Modern Money Mechanics - Wikimedia
Modern Money MechanicsA Workbook on Bank Reserves and Deposit ExpansionFederal Reserve Bank of Chicago
Modern Money MechanicsThe purpose of this booklet is to desmmbethe basicprocess of money creation in a actionalreserve" banking system. l7ze approach taken illustrates the changesin bank balance sheets that occur when deposits in bankschange as a result of monetary action by the FederalReserve System -the central bank of the United States.The relationshipsshown are based on simplil5ringassumptions. For the sake of simplicity, the relationshipsare shown as if they were mechanical, but they are not,as is described later in the booklet. Thus, they should notbe intwreted to imply a close and predictable relationship between a specific central bank transaction andthe quantity of money.The introductorypages contain a briefgeneraldesm'ption of the characte*ics of money and how theUS. money system works. m e illustrations in thefbllowing two sections describe two processes: fijirst, howbank akposits expand or contract in response to changesin the amount of reserves supplied by the centml bank;and second, how those reserves are afected by bothFederal Reserve actions and otherjizctm. A final section deals with some of the elements that modifi, at leasti the short Tun, the simple mechanical relationshipbetween bank reserves and deposit money.Money is such a routine part of everyday living thatits existence and acceptance ordinarily are taken for granted. A user may sense that money must come into beingeither automatically as a result of economic activity or asan outgrowth of some government operation. But just howthis happens all too often remains a mystery.What Is Money?If money is viewed simply as a tool used to facilitatetransactions, only those media that are readily accepted inexchange for goods, services, and other assets need to beconsidered. Many things -from stones to baseball cards-have served this monetary function through the ages.Today, in the United States, money used in transactions ismainly of three kinds -currency (paper money and coinsin the pockets and purses of the public); demand deposits(non-interest-bearingchecking accounts in banks); andother checkable deposits, such as negotiable order ofwithdrawal (NOW)accounts, at all depository institutions,including commercial and savings banks, savings and loanassociations, and credit unions. Travelers checks also areincluded in the definition of transactions money. Since 1in currency and 1 in checkable deposits are freely convertible into each other and both can be used directly forexpenditures, they are money in equal degree. However,only the cash and balances held by the nonbank public arecounted in the money supply. Deposits of the U.S. Treasury, depository institutions, foreign banks and officialinstitutions, as well as vault cash in depository institutionsare 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 M1as well as certain other hancial assets (such as savingsand time deposits at depository institutions and shares inmoney market mutual funds) which are relatively liquidbut believed to represent principally investments to theirholders rather than media of exchange. While funds canbe shifted fairly easily between transaction balances andthese other liquid assets, the moneycreation process takesplace principally through transaction accounts. In theremainder of this booklet, "money" means MI.The distribution between the currency and depositcomponents of money depends largely on the preferencesof the public. When a depositor cashes a check or makesa cash withdrawal through an automatic teller machine, heor she reduces the amount of deposits and increases theamount of currency held by the public. Conversely, whenpeople have more currency than is needed, some is returned to banks in exchange for deposits.While currency is used for a great variety of smalltransactions, most of the dollar amount of money payments in our economy are made by check or by electronic
transfer between deposit accounts. Moreover, currencyis a relatively small part of the money stock. About 69percent, or 623 biion, of the 898 biion total moneystock in December 1991,was in the form of transactiondeposits, of which 290 billion were demand and 333billion were other checkable deposits.What Makes Money Valuable?In the United States neither paper currency nordeposits have value as commodities. Intrinsically,a dollarbii is just a piece of paper, deposits merely book entries.Coins do have some intrinsic value as metal, but generallyfar less than their face value.What, then, makes these instruments -checks,paper money, and coins -acceptable at face value inpayment of all debts and for other monetary uses? Mainly,it is the confidence people have that they will be able toexchange such money for other financial assets and forreal