypattern.
Majorchangesalsooccur overholidayperiods and during
the Christmasshoppingseason-timeswhen peoplefind
itconvenientto keep more pocketmoney onhand. (See
chart.) Thepublic acquirescurrencyfrombanksby cash-
ingchecks6 When deposits,which arefractionalreserve
money,areexchangedfor currency,which is 100percent
reserve money,thebanking systemexperiencesa net
reserve drain. Under the assumed 10percent reserve
requirement,agivenamountof bank reservescan support
depositsten times asgreat,but when drawnupon to meet
currencydemand,the exchangeisoneto one. A $1in-
creasein currencyusesup $1of reserves.
Supposea bank customercashed a $100checkto
obtaincurrencyneeded for aweekend holiday. Bank
depositsdecline$100becausethe customerpaysfor the
currencywith a checkonhis orher transactiondeposit;
and thebank'scurrency (vaultcash reserves) isalso r e
duced $100. See illustration 15.
Now the bank has lesscurrency. It may replenish
serveBank -makingpaymentby authorizinga charge
to itsreserve account. Onthe ReserveBank's books,the
chargeagainstthe bank'sreserveaccountisoffsetby an
increasein theliabilityitem "FederalReservenotes." See
illustration 16. The ReserveBank shipmentto thebank
mightconsist,atleastin part, of US. coinsratherthan
FederalReserve notes. All coins,aswell asa smallamount
of paper currencystilloutstandingbut no longerissued,
are obligationsof theTreasury. Tothe extentthat ship
ments of cash to banksarein the formof coin,the offset-
ting entryon the ReserveBank's books isa declinein its
Thepublic nowhas the samevolumeof money as
before,exceptthat more isin the formof currency and
lessis in the form of transactiondeposits. Under a 10
percent reserve requirement,the amountof reservesre-
quired againstthe $100of depositswas only$10,while a
full$100of reserveshave been drainedawayby the dis
bursement of $100in currency. Thus,if the bank had no
excessreserves,the $100withdrawalin currencycausesa
reserve deficiencyof $90. Unlessnewreservesarepro-
videdfrom someother source,bank assetsand deposits
will haveto be reduced (accordingto the contractionpro-
cessdescribedon pages 12and 13)by an additional$900.
At thatpoint, the reservedeficiencycaused by the cash
withdrawalwould be eliminated.
When CurrencyReturns to Banks, Reserves Rise
Afterholidayperiods,currencyreturnsto the banks.
Thecustomerwho casheda checkto coveranticipated
held thafs beyond normal pocketmoney needs. Most of it
16 / Modern Money Mechanb
Currency heldby the public
weekly averages, billions of dollars, not seasonally adjusted
probablywill have changedhands, and itwill be deposited
by operatorsof motels,gasoline stations,restaurants,and
retail stores. Thisprocessisexactlythe reverseof the
isreturned may not be the samebanks thatpaid itout.
But in the aggregate,the banksgain reservesas 100
percentreserve money isconvertedback intofractional
When $100of currencyisreturned to the banks,
depositsandvaultcash are increased. See illustration 1Z
Thebanks cankeep the currencyasvaultcash,which also
countsasreserves. Morelikely,the currencywill be
shippedto the ReserveBanks. The ReserveBankscredit
bank reserve accountsand reduce Federal Reservenote
liabiities. See illustration 18. Sice only$10must be held
againstthe new$100in deposits,$90isexcessreserves
and cangiverise to $900of additionaldeposits.
To avoidmultiplecontractionor expansionof deposit
money merely becausethe public wishesto changethe
compositionofitsmoneyholdings,the effectsof changes
in the public's currencyholdings on bank reservesnor-
mally areoffsetby System open marketoperations.
6Thesame balance sheet entries applywhether the individualphysically
cashesapapercheckorobtainscurrencybywithdrawingcashthrough an- -
'Under current reserve accounting regulations,vault cash reserves are
used tosatisfyreserverequirements inafuturemaintenanceperiodwhile
reserve balances sati* requirements in the currentperiod. As a result,
theimpactonabank's currentreservepositionmaydifferfromthat shown
unless the bank restores its vault cash position in the current period via
changes in its reserve balance.
When a depositorcashesa check,both
depositsandvaultcash reserves decline.
I Assets Liabilities
Assets Liabilities Assets Liabilities
Reserve accounts: Vault cash +I00
Bank A Reserveswith
F.R. notes +I00 F.R. Banks - 100
When currencycomesback to the banks, both
If the bank replenishesitsvaultcash,itsaccountat the ReserveBank is drawn downin exchangefornotes
issued by the Federal Reserve.
If the currencyisreturned to the Federal Reserve,reserveaccountsarecredited and Federal Reserve
notes aretaken outof circulation.
Assets Liabilities Assets
Vault cash - 100
FA. notes F.R. Banks +I00
FactorsAfecting Bark Reserues 17
Changesin US. Treasury
Depositsin Federal Bank
tutethe bulk of the depositliabilitiesof the FederalRe-
serveSystem. Otherinstitutions,however,alsom & ~ n
balancesin the Federal ReserveBanks-mainly the U.S.
Treasury,foreigncentralbanks, and internationalhancial
institutions. In general,when these balances rise, bank
reserves fall,and viceversa. 'I'his occursbecausethe
fundsu se agenciesto build up their depositsin
the Res s ultimatelycomefrom depositsin
banks. Gonvemly,recipientsof paymentsfrom these
agenciesnormallydepositthe fundsin banks.
the collectionprocessthese banks receivecre
rtant nonbank depositoristhe US.
Treasury. Partof theTreasury's ope
iskeptin the Federal ReserveBanks,
depositoryinstitutionsalloverthe counm,in d l e d
'Treasury tax andloan" m&L) note accounts.
a&) Disbursementsby theTreasury,h
madeagainstitsbalances atthe Federal Reserve. Thus,
transfersfrombanks to Federal ReserveBanks are made
assurethat sufficientfundsare availableto coverTreasury
checksasthey arepresented for payment8
the banksby the fullamountofthe transferasfundsmove
frorntheTT&Lbalances (Via chargesto bank reserve
accounts)toTreasurybalances at the ReserveBanks.
Becausereservesare not required againstTT&Lnote
accounts,these transfers do not reducerequired reserves?
