MODERN MONEY MECHANICS

A Workbook on Bank Reserves and Deposit Expansion

Federal Reserve Bank of Chicago

This complete booklet is available in printed

form free of charge from:
Public Information Center
Federal Reserve Bank of Chicago
P. O. Box 834
Chicago, IL 60690-0834

telephone: 312 322 5111

Introduction

The purpose of this booklet is to describe the basic process of money creation
in a "fractional reserve" banking system. The approach taken illustrates the
changes in bank balance sheets that occur when deposits in banks change as
a result of monetary action by the Federal Reserve System - the central bank
of the United States. The relationships shown are based on simplifying
assumptions. For the sake of simplicity, the relationships are shown as if they
were mechanical, but they are not, as is described later in the booklet. Thus,
they should not be interpreted to imply a close and predictable relationship
between a specific central bank transaction and the quantity of money.

The introductory pages contain a brief general description of the

characteristics of money and how the U.S. money system works. The
illustrations in the following two sections describe two processes: first, how
bank deposits expand or contract in response to changes in the amount of
reserves supplied by the central bank; and second, how those reserves are
affected by both Federal Reserve actions and other factors. A final section
deals with some of the elements that modify, at least in the short run, the
simple mechanical relationship between bank reserves and deposit money.

Money is such a routine part of everyday living that its existence and
acceptance ordinarily are taken for granted. A user may sense that money
must come into being either automatically as a result of economic activity or
as an outgrowth of some government operation. But just how this happens all
too often remains a mystery.
What is Money?

If money is viewed simply as a tool used to facilitate transactions, only those

media that are readily accepted in exchange for goods, services, and other
assets need to be considered. Many things - from stones to baseball cards -
have served this monetary function through the ages. Today, in the United
States, money used in transactions is mainly of three kinds - currency (paper
money and coins in the pockets and purses of the public); demand deposits
(non-interest bearing checking accounts in banks); and other checkable
deposits, such as negotiable order of withdrawal (NOW) accounts, at all
depository institutions, including commercial and savings banks, savings and
loan associations, and credit unions. Travelers checks also are included in the
definition of transactions money. Since $1 in currency and $1 in checkable
deposits are freely convertible into each other and both can be used directly
for expenditures, they are money in equal degree. However, only the cash
and balances held by the nonbank public are counted in the money supply.
Deposits of the U.S. Treasury, depository institutions, foreign banks and
official institutions, as well as vault cash in depository institutions are
excluded.

This transactions concept of money is the one designated as M1 in the

Federal Reserve's money stock statistics. Broader concepts of money (M2
and M3) include M1 as well as certain other financial assets (such as savings
and time deposits at depository institutions and shares in money market
mutual funds) which are relatively liquid but believed to represent principally
investments to their holders rather than media of exchange. While funds can
be shifted fairly easily between transaction balances and these other liquid
assets, the money-creation process takes place principally through transaction
accounts. In the remainder of this booklet, "money" means M1.

The distribution between the currency and deposit components of money

depends largely on the preferences of the public. When a depositor cashes a
check or makes a cash withdrawal through an automatic teller machine, he or
she reduces the amount of deposits and increases the amount of currency held
by the public. Conversely, when people have more currency than is needed,
some is returned to banks in exchange for deposits.

While currency is used for a great variety of small transactions, most of the
dollar amount of money payments in our economy are made by check or by
electronic transfer between deposit accounts. Moreover, currency is a
relatively small part of the money stock. About 69 percent, or $623 billion, of
the $898 billion total stock in December 1991, was in the form of transaction
deposits, of which $290 billion were demand and $333 billion were other
checkable deposits.

What Makes Money Valuable?

In the United States neither paper currency nor deposits have value as
commodities. Intrinsically, a dollar bill is just a piece of paper, deposits
merely book entries. Coins do have some intrinsic value as metal, but
 generally far less than their face value.

What, then, makes these instruments - checks, paper money, and coins -
acceptable at face value in payment of all debts and for other monetary uses?
Mainly, it is the confidence people have that they will be able to exchange
such money for other financial assets and for real goods and services
whenever they choose to do so.

Money, like anything else, derives its value from its scarcity in relation to its
usefulness. Commodities or services are more or less valuable because there
are more or less of them relative to the amounts people want. Money's
usefulness is its unique ability to command other goods and services and to
permit a holder to be constantly ready to do so. How much money is
demanded depends on several factors, such as the total volume of
transactions in the economy at any given time, the payments habits of the
society, the amount of money that individuals and businesses want to keep on
hand to take care of unexpected transactions, and the forgone earnings of
holding financial assets in the form of money rather than some other asset.
Control of the quantity of money is essential if its value is to be kept stable. Money's real
value can be measured only in terms of what it will buy. Therefore, its value varies inversely
with the general level of prices. Assuming a constant rate of use, if the volume of money
grows more rapidly than the rate at which the output of real goods and services increases,
prices will rise. This will happen because there will be more money than there will be goods
and services to spend it on at prevailing prices. But if, on the other hand, growth in the supply
of money does not keep pace with the economy's current production, then prices will fall, the
nations's labor force, factories, and other production facilities will not be fully employed, or
both.

Just how large the stock of money needs to be in order to handle the transactions of the
economy without exerting undue influence on the price level depends on how intensively
money is being used. Every transaction deposit balance and every dollar bill is part of
somebody's spendable funds at any given time, ready to move to other owners as transactions
take place. Some holders spend money quickly after they get it, making these funds available
for other uses. Others, however, hold money for longer periods. Obviously, when some
money remains idle, a larger total is needed to accomplish any given volume of transactions.

Who Creates Money?

Changes in the quantity of money may originate with actions of the Federal Reserve System
(the central bank), depository institutions (principally commercial banks), or the public. The
major control, however, rests with the central bank.

The actual process of money creation takes place primarily in banks.(1) As noted earlier,
checkable liabilities of banks are money. These liabilities are customers' accounts. They
increase when customers deposit currency and checks and when the proceeds of loans made
by the banks are credited to borrowers' accounts.
In the absence of legal reserve requirements, banks can build up deposits by increasing loans
and investments so long as they keep enough currency on hand to redeem whatever amounts
the holders of