goods and services whenever they choose to do so.Money, like anything else, derives its value from itsscarcity in relation to its usefulness. Commodities or services are more or less valuable because there are more orless of them relative to the amounts people want. Money'susefulness is its unique ability to command other goodsand services and to permit a holder to be constantly readyto do so. How much money is demanded depends onseveral factors, such as the total volume of transactionsin the economy at any given time, the payments habits ofthe society, the amount of money that individuals andbusinesses want to keep on hand to take care of unexpected transactions, and the foregone earnings of holdingtinancial assets in the form of money rather than someother asset.Control of the quantity of money is essential if itsvalue is to be kept stable. Money's real value can be measured only in terms of what it will buy. Therefore, its valuevaries inverselywith the general level of prices. Assuminga constant rate of use, if the volume of money grows morerapidly than the rate at which the output of real goods andservices increases, prices will rise. This will happen b ecause there will be more money than there will be goodsand services to spend it on at prevailing prices. But if, onthe other hand, growth in the supply of money does notkeep pace with the economy's current production, thenprices will fall, the nation's labor force, factories, and otherproduction facilities will not be fully employed, or both.Just how large the stock of money needs to be inorder to handle the transactions of the economy withoutexerting undue iduence on the price level depends onhow intensively money is b e i i used. Every transactiondeposit balance and every dollar bill is a part of somebody's spendablefunds at any given time, ready to moveto other owners as transactions take place. Some holdersspend money quickly after they get it, making these fundsavailable for other uses. Others, however, hold money forlonger periods. Obviously,when some money remainsidle, a larger total is needed to accomplish any givenvolume of transactions.Who Creates Money?Changes in the quantity of money may originate withactions of the Federal Reserve System (the central bank),depository institutions (principally commercial banks), orthe public. The major control, however, rests with thecentral bank.The actual process of money creation takes placeprimarily in banks.' As noted earlier, checkable liabilitiesof banks are money. These liabilitiesare customers' accounts. They increase when customers deposit currencyand checks and when the proceeds of loans made by thebanks are credited to borrowers' accounts.In the absence of legal reserve requirements, bankscan build up deposits by increasing loans and investmentsso long as they keep enough currency on hand to redeemwhatever amounts the holders of deposits want to convertinto currency. This unique attribute of the banking business was discovered many centuries ago.It started with goldsmiths. As early bankers, theyinitially provided safekeeping services, making a profit fromvault storage fees for gold and coins deposited with them.People would redeem their "deposit receipts" wheneverthey needed gold or coins to purchase something,andphysically take the gold or coins to the seller who, in turn,would deposit them for safekeeping, often with the samebanker. Everyone soon found that it was a lot easier simplyto use the deposit receipts directly as a means of payment.These receipts, which became known as notes, were acceptable as money since whoever held them could go tothe banker and exchange them for metallic money.Then, bankers discovered that they could make loansmerely by giving their promises to pay, or bank notes, toborrowers. In this way, banks began to create money.More notes could be issued than the gold and coin on handbecause only a portion of the notes outstandingwould bepresented for payment at any one time. Enough metallicmoney had to be kept on hand, of course, to redeem whatever volume of notes was presented for payment.Transaction deposits are the modem counterpart ofbank notes. It was a small step from printing notes to making book entries crediting deposits of borrowers, which theborrowers in turn could "spend" by writing checks, thereby"printing" their own money.In orderto describe the moneycreationprocessas simplyas possible,theterm Bank" used in this booklet should be understood to encompass alldepositoryinstitutions. Sincethe Depository InstitutionsDeregulationandMonetary ControlAct 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 onwhich payment of interest is still legally prohibited) at all depositoryinstitutions are subject to the reserve requirements set by the FederalReserve. Thus an such institutions, not just commercial banks, have thepotential for creating money.