SupposeaTreasurycallpayableby BankA amounts
to $1,000. The Federal Reserve Banksare authorized to
transfer the amountof theTreasurycallfromBankA's
reserve accountatthe FederalReserve to the account of
the U.S. Treasuryatthe FederalReseme. As a result of
the transfer,both reservesandTT&Lnotebalancesof the
bank arereduced. On the books of the ReserveBank,
bank reserves declineandTreasurydepositsrise.
causea reserve deficiencyof $1,000sinceno resemes are
releasedby the declineinlT&Lnote accountsatdeposi-
As theTreasurymakes expenditures,checksh w n
on itsbalancesin the ReserveBanksare paid tothe public,
andthese fundsiindtheirway back to banksin the form of
deposits. The banks receive reserve creditequalbthe full
amountof these depositsalthoughthe corresponding
increasein theirrequired reservesis only 10percent of
-- ---- -- - -- --
Operatingcash balanceof the US. Treasury
weekly averages, billions of dollars, not seasonally adjusted
Supposea governmentemployeedepositsa $1,000
checkin Bankk The bank sendsthe checkto
itsFederalReserveBankfor collection. The Reserve Bank
then creditsBankATsreserve accountand chargesthe
Treasury's account. As a result, thebank gainsboth re-
servesand deposits. Whilethere is no changein the as-
setsortotalliabilitiesof the Reserve Banks,the funds
drawn awayfrom theTreasury's balances havebeen shift-
ed to bank reserve accounts.
One of the objectivesof theTT&Lnoteprogram,
which requiresdepositoryinstitutionsthatwant to hold
Treasuryfundsfor more than onedayto pay intereston
them,isto allowtheTreasuryto hold itsbalanceatthe
ReserveBanksto the minimum consistentwith current
paymentneeds. By mainMng a fairlyconsmt balance,
largedrainsfrom oradditionsto bank reservesfromwide
swingsin theTreasury's balancethat would requireexten-
siveoffsettingopenmarket operationscan be avoided.
Nevertheless,there are stillperiodswhen these fluctua-
tionshave large reserveeffects. In 1991,forexample,
Banks averaged only$56million,but ranged from"$4.15
biion to +$8.57billion.
payment needs, the Treasury m y place the excess funds in lT&L note
accountslfirough a "direct investment." The accountingentries are the
same, but of opposite signs,as those shown when funds are transferred
from'lT&L note accountstoTreasurydeposits atthe Fed.
ies initially are credited to reservable demand deposits due to the U.S.
govement. Becausesuch tax paymentstypicallycomefrom reservable
transactionaccounts,required reservesarenot materiallyaffectedon this
in a nonreservable note account or remitted to the Federal Reserve for
creditto theTreasury'sbalanceatthe Fed, required reservesdecline.
Liabilities Assets Liabilities
When theTreasurybuildsupitsdepositsat the Federal Reservethrough"calls"on?T&L notebalances,
Reserve accounts: Reserveswith
Bank A - 1.000 f---,F.R Banks
Treasury tax and
loan note account - 1,000
Liabilities Assets Liabilities
Reserve accounts: Reserveswith
Bank A +1.000UF.R. Banks
deposits - 1.000
Checkswrittenon theTreasury's accountatthe Federal ReserveBank aredepositedin banks. As these are
collected,banksreceivecreditto theirreserveaccountsatthe Federal ReserveBanks.
FactonMeetingBank RCSCNCS 19
Changesilz Federal Reseme Float
Alargeproportionof checksdrawnonbanks and
depositedin otherbanksiscleared (collected)through the
Federal ReserveBanks. Someof thesechecksarecredit-
ed immediatelytotheresem accountsof the depositing
b& and arecollectedthe samedayby debitingthe
reserve accountsof the banksonwhichthe checksare
drawn. All checksarecreditedto theaccountsof the
relatedtothe timeitnormallytakesthe FederalReserveto
collectthe checks,but rarelymore thantwobusiness days
aftertheyarereceived atthe ReserveBanks,eventhough
they may notyethavebeen collected dueto processing,
mspomtion, or otherdelays.
isincludedin FederalResenre Onthe booksof
the FederalReserveBanks,balance sheetfloat, orstate-
tweenthe asset account"itemsin processof collection,"
andthe liabiityaccount"deferredcredititems." State-
mentfloatisusuallypositive sinceitismore oftenthecase
thatreserve creditisgivenbeforethe checksareactually
collectedthan the otherwayaround.
on a"reserves-fadof' frameworkratherthan abalance
sheetaccountingkamework. Aspublished,Federal Re-
wellasfloat-related"as-of' adjustments." Theseadjust-
cessingtransactionsrelated to Federal Reservepriced
services. As-ofadjustmentsdonot changethebalance
sheetsof eitherthe Federal ReserveBanksoran individ-
ualbank. Rather they arecorrectionstothe bank'sreserve
position,thereby affectingthe calculationof whether or
An Increase in Federal Reserve
Asfloatrises, totalbank reservesrise by the same
amount. For example,supposeBankAreceiveschecks
totaling$100drawnon BanksB, C,and D, allin distant
cities. BankAincreasesthe accountsof itsdepositors
$100,and sendsthe itemsto aFederalReserveBankfor
collection. Upon receipt of the checks,the ReserveBank
increasesitsownassetaccount"itemsin processof collec-
items" (checksand other itemsnotyet creditedta the
sendingbanks' reserveaccounts). Aslongasthesetwo
accountsmove together,there isno changein floator in
totalreservesfromthis source. See illustmtiotz21.
On the next businessday (assumingBanksB, C,
and D are oneday deferred availabilitypoints), the Re-
serveBankpaysBankA. The ReserreBank's "deferred
credititems"accountisreduced,and BankA's reserve
accountisincreased $100. If theseitemsactuallytake
morethan onebusinessdayto collectsothat "items in
10 / Modem Momy Mechanics
FederalReservefloat (includingas-of adjustments)
annual averages, billions of dollars
processof collection*arenot reducedthat day,the credit
to BankA representsan addition to totalbank reserves
sincethe reserveaccountsof BanksB, C,and Dwillnot
havebeen commensmtelyreduced.= See iEZusl.ration22.
A Decline in Fed Reserve Float Reduces
Onlywhen the checksareactuallycollectedfrom
BanksB, C,and D doesthe floatinvolvedin the aboveex-
ampledisappear-"items in processof collectioni'of the
Reserve Bank declineasthe reserveaccountsof BanksB,
C,and D are reduced. See illustration23.
declineddramaticallyfrom 1979through 1984,in part
reflectingactionstaken to implementprovisionsof the
MonetaryControlAct that directedthe Federal Reserveto
reduce andpricefloat. (Set: chant.) Since1984,Federal
Reservefloathas been fairlystableon anannualaverage
basis,but oftenfluctuatessharplyover shortperiods.
