Modern Money Mechanics 3
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Bank Reserves - How They Change Money has been defined as the sum of transaction accounts in depository institutions, and currency and travelers checks in the hands of the public. Currency is something almost everyone uses every day. Therefore, when most people think of money, they think of currency. Contrary to this popular impression, however, transaction deposits are the most significant part of the money stock. People keep enough currency on hand to effect small face-to-face transactions, but they write checks to cover most large expenditures. Most businesses probably hold even smaller amounts of currency in relation to their total transactions than do individuals. Since the most important component of money is transaction deposits, and since these deposits must be supported by reserves, the central bank's influence over money hinges on its control over the total amount of reserves and the conditions under which banks can obtain them. The preceding illustrations of the expansion and contraction processes have demonstrated how the central bank, by purchasing and selling government securities, can deliberately change aggregate bank reserves in order to affect deposits. But open market operations are only one of a number of kinds of transactions or developments that cause changes in reserves. Some changes originate from actions taken by the public, by the Treasury Department, by the banks, or by foreign and international institutions. Other changes arise from the service functions and operating needs of the Reserve Banks themselves. The various factors that provide and absorb bank reserve balances, together with symbols indicating the effects of these developments, are listed on the opposite page. This tabulaton also indicates the nature of the balancing entries on the Federal Reserve's books. (To the extent that the impact is absorbed by changes in banks' vault cash, the Federal Reserve's books are unaffected.) Independent Factors Versus Policy Action It is apparent that bank reserves are affected in several ways that are independent of the control of the central bank. Most of these "independent" elements are changing more or less continually. Sometimes their effects may last only a day or two before being reversed automatically. This happens, for instance, when bad weather slows up the check collection process, giving rise to an automatic increase in Federal Reserve credit in the form of "float." Other influences, such as changes in the public's currency holdings, may persist for longer periods of time. Still other variations in bank reserves result solely from the mechanics of institutional arrangements among the Treasury, the Federal Reserve Banks, and the depository institutions. The Treasury, for example, keeps part of its operating cash balance on deposit with banks. But virtually all disbursements are made from its balance in the Reserve Banks. As is shown later, any buildup in balances at the Reserve Banks prior to expenditure by the Treasury causes a dollar-for-dollar drain on bank reserves. In contrast to these independent elements that affect reserves are the policy actions taken by the Federal Reserve System. The way System open market purchases and sales of securities affect reserves has already been described. In addition, there are two other ways in which the System can affect bank reserves and potential deposit volume directly; first, through loans to depository institutions, and second, through changes in reserve requirement percentages. A change in the required reserve ratio, of course, does not alter the dollar volume of reserves directly but does change the amount of deposits that a given amount of reserves can support. Any change in reserves, regardless of its origin, has the same potential to affect deposits. Therefore, in order to achieve the net reserve effects consistent with its monetary policy objectives, the Federal Reserve System continuously must take account of what the independent factors are doing to reserves and then, using its policy tools, offset or supplement them as the situation may require. By far the largest number and amount of the System's gross open market transactions are undertaken to offset drains from or additions to bank reserves from non-Federal Reserve sources that might otherwise cause abrupt changes in credit availability. In addition, Federal Reserve purchases and/or sales of securities are made to provide the reserves needed to support the rate of money growth consistent with monetary policy objectives. In this section of the booklet, several kinds of transactions that can have important week-to-week effects on bank reserves are traced in detail. Other factors that normally have only a small influence are described briefly on page 35. Factors Changing Reserve Balances - Independent and Policy Actions
* These factors represent assets and liabilities
of the Treasury. Changes in them typically affect reserve balances
through a related change in the Federal Reserve Banks' liability
"Treasury deposits." Changes in the Amount of Currency Held by the Public