What Iimits the Amount of Money BanksCan Create?If deposit money can be created so easily, what is toprevent banks from making too much -more than sufticient to keep the nation's productive resources fully employed without price inflation? Like its predecessor, themodem bank must keep available,to make payment ondemand, a considerable amount of currency and funds ondeposit with the central bank. The bank must be preparedto convert deposit money into currency for those depositors who request currency. It must make remittance onchecks written by depositors and presented for paymentby other banks (settle adverse clearings). Finally, it mustmaintain legally required reserves, in the form of vault cashand/or balances at its Federal Reserve Bank, equal to aprescribed percentage of its deposits.The public's demand for currency varies greatly, butgenerally follows a seasonal pattern that is quite predictable. The effects on bank funds of these variations in theamount of currency held by the public usually are offset bythe central bank, which replaces the reserves absorbed bycurrency withdrawals from banks. Oust how this is donewill be explained later.) For all banks taken together, thereis no net drain of funds through clearings. A check drawnon one bank normally will be deposited to the credit ofanother account, if not in the same bank, then in someother bank.These operating needs influence the minimumamount of reserves an individual bank will hold voluntarily.However, as long as this minimum amount is less thanwhat is legally required, operating needs are of relativelyminor importance as a restraint on aggregate deposit expansion in the banking system. Such expansion cannotcontinue beyond the point where the amount of reservesthat 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 couldexpand only until they were five times as large as reserves.Reserves of 10 million could support deposits of 50million. The lower the percentage requirement, the greaterthe deposit expansion that can be supported by each additional reserve dollar. Thus, the legal reserve ratio togetherwith the dollar amount of bank reserves are the factors thatset the upper limit to money creation.What Are Bank Reserves?Currency held in bank vaults may be counted aslegal reserves as well as deposits (reserve balances) at theFederal Reserve Banks. Both are equally acceptable insatisfaction of reserve requirements. A bank can alwaysobtain reserve balances by sending currency to its ReserveBank and can obtain currency by drawing on its reservebalance. Because either can be used to support a muchlarger volume of deposit liabilities of banks, currency incirculation and reserve balances together are often referred to as "high-poweredmoney" or the "monetary base."Reserve balances and vault cash in banks, however, are notcounted as part of the money stock held by the public.4Modem Money MechanicsFor individual banks, reserve accounts also serve asworking balances? Banks may increase the balances intheir reserve accounts by depositing checks and proceedsfrom electronic funds transfers as well as currency. Orthey may draw down these balances by writing checks onthem or by authorizing a debit to them in payment forcurrency, customers' checks, or other funds transfers.Although reserve accounts are used as workingbalances, each bank must maintain, on the average for therelevant reserve maintenance period, reserve balances atthe Reserve Bank and vault cash which together are equalto its required reserves, as determined by the amount ofits deposits in the reserve computation period.Where Do Bank Reserves Come From?Increases or decreases in bank reserves can resultfrom a number of factors discussed later in this booklet.From the standpoint of money creation, however, theessential point is that the reserves of banks are, for themost part, W i t i e s of the Federal Reserve Banks, and netchanges in them are largely determined by actions of theFederal Reserve System. Thus, the Federal Reserve,through its abiity to vary both the total volume of reservesand the required ratio of reserves to deposit liabilities,influences banks' decisions with respect to their assets anddeposits. One of the major responsibilities of the FederalReserve System is to provide the total amount of reservesconsistent with the monetary needs of the economy atreasonably stable prices. Such actions take into consideration, of course, any changes in the pace at which moneyis being used and changes in the public's demands forcash balances.The reader should be mindful that deposits andreserves tend to expand simultaneouslyand that the Federal Reserve's control often is exerted through the marketplace as individualbanks find it either cheaper or moreexpensive to obtain their required reserves, depending onthe willingness of the Fed to support the current rate ofcredit and deposit expansion.While an individual bank can obtain reserves bybidding them away from other banks, this cannot be doneby the banking system as a whole. Except for reservesborrowed temporarily from the Federal Reserve's discountwindow, as is shown later, the supply of reserves in thebanking system is controlled by the Federal Reserve.Moreover, a given increase in bank reserves is notnecessarily accompanied by an expansion in money equalto the theoretical potential based on the required ratio ofreserves to deposits. What happens to the quantity ofZPartof an individual bank's reserve account may represent its reservebalance used to meet its reserve requirements while another part may beits required clearing balance on which earnings credits are generated topay for Federal Reserve Bank services.