From the standpointof the effectonbank reserves,the
volumechangesin a difticdt-to-predictway. Floatcan
by oneswhere actualcollectionsexceed newitemsbeing
received for collection. Thus,reservesgainedfromfloat
'"Federal Reserve float also arises from other funds transfer sentices
provided by the Fed, such as wire transfers, securities transfers, and
day deferred availability,then neitherstatementfloatnor reserveswould
increase,although both should. BankA's reservepositionandpublished
Items in process
of collection +I00
When a bank receives depositsin the formof checksdrawn onotherbanks, itcan send them to the Federal
ReserveBank for collection. (Required reserves arenot affected immediatelybecauserequirementsapplyto
net transactionaccounts,i.e., total transactionaccountsminus both cash itemsin processof collectionand
Liabilities Assets Liabilities
Deferred Cash items in
credit items +I00 process
of collection +I00
Deferred Cash items in
credit items -100 processof
Reserve accounts: collection - 100
Bank A Reserves with
F.R. Banks +I00
Ifthe reserveaccountofthe payee bank iscreditedbeforethe reserveaccountsof the payingbanksaredebited,
Items in process
of collection - 100
But upon actualcollectionof the items,accountsof the payingbanks arecharged,andtotalreservesdecline.
Liabilities Assets Liabilities
Facton qdFectingBank R-LS 21
In orderto fostera safeand efficientpaymentssystem,
the Federal Reserve offersbanksavarietyof paymentsser-
vices, Priorto passage of the Monetary ControlAct in 1980,
the Federal Reserve offeredits servicesfree,but onlyto
banksthat were membersof the Federal ReserveSystem.
TheMonetaryControlAct directed the Federal Reserveto
offeritsservicesto alldepositoryinstitutions,to chargefor
these services,and to reduceandprice FederalReserve
float.13 Except forfloat,allservicescovered by theActwere
pricedby the end of 1982. Implementationof floatpricing
essentiallywascompleted in 1983.
Theadvent of FederalReservepriced servicesled
to severalchangesthat affectthe use of fundsin banks' re-
serveaccounts. As a result,onlypart of the totalbalancesin
bank reserve accountsisidentifiedas"reservebalances"
availableto meet reserverequirements. Otherbalancesheld
in reserveaccountsrepresent "service-relatedbalancesand
adjustments (tocompensateforfloat)." Service-relatedbal-
ancesare"requiredclearingbalances"held by banksthat use
ancesheld by banksthatpay for floatwith as-of adjustments.
An Increase in Required Clearing B b c e s
Reduces Reserve Balances
Proceduresfor establishingand maintainingclearing
balances were approvedby the Board of Governorsof the
FederalReserve Systemin February 1981. Abank may be
requiredto hold a clearingbalanceif ithas no required re-
servebalance or if itsrequired reservebalance (held to satis-
fy reserverequirements) isnotlargeenoughto handle its
volumeof clearings. Tmicallya bank holdsboth reservebal-
ancesandrequired clearingbalancesin the samereserve
account. Thus,asrequired clearingbalancesareestablished
or increased,theamountof fundsin reserveaccountsidenti-
SupposeBankAwants to use FederalReserve services
but has a reserve balance requirementthatislessthan its
expected operatingneeds. With itsReserveBank,it isdeter-
mined that Bank Amust maintain a required clearingbalance
of $1,000. If BankA has no excessreservebalance, itwill
have to obtainfundsfrom someother source. Bank Acould
sell$1,000of securities,but thiswill reducethe amountof
totalbank reservebalancesand deposits. See illrkstration24.
Banksarebilled eachmonthfor the Federal Reserve
servicesthey have used with paymentcollected ona speci-
fieddaythe followingmonth. All requiredclearingbalances
held generate"earningscredits"which canbe used onlyto
offsetchargesfor FederalReserve services.14Alternatively,
bankscanpay for servicesthrough a directchargeto their
reserve accounts. If accrued earningscreditsare used to pay
for services,then reservebalancesareunaffected. On the
otherhand,if paymentfor servicestakesthe form of a direct
chargeto thebank's reserveaccount,then reservebalances
decline. See illustrafian25.
22 Mudai Money M~ckanlo
Service-relatedbalances and adjustments
weekly averages, billions of dollars, not seasonally adjusted
-Of Adjushents Reduce
In 1983,the Federal Reservebegan pricing explicitly
generated by checksdepositedby a bank servedby oneRe-
serveBank but h w n ona bank servedby anotherReserve
Bank. The depositingbank has three optionsin payingfor
interterritorycheckfloatitgenerates. It can use itsearnings
credits,authorizea direct charge to itsreserveaccount,or
payfor the floatwith an as-of adjustment. If eitherof the first
two optionsischosen,the accountingentriesarethe sameas
payingfor otherpriced services. If the as-of adjustmento p
tion ischosen,however,the balance sheetsof the Reserve
Banksand the bank arenot directlyaffected. In effectwhat
happensisthatpart of the total balancesheld in thebank's
reserveaccountisidentifiedasbeing held to compensatethe
Federal Reserveforfloat. Thispart, then,cannotbe used to
quirements. Floatpricingas-ofadjustmentsareapplied two
weeks afterthe related floatisgenerated. Thus, an individual
bank has sufticienttime to obtain fundsfrom other sourcesin
orderto avoid anyreserve deficienciesthatmightresult from
floatpricingas-of adjustments, If allbankstogetherhave no
excessreserves,however,thefloatpricing as-of adjustments
lead to a declinein totalbank reservebalances.
adjustmentscan bevolatile,primarily reflecting adjustments
to compensateforfloat. (See cilart,) Sincethese changes
areknown in advance,anyundesired impacton reserve bal-
ancescanbe offseteasilythrough open market operations,
'The Act specified that fee schedules cover services such as check
clearing and collection, wire transfer, automated clearinghouse, settle-
ment, securitiessafekeeping, noncash collection, Federal Reserve float,
and any new servicesoffered.
M"Eamingscreditsn are calculated by multiplying the actual average
c l e a ~ gbalanceheld overamaintenanceperiod,upto that requiredplus
rate. The clearing balance band is 2 percent of the required clearing
balanceor$25,000,whichever amountis larger.
*Whilesometypes of floatarepriceddirectly,the FederalReserveprices
the per-itemfeesforthe priced service.