Changes in the amount of currency held by the public typically follow a fairly regular intramonthly pattern. Major changes also occur over holiday periods and during the Christmas shopping season - times when people find it convenient to keep more pocket money on hand. (See chart.) The public acquires currency from banks by cashing checks. (6) When deposits, which are fractional reserve money, are exchanged for currency, which is 100 percent reserve money, the banking system experiences a net reserve drain. Under the assumed 10 percent reserve requirement, a given amount of bank reserves can support deposits ten times as great, but when drawn upon to meet currency demand, the exchange is one to one. A $1 increase in currency uses up $1 of reserves. Suppose a bank customer cashed a $100 check to obtain currency needed for a weekend holiday. Bank deposits decline $100 because the customer pays for the currency with a check on his or her transaction deposit; and the bank's currency (vault cash reserves) is also reduced $100. See illustration 15. Now the bank has less currency. It may replenish its vault cash by ordering currency from its Federal Reserve Bank - making payment by authorizing a charge to its reserve account. On the Reserve Bank's books, the charge against the bank's reserve account is offset by an increase in the liability item "Federal Reserve notes." See illustration 16. The reserve Bank shipment to the bank might consist, at least in part, of U.S. coins rather than Federal Reserve notes. All coins, as well as a small amount of paper currency still outstanding but no longer issued, are obligations of the Treasury. To the extent that shipments of cash to banks are in the form of coin, the offsetting entry on the Reserve Bank's books is a decline in its asset item "coin." The public now has the same volume of money as before, except that more is in the form of currency and less is in the form of transaction deposits. Under a 10 percent reserve requirement, the amount of reserves required against the $100 of deposits was only $10, while a full $100 of reserves have been drained away by the disbursement of $100 in currency. Thus, if the bank had no excess reserves, the $100 withdrawal in currency causes a reserve deficiency of $90. Unless new reserves are provided from some other source, bank assets and deposits will have to be reduced (according to the contraction process described on pages 12 and 13) by an additional $900. At that point, the reserve deficiency caused by the cash withdrawal would be eliminated. When Currency Returns to Banks, Reserves Rise After holiday periods, currency returns to the banks. The customer who cashed a check to cover anticipated cash expenditures may later redeposit any currency still held that's beyond normal pocket money needs. Most of it probably will have changed hands, and it will be deposited by operators of motels, gasoline stations, restaurants, and retail stores. This process is exactly the reverse of the currency drain, except that the banks to which currency is returned may not be the same banks that paid it out. But in the aggregate, the banks gain reserves as 100 percent reserve money is converted back into fractional reserve money. When $100 of currency is returned to the banks, deposits and vault cash are increased. See illustration 17. The banks can keep the currency as vault cash, which also counts as reserves. More likely, the currency will be shipped to the Reserve Banks. The Reserve Banks credit bank reserve accounts and reduce Federal Reserve note liabilities. See illustration 18. Since only $10 must be held against the new $100 in deposits, $90 is excess reserves and can give rise to $900 of additional deposits(7). To avoid multiple contraction or expansion of deposit money merely because the public wishes to change the composition of its money holdings, the effects of changes in the public's currency holdings on bank reserves normally are offset by System open market operations. 6The same balance sheet entries apply whether the individual physically cashes a paper check or obtains currency by withdrawing cash through an automatic teller machine. back 7Under current reserve accounting regulations, vault cash reserves are used to satisfy reserve requirements in a future maintenance period while reserve balances satisfy requirements in the current period. As a result, the impact on a bank's current reserve position may differ from that shown unless the bank restores its vault cash position in the current period via changes in its reserve balance. back 15 When a depositor cashes a check, both deposits and vault cash reserves decline. back
16 If the bank replenishes its vault cash, its account at the Reserve Bank is drawn down in exchange for notes issued by the Federal Reserve. back
17 When currency comes back to the banks, both deposits and vault cash reserves rise. back
18 If the currency is returned to the Federal reserve, reserve accounts are credited and Federal Reserve notes are taken out of circulation. back
Modern Money Mechanics
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