money will vary, depending upon the reactions of thebanks and the public. A number of slippages may occur.What amount of resmes will be drained into the public'scurrency holdings? To what extent will the increase intotal reserves remain unused as excess reserves? Howmuch will be absorbed by deposits or other liabiities notdefined as money but against which banks might also haveto hold reserves? How sensitive are the banks to policyactions of the central bank? The significance of thesequestions will be discussed later in this booklet. The answers indicate why changes in the money supply may bedifferent than expected or may respond to policy actiononly after considemble time has elapsed.In the succeeding pages, the effects of various transactions on the quantity of money are described and illustrated. The basic working tool is the T account, whichprovides a simple means of tracing, step by step, the effectsof these transactions on both the asset and liabity sides ofbank balance sheets. Changes in asset items are enteredon the left half of the T and changes in liabiities on theright half. For any one transaction, of course, there mustbe at least two entries in order to maintain the equality ofassets and liabiities.Introduction5
Bank Deposits-How l%ey Expand or ContractLet us assume that expansion in the money stock isdesired by the Federal Reserve to achieve its policy objectives. One way the central bank can initiate such an expansion is through purchases of securities in the open marketPayment for the securities adds to bank reserves. Suchpurchases (and sales) are called "open market operations."How do open market purchases add to bank reservesand deposits? Suppose the Federal Reserve System,through its trading desk at the Federal Reserve Bank ofNew York, buys 10,000 of Treasury bills from a dealer inIn today's world of computerU.S. government securitie . ized financial transactions, the Federal Reserve Bankpays for the securitieswith an "electronic" check drawnon itself! Via its "Fedwire" transfer network, the FederalReserve notifies the dealer's designated bank (Bank A)that payment for the securities should be credited to (deposited in) the dealer's account at Bank A At the sametime, Bank A's reserve account at the Federal Reserveis credited for the amount of the securities purchase.The Federal Reserve System has added 10,000 of securities to its assets, which it has paid for, in effect, by creatinga liability on itself in the form of bank reserve balances.These reserves on Bank A's books are matched by 10,000 of the dealer's deposits that did not exist before.See illustration 1.How the Multiple Expansion Process WorksIf the process ended here, there would be no "multiple" expansion, i.e., deposits and bank reserves wouldhave changed by the same amount However, banks arerequired to maintain reserves equal to only a fraction oftheir deposits. Reserves in excess of this amount may beused to increase earning assets -loans and investments.Unused or excess reserves earn no interest Under currentregulations,the reserve requirement against most transaction accounts is 10 percent5 Assuming, for simplicity,auniform 10 percent reserve requirement against all transaction deposits, and further assuming that all banks attemptto remain fully invested, we can now trace the process ofexpansion in deposits which can take place on the basis ofthe additional reserves provided by the Federal ReserveSystem's purchase of U.S. government securities.The expansion process may or may not begin withBank A, depending on what the dealer does with the money received from the sale of securities. If the dealer immediately writes checks for 10,000 and all of them aredeposited in other banks, Bank A loses both deposits andreserves and shows no net change as a result of the System's open market purchase. However, other banks havereceived them. Most likely, a part of the initial deposit willremain with Bank A, and a part will be shifted to otherbanks as the dealer's checks clear.6Modem Money MechanicsIt does not really matter where this money is at anygiven time. The important fact is that these deposits do notdisappear. They are in some deposit accounts at al
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
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