When BankA establishesa requiredclearing
balanceata FederalReserveBank by selling
- balance +1.000
securities,the reserve balances and depositsof Assets
otherbanksdecline. U.S. government
securities - 1,000
with F.R. Banks:
Bank A +1,000 4-
with F.R Banks:
Other banks - 1,000
Deposits .. -1,000
When BankA isVied monthly for FederalReserveservicesused, itcan pay for these servicesby having
earningscreditsapplied and/or by authorizinga directchargeto itsreserve account SupposeBankA has
accrued earningscreditsof $100but incursfeesof $125.Then both methodswould be used. On the Federal
Reserve Bank's books,the liabiityaccount "earningscreditsdueto depositoryinstitutions"declinesby$100
and BankA's reserve account isreduced by $25. Offsettingthese entriesisa reduction in the Fed's (other)
assetaccount "accrued serviceincome." On BankA'sbooks, the accountingentriesmight be a $100reduc-
tion to itsassetaccount "earningscreditduefrom FederalReserveBanks "and a $25reduction in itsreserve
account, which are offsetby a $125declinein itsliabiity 'accounts payable." Whilean individualbank may
use differentaccountingentries,the net effectonreservesisa reduction of $25,the amountof billed feesthat
were paid through a directchargeto BankA's reserve account
income - 125
Earnings credits Earnings credits
due to depository due from
institutions F.R Banks -100
- 25 H F . R Banks - 25
FacfonmetingBark R m e s 23
Loans to depository institutions
monthly averages, billions of dollars, not seasonally adjusted
Prior to passage of the Monetary ControlAct of 1980,
onlybanks that were members of the Federal Reserve Sys-
tem had regular accessto the Fed's "discountwindow."
Sincethen, all institutionshaving depositsreservableunder
theAct alsohave been ableto borrow fromthe Fed. Under
conditionssetby the Federal Reserve,loansare available
under three credit programs: adjustment, seasonal,and ex-
tended credit.16 The averageamountof each type of discount
windowcredit provided variesover time. (See rlrn~-fi
When a bank borrowsfroma FederalReserve Bank, it
borrows reserves. The acquisitionof reserves in this manner
diem in an importantway from the cases already illustrated.
Banksnormally borrow adjustmentcredit onlyto avoid re-
servedeficienciesor overdrafts,not to obtain excessre-
serves. Adjustmentcreditborrowings,therefore, are
reserves on which expansion has already taken place. How
can this happen?
In their effortsto accommodatecustomersas well as to
keepfullyinvested,banks frequentlymake loansin anticipa-
tion of inflowsof loanablefundsfromdepositsor money
market sources. Loans add to bank depositsbut not to bank
reserves. Unless excessreserves can be tapped, banks will
not have enough reserves to meet the reserve requirements
againstthe new deposits. Likewise,individualbanks may
incur deficienciesthrough unexpected depositoutflowsand
correspondinglosses of reserves through clearings. Other
banks receivethese depositsand can increase their loans
accordingly,but the banks that lost them may not be ableto
reduce outstandingloansor investmentsin order to restore
their reserves to required levelswithin the required time
period. In either case, a bank may borrow reserves tempo-
rarily fromitsReserve Bank.
Supposea customer of Bank Awantsto borrow $100.
On the basisof the management'sjudgment that the bank's
reserveswillbe sufticientto provide the necessary funds,the
customeris accommodated. The loan is madeby increasing
"loans"and creditingthe customer's depositaccount. Now
BankA's depositshave increased by $100. However, if re-
servesare insufticientto supportthe higher deposits,Bank A
will have a $10reserve deficiency,assumingrequirements of
10percent. See zllustratlo~z26. Bank Amay temporarily
borrowthe $10from its Federal Reserve Bank,which makes
a loanby increasingits asset item "loansto depositoryinstitu-
tions" and crediting Bank A's reserve account. Bank A
gains reserves and a correspondingliability"borrowingsfrom
FederalReserveBanks." See tlitutruiito~z27
To repay borrowing, a bank must gain reserves through
either depositgrowth or asset liquidation. 3cr ~llrrstrntio~z2%
Abank makes payment by authorizinga debitto its reserve
account atthe Federal Reserve Bank. Repaymentof borrow-
ing,therefore,reduces both reserves and "borrowingsfrom
FederalReserveBanks." S ~ Pziiustmtzon 29
Unlike loans made under the seasonaland extended
creditprograms,adjustmentcredit loans to banks generally
must be repaid within a shorttime sincesuch loans are made
primarilyto cover needs created by temporaryfluctuationsin
deposits and loansrelativeto 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 forcethese other banks to borrow, especially
in periods of heavy credit demands. Even at timeswhen the
totalvolume of adjustmentcredit borrowing is rising, some
individualbanks are repayingloanswhile others are borrow-
ing. In the aggregate, adjustmentcredit borrowing usually
increases in periods of rising business activitywhen the
public's demands for credit are rising more rapidly than
nonborrowedreserves are being provided by Systemopen
Although reserve expansionthrough borrowingis initi-
ated by banks, the amount of reserves that banks can acquire
in thisway ordinarilyislimitedby the Federal Reserve's ad-
ministration of the discountwindowand by its controlofthe
rate charged banks for adjustmentcredit loans-the discount
rate.17 Loansare made onlyfor approved purposes, and other
reasonablyavailable sources of funds must have been fully
used. Moreover,banks are discouragedfromborrowingad-
justment credit too frequentlyor for extended time periods.
Raisingthe discountrate tends to restrain borrowingby
increasingits cost relativeto the cost of alternativesources
Discountwindow administrationis an importantadjunct
to the other Federal Reservetoolsof monetarypolicy. While
the privilege of borrowing offersa "safetyvalve"to temporarily
relieve severe strains on the reserve positions of individual
banks, there is generallya strong incentivefor a bank to repay
borrowing beforeaddingfurther to its loansand investments.
- --- --- -. - -- --
'fiAdjustmentcredit is short-term credit available to meet temporary needs
for funds. Seasonalcredit is availablefor longer periods to smallerinstitu-
tionshavingregular seasonalneedsforfunds. Extendedcreditmaybemade
available to an institution or group of institutions experiencing sustained
liquiditypressures. The reservesprovided through extendedcreditborrow-
ing typicallyare offset by open market operations.
';Flexible discount rates related to rates on moneymarket sources of funds
currentlyarecharged forseasonalcredit andforextendedcreditoutstanding
more than 30 days.
24 1 Modem Money Mechanrcs
326 I Abank mayincur a reserve deficiencyif it makes
loanswhen ithasno excess reserves.
I ~ssets Liabilities
1 Assets Liabilities
27 Borrowingfrom aFederal Reserve Bank to coversuch adeficitis accompaniedby a directcreditto the
1 Nofirher expansion can takephce on the new reserves because thya nall neededagainst the deposits created in (26).
Securities - 10
Reserve accounts: Reserves with Borrowingsfrom
Bank A + 10-F.R Banks F.R. Banks + 10
Repaymentof borrowingsfromthe Federal ReserveBank reducesreserves.
Bank A - 10
Reserveaccounts: Reserves with
Bank A - 10-F.R.Banks - 10
FactorsmetingEank Resewes 25
Thusfarwe have describedtransactionsthat affectthe
volume of bank reservesand the impactthesetransactions
haveupon the capacityof the banksto expandtheirassets
and deposits. It isalsopossible toiduence depositexpan-
sionorcontractionby changingthe required minimumratio
of reservesto deposits.
Theauthoritytovary required reserve percentagesfor
banksthatwere membersof the FederalReserve System
(memberbanks) was firstgranted by Congresstothe Fed-
eralReserve Board of Governorsin 1933. The rangeswithin
which this authoritycanbe exercisedhavebeen changed
severaltimes,mostrecentlyin the MonetaryControlAct of
1980,which providedforthe establishmentof reserve r e
?he 1980statuteestablishedthe followinglimits:
On transadon accounts
first$25 million 3%
above $25 million 8%to 14%
On nonpmonal time deposits 0%to 9%
The 1980lawinitiallysetthe requirementagainsttransaction
accountsover$25million at 12percent andthat against
nonpersonaltime depositsat3percent Theinitial$25mik
lion "lowreservetranche"wasindexed to changeeachyear
in linewith 80percent of thegrowth in transactionaccounts
atalldepositoryinstitutions. (For example,thelowreserve
tranchewas increased from$41.1millionfor 1991to $42.2
million for 1992.) In addition,reserve requirementscan be
imposedon certainnondepositsourcesof funds,suchas
Eurocurrencyliabiitie~?~(Initiallythe Board seta 3percent
The Garn-StGermainAct of 1982modiied these provi-
sionssomewhatby exemptingfromreserve requirements
thefirst$2million of totalresemble liabiitiesateachdepos
itoryinstitution. Similarto the lowreserve trancheadjust-
mentfortransaction accounts,the $2million "resemble
liabiitiesexemptionamount"was indexedto 80percent of
annualincreasesin totalresembleliabiities. (For example,
the exemption amountwas increased from $3.4 millionfor
1991to $3.6millionfor 1992.)
TheFederalReserve Board isauthorized to change,at
accountsabovethelow reserve trancheand on nonpersonal
time depositswithiithe rangesindicatedabove. In addition,
the Board may impose differingreserve requirementson
nonpersonaltime depositsbased on the maturityofthe de-
posit. m e Board initiallyimposedthe 3percent nonper-
sonaltime depositrequirement only on such depositswith
Duringthe phasein period,which ended in 1984for
mostmember banksand in 1987for most nonmemberinsti-
tutions,requirementschanged accordingto a predetermined
schedule,withoutanyactionby the FederalReserveBoard.
Apart fromthese legallyprescribedchanges,oncethe Mone-
tary ControlAct provisionswere implementedin late 1980,
the Board did not changeanyreserve requirement ratiosuntil
late 1990. m e originalmaturitybreak for requirementson
nonpersonaltime depositswas shortened severaltimes, once
in 1982andtwice in 1983,in connectionwith actionstakento
deregulate ratespaid on deposits.) In December 1990,the
Board reduced reserve requirements againstnonpersonal
time depositsand Eurocurrencyliabilitiesfrom 3percentto
zero. EffectiveinApril 1992,the reserve requirementon
transactionaccountsabovethe low reservetranchewaslow-
eredfrom 12percentto 10percent.
When reserve requirementsarelowered,a portion of
banks' existingholdingsof required reservesbecomesexcess
reservesand may be loaned or invested. For example,with a
requirement of 10percent, $10of reserveswould be required
to support$100of deposits. See illustration30. Buta reduc-
tion in the legalrequirementto 8percentwould tieup only$8,
freeii$2outof each $10of reservesfor use in creatingaddi-
tionalbank creditand deposits. See illustration 31.
An increasein reserverequirements,on the otherhand,
absorbsadditionalreserve funds,andbankswhich haveno
excessreservesmust acquirereservesorreduce loansor
investmentsto avoid a reserve deficiency. Thusan increase
in the requirementfrom 10percentto 12percentwould boost
required reservesto $12foreach $100of deposits. Assuming
bankshave no excessreserves,thiswould forcethemto
liquidateassetsuntilthe reserve deficiencywas eliminated,
atwhich pointdepositswould be onesixthlessthan before.
See illustration 32.
Reserve Requirements and Monetary Policy
The powerto changereserve requirements,likepur-
chasesand salesof securitiesby the FederalReserve,isan
instrumentof monetarypolicy. Even a smallchangein r e
quirements-say,onehalf of onepercentagepoint-can
have a largeandwidespread impact. Otherinstrumentsof
monetarypolicy have sometimesbeen used to cushionthe
initialimpactof a reserverequirement change. Thus,the
Systemmay sellsecurities(or purchase lessthan otherwise
would be appropriate) to absorbpartof the reservesreleased
by a cutin requirements.
It shouldbe noted that in additionto their initialimpact
onexcessreserves,changesin requirements alterthe expan-
sionpower of everyreserve dollar. Thus,suchchangesaffect
the leverageof allsubsequentincreasesor decreasesin re-
servesfrom anysource. For this reason,changesin thetotal
volume of bank reservesactuallyheld between pointsin time
when requirementsdiier do not provide an accurateindica-
tion of the FederalReserve'spolicy actions.
Both reserve balancesandvaultcash areeligibleto
satisfyreserverequirements. To the extentsomeinstitutions
normally hold vaultcashto meet operatingneedsin amounts
exceedingtheir required reserves,they areunlikelytobe
affected by anychange in requirements.
reserve requirements can be imposed at any level on any liability of
depositoryinstitutionsfor as long as six months;and,if essentialfor the
transactionaccountscan be imposed.
Under a 10percent reserve requirement,
$10of reservesareneeded to supporteach
$100of deposits. Assets Liabilities
With a reductionin requirementsfrom 10
percent to 8percent,fewerreservesare
required againstthe samevolumeof deposits Assets
sothat excessreservesarecreated. These can Loansand
be loaned or invested. investments 90
Thereis no changein the totalamount of bank reserves.
With an increase in requirementsfrom 10
percent to 12percent,more reservesare
required againstthe samevolumeof deposits. Assets
Theresultingdeficienciesmust be coveredby
liquidationof loansorinvestments. .. Loans and
...becausethetotal amountof bank reservesremains
FactorsmctirrgBank Resemes 27
The FederalReservehas engaged in foreign currency
operationsforitsown accountsince 1962. In addition,
itactsasthe agentforforeign currency transactions of the
U.S. Treasury,and sincethe 1950shas executedtransac-
tionsforcustomerssuch asforeigncentralbanks. Perhaps
the mostpublicized type of foreign currency transaction
undertakenby the FederalReserveisinterventionin the
oneof severalforeign-relatedtransactionsthathave the
potentialforincreasingor decreasingreserves of banks,
thereby affectingmoney and creditgrowth.
Severalforeign-relatedtransactionsand their effects
on U.S. bank reservesare describedin the next fewpages.
Includedaresomebut not all of thetypes of transactions
used. Thekeypointto remember,however,isthatthe
FederalReserveroutinely offsetsanyundesired changein
U.S bank reservesresultingfromforeign-relatedtransac-
tions. As a result, suchtransactionsdonot affectmoney
and creditgrowthin the United States.
Foreign Exchange Intervention for the Federal
When the Federal Reserveintervenesin foreign
exchangemarketsto selldollarsforitsown it
acquiresforeigncurrencyassetsand reservesof U.S. banks
initiallyrise. In contrast,when the Fed intervenestobuy
dollarsfor itsown account, it usesforeigncurrencyassek
to pay forthe dollarspurchased and reservesof US. banks
Considerthe examplewhere the FederalReserve
intervenesin theforeign exchangemarketsto sell$100of
U.S. dollarsfor itsown account. In thistransaction,the
Federal Reservebuys a foreignarrencydenominated
depositof a U.S. bank held at a foreign commercialbarkz0
andpays for thisforeigncurrencydepositby crediting$100
totheU.S. bank's reserveaccountattheFed. TheFederal
Reserve depositsthe foreigncurrencyproceedsin itsac-
countata Foreign CentralBank,and asthistransaction
clears,the foreignbank's reservesatthe ForeignCentral
Bank decline. See illustration33onpages 3031. Initially,
then,the Fed's interventionsaleof dollarsin thisexample
leadsto an increase in Federal ReserveBank assetsdenom-
inated in foreigncurrenciesand an increase in reservesof
Supposeinstead thatthe FederalReserveintervenes
in theforeignexchangemarketsto buy $100of US. dollars,
againforitsown account. The FederalReservepurchasesa
dollardenominateddepositof a foreignbank held at a US.
bank,andpays for this dollar depositby drawingonits
foreigncurrency depositat a Foreign CentralBank. m e
FederalReservemighthave to sellsomeof itsforeign cur-
rency investmentsto build up itsdepositsatthe Foreign
CentralBank,but thiswould not affectU.S. bank reserves.)
As the FederalReserve's accountatthe ForeignCentral
Bank ischarged,theforeignbank's reservesatthe Foreign
CentralBankincrease. In turn,the dollardepositof the
foreignbank atthe U.S. bank declinesasthe U.S. bank
transfers ownershipof those dollarsto the Federal Reserve
28 M& Money Mechanics
Federal ReserveBank assets denominated
end of month, billionsof dollars, not seasonally adjusted
via a $100chargeto itsreserveaccountatthe FederalRe
serve. See illustration 34 on pages 3031. Initially,then,the
Fed's interventionpurchaseof dollarsin thisexampleleads
to a decreasein Federal Reserve Bank assetsdenominatedin
foreign currenciesand adecreasein reservesof U.S. banks.
Asnoted earlier,the Federal Reserveoffsetsor "ster-
ilizes" anyundesired changein U.S. bank reservesstemming
dollars. For example,Federal ReserveBank assetsdenomi-
nated inforeigncurrenciesrose dramaticallyin 1989,in part
dueto significantU.S. interventionsalesofdollars. (See chart
on thispage.) Totalreserves of U.S. banks, however,declined
slightlyin 1989asopen market operationswereused to "ster-
ilize" the initialintervention-inducedincrease in reserves.
Monthly Revaluation of Foreign Currency Assets
Federal Reserve Bank assetsdenominated in foreigncurren-
ciesisthe monthly revaluationof such assets. Twobusiness
daysprior to the end of the month,the Fed's foreigncurrency
assetsareincreased if their marketvaluehasappreciated or
decreasedif their valuehas depreciated. The offsettine;ac-
countingentryonthe Fed's balance sheetisto the "exchange
translationaccount"included in "otherF.R liabiities." These
changesin the Fed's balance sheetdonot alterbank reserves
directly. However, sincethe FederalReserveturnsoverits
net earningsto theTreasuryeachweek,the revaluationaf-
fectsthe amountof the Fed's paymentto theTreasury,which
in turn iniluencesthe sizeof 'IT&Lcallsandbank reserves.
(Seeexplanationonpages 18and 19.)
rests with the U.S. Treasury. Foreign exchange transactions for the
Federal Reserve'saccountare carriedout under directivesissued by the
of exchange rate policy establishedby the US. Treasury in consultation
withthe Fed. Theyareimplementedatthe FederalReserve Bankof New
York,typicallyatthe same timethat similartransactionsareexecutedfor
2oAmericanstravelingto foreign countries engagein "foreignexchange"
transactionswhenever they obtain foreign coins and paper currency in
exchangefor U.S.coinsand currency. However,mostforeignexchange
transactionsdo not involve the physicalexchangeof coinsand currency.
Rather, most of these transactions represent the buying and selling of
foreign currenciesby exchangingone bank depositdenominated in one
currencyforanotherbank depositdenominatedin anothercurrency. For
onreserveswouldbe the same if the U.S.orforeignpublicwere involved.
Foreign-RelatedTransactions for the Treasury
U.S. interventionin foreign exchangemarketsby the
FederalReserve usually is dividedbetween itsown account
and theTreasury'sExchangeStabilizationFund (ESF')ac-
count. The impacton U.S. bank reservesfromthe interven-
tion transactionisthe sameforboth -salesof dollarsadd
to reserveswhilepurchasesof dollarsdrainreserves. See
illustration 35 on pages 3@31. Dependingupon how the
Treasurypaysfor,orhances,itspart of the intervention,
however,the FederalReservemay not need to conduct
in the ESFs accountatthe Federal Reserve. Therefore,
theTreasurygenerally has to convertsomeESFassetsinto
dollaror foreigncurrencydepositsin order to payfor itspart
of an intervention transaction. Likewise,the dollar or for-
eign currency depositsacquiredby the ESFin the interven-
tion typicallyare drawndownwhen the ESFinveststhe
proceeds in earningassets.
For example,to hance an interventionsaleof dollars
(such asthat shownin illustration 35),theTreasurymight
redeem someof the U.S. governmentsecuritiesissuedto
the ESF,resulting in a transferof fundsfromtheTreasury's
(generalaccount)balancesatthe Federal Reserveto the
ESFsaccountatthe Fed. (Onthe Federal Reserve's bal-
ancesheet, the ESFs accountisincluded in the liability
category"other deposits.") TheTreasury,however,would
need to replenish itsFed balancesto desiredlevels,perhaps
by increasingthe size of ?T&L calls-a transactionthat
drainsU.S. bank reserves. The interventionandfinancing
transactionsessentiallyoccur simultaneously. As a result,
U.S. bank reservesadded in the interventionsaleof dollars
areoffsetby the drainin U.S. bank reservesfromthe?T&L
call. See illustrations35 and 36 on pages 3@31. Thus,no
FederalReserveoffsettingactionswould be needed if the
Treasuryh c e d the interventionsaleof dollarsthrough
Offsettingactionsby the Federal Reservewould be
needed,however,if theTreasuryrestored depositsaffected
by foreign-relatedtransactionsthrough a number of transac-
tions involvingthe FederalReserve. These includethe
Treasury's issuanceof SDRorgold certificatesto the Feder-
al Reserve and the "warehousing"of foreign currenciesby
SDR certtj5cate.s. OccasionallytheTreasuryacquires
dollardepositsfor the ESFs accountby issuingcertificates
to the FederalReserve againstallocationsof SpecialDraw-
ingRights (SDRs) received fromthe InternationalMonetary
Fund.21For example,$3.5biion of SDRcertificateswere
issued in 1989,and another$1.5billion in 1990. This"mone-
tization"of SDRsisreflected onthe Federal Reserve's bal-
account"and an increasein itsliability"other deposits
If the ESFusesthese dollar depositsdirectlyin an
intervention saleof dollars,then the intervention-induced
increase in U.S. bank reservesisnot altered. See illustra-
tions 35 and 370n pages 3@31. If not needed immediately
for an intervention transaction,the ESFmightuse the dollar
depositsfrom issuanceof SDRcertificatesto buy securities
USgold stock, gold certificates and SDR certificates
end of year, billions of dollars
from theTreasury,resulting in a transferof fundsfrom the
ESFs accountatthe FederalReservetotheTreasury'sac-
countat the Fed. U.S. bank reserveswould then increaseas
theTreasuryspentthe fundsor transferred them to banks
through a d i iinvestmentto ?T&L note accounts.
Goldstock andgold certtj5cates. Changesin the U.S.
monetarygold stockused to be an importantfactor affecting
bank reserves. However,the gold stockandgoldcertificates
issued to the FederalReservein "monetizing"gold,have not
changedsignificantlysincethe early 1970s. (See chart on
Priorto August 1971,theTreasurybought and sold
goldfor a fixedpricein termsof U.S. dollars,mainly atthe
initiativeof foreigncentralbanks and governments. Gold
purchasesby theTreasurywere added to the U.S. monetary
gold stock,and paid forfromitsaccountatthe Federal
Reserve. Asthe sellersdepositedtheTreasury's checksin
banks, reservesincreased. To replenish itsbalance atthe
Fed,theTreasuryissued gold certificatesto the Federal
Reserveand received a creditto itsdepositbalance.
Treasurysalesof gold have the oppositeeffect Buy-
ers' checksarecredited to theTreasury'saccountand re-
servesdecline. Because the officialU.S. gold stockis now
fully"monetized,"theTreasurycurrentlyhas to use its
depositsto retiregold certificatesissued to the Federal
Reservewhenevergold issold. However,thevalueof gold
certificatesretired,aswell asthe net contractionin bank
reserves,isbased onthe officialgold price. Proceedsfrom
agold saleatthe marketpriceto meet demandsof domestic
buyerslikelywould be greater. The differencerepresents
theTreasury's profit,which,when spent,restores deposits
and bank reservesby a likeamount.
WhiletheTreasuryno longer purchasesgold and
salesof gold have been limited,increasesin the officialprice
of gold have added to thevalue of the gold stock. W e
officialgold pricewaslastraised,from$38.00 to $42.22 per
troy ounce,in 1973.)
lar depositsatthe Federal Reserveby "warehousing"foreign
currencieswith the Fed. (Forexample,$7billion of foreign
21SDRswere createdin 1970for use by governmentsin officialbalanceof
When the Federal Reserve intervenesto selldollarsfor itsown
account, it pays for a foreignarrencydenominateddepositof a U.S.
bank at a foreigncommercialbank by creditingthe reserveaccountof Liabilities
the U.S. bank,and acquiresa foreigncurrencyassetin the form of a Depositsat Reserves:
depositat a ForeignCentralBank. The Federal Reserve,however,will ForeignCentral US.bank + 100-offset the increase in U.S. bank reservesif it isinconsistentwith
When the Federal Reserveintervenestobuy dollarsforitsown
account, it drawsdown itsforeign currencydepositsata Foreign
CentralBankto pay fora dollardenominated depositof a foreignbank Liabilities
at a U.S. bank,whichleadsto a contractionin reservesof the US. Depositsat Reserves:
bank. Thisreductionin reserveswillbe offsetby the Federal Reserve ForeignCentral U.S. bank - 100 -if itisinconsistentwith domesticpolicy objectives.
In aninterventionsaleof dollarsforthe U.S. Treasury,depositsof the ESF atthe FederalReserve areused to pay
fora foreigncurrencydepositof a US. bank ata foreignbank, and the foreign currencyproceedsare deposited in
an accountat a Foreign CentralBank. U.S. bank reservesincreaseasa result of thisinterventiontransaction.
Assets Liabilities Assets Liabilities Assets Liabilities
Depositsat Other deposits:
Concurrently,theTreasurymusth c e the interventiontransactionin (35). ?he Treasurymightbuild up depositsin
the ESFsaccountatthe Federal Reserveby redeemingsecuritiesissuedto the ESF, and replenish itsown (general
account) depositsatthe Federal Reserveto desiredlevelsby issuinga callon?T&L note accounts. Thissetof transac-
tions drainsreserves of U.S. banksby the sameamountasthe interventionin (35) added to U.S. bank reserves.
Liabilities Assets Liabilities Assets Liabilities
Treas. deps.: net 0
Alternatively,theTreasurymighth n c e the interventionin (35) by issuing SDRcertificatesto the Federal
Reserve,a transactionthatwould not disturbthe additionof US. bank reserves in intervention(35). The Federal
Reserve,however,would offset anyundesired changein U.S. bank reserves.
30 1 Modem Monq Mechanics
Assets Liabilities Assets Liabilities
FA. Banks + 100
SDR certificates SDR certificate Other deposits:
issuedto account + I00 ESF + 100
Assets Liabilities Assets Uabiliti~ Assets Liabilities
foreign bank - 100 foreign bank - 100
Assets Liabilities Assets Liabilities Assets Liabilities
,-b F.R. Banks foreign bank - 100
ForeignCentral foreign bank + 100
Assets Liabilities Assets Liabilities Assets Liabilities
Depositsat Reserves of
foreign bank - 100 foreign bank - 100
Reserveswith TT&Laccts. - I00
-F.R. Banks - 1007
FactotsMxfingBank Rcsmes 31
currencieswerewarehoused in 1989.) TheTreasuryor
ESFacquiresforeigncurrencyassetsasa result of transac-
tionssuch asinterventionsalesof dollarsor salesof U.S.
governmentsecuritiesdenominated in foreigncurrencies.
When the FederalReservewarehousesforeign currencies
nated in foreigncurrencies"increase asdoTreasurydepos-
itsatthe Fed. As these depositsare spent, reservesof U.S.
banks rise. In contrast,theTreasurylikelywill have to
increasethe sizeof lT&Lcalls-a transactionthat drains
reserves-when it repurchaseswarehousedforeigncur-
renciesfrom the FederalReserve. (In1991,$2.5billion of
warehoused foreigncurrencieswere repurchased.) The
repurchasetransactionisreflected onthe Fed's balance
sheetasdeclinesin bothTreasurydepositsatthe Federal
Reserve and FederalReserveBank assetsdenominatedin
Transactionsfor Foreign Customers
tain depositsat the Federal Reserveto facilitatedollar-
denominatedtransactions. These"foreign deposits"on the
liabilityside of the Fed's balance sheettypicallyareheld at
minimallevelsthatvary littlefromweek to week. For ex-
ample,foreign depositsatthe FederalReserveaveraged
only$237million in 1991,rangingfrom$178million to $319
millionon aweekly averagebasis. Changesin foreign
depositsare smallbecause foreigncustomers"manage"
their FederalReservebalancesto desired levelsdailyby
buying and sellingU.S. governmentsecurities. The extent
of these foreigncustomer"cash management"transactions
isreflected,in part, by largeand frequentchangesin mar-
ketableU.S. governmentsecuritiesheld in custodyby the
Federal Reserveforforeigncustomers. (Seechart.) The
net effectof foreign customers'cash managementtransac-
tionsusuallyisto leaveU.S. bank reservesunchanged.
Managingfbreign depositsthroughsales ofsecurities.
Foreigncustomersof the FederalReservemake dollar-
salesof dollarsby foreign centralbanks,by drawingdown
their depositsatthe Federal Reserve. As these fundsare
deposited in U.S. banks and cleared,reserves of U.S. banks
rise. See illustration38. However,if paymentsfromtheir
accountsatthe FederalReservelowerbalancesto below
desiredlevels,foreigncustomerswill replenish their Feder-
al Reserve depositsby sellingU.S. governmentsecurities.
Actingastheir agent,the Federal Reserveusuallyexecutes
foreigncustomers' sellordersin the market. As buyerspay
for the securitiesby drawingdown depositsat U.S. banks,
reservesof U.S. banksfalland offset the increasein re-
servesfromthe disbursementtransactions. Thenet effect
isto leave U.S. bank reservesunchanged when U.S. govern-
ment securitiesof foreign customersare sold in the mar-
ket. See illustrations38 and 39. Occasionally,however,the
FederalReserve executesforeigncustomers' sellorders
withthe System's account. When thisis done,the risein
reservesfromthe foreign customers' disbursementof funds
remainsin place. See illustratiolzs 38 and 40. The Federal
Reservemightchooseto executesellorderswith the Sys-
tem's accountif an increase in reservesisdesiredfor do-
MarketableUSgovernmentsecurities held in
custodyfor foreign customers during 1991
Wednesday outsmndings,billions of dollars
235 ~ ~ ' ' ' 1 ' ' ' ~ ' ' ' ~ ' ' ' ' ~ ' ' ' ~ ' ' ' ' ~ ' ' ' ~ ' ' ' 1 ' ' ' ' 1 ' ' ' 1 ' ' ' i
Feb. Apr. June Aug. Oct. Dec.
Managragrngfbreign deposits throughpurchases ofsecuri-
ties. Foreigncustomersof the FederalReservealsoreceive
a variety of dollardenominatedpayments, includingpro-
ceedsfrominterventionpurchasesof dollarsby foreign
centralbanks, that are drawn on U.S. banks. As thesefunds
arecreditedto foreign depositsatthe FederalReserve,r e
servesof U.S. banks decline. Butif receiptsof dollardenom-
hated paymentsraisetheir depositsatthe FederalReserve
to levelshigherthan desired,foreigncustomerswillbuy U.S.
governmentsecurities. The net effedtgenerally istoleave
U.S. bank reserves unchanged when the U.S. government
securitiesare purchased in the market.
Usingthe swap network. Occasionally,foreigncentral
banksacquiredollar depositsby activatingthe "swap"net-
work,which consistsof reciprocalshort-termcreditarrange-
mentsbetweenthe Federal Reserveand certainforeign
centralbanks. When a foreigncentralbank drawson its
swapline atthe Federal Reserve,itimmediatelyobtainsa
dollar depositatthe Fed in exchangeforforeigncurrencies,
and agreesto reversethe exchange sometimein thefuture.
Onthe FederalReserve's balance sheet,activationof the
swapnetworkisreflected asan increase in FederalReserve
Bank assetsdenominatedin foreigncurrenciesand an in-
creasein the liabiitycategoryYoreign deposits." Whenthe
swaplineisrepaid,both of these accountsdecline. Reserves
of U.S. bankswill risewhen the foreigncentralbank spends
itsdollarproceedsfromthe swapdrawing. See illustration
41. In contrast, reservesof U.S. bankswillfall asthe foreign
centralbank rebuilds its depositsatthe Federal Reserve
in orderto repaya swapdrawing.
The accountingentriesand impacton U.S. bank r e
servesarethe same if the FederalReserveuses the swap
networkto borrowand repayforeign currencies. However,
the Federal Reservehas not activatedthe swapnetwork in
nTechnically, warehousing consists of two parts: the Federal Reserve's
for dollardepositsnow, and the Treasury's agreementto repurchasethe
foreigncurrenciessometimein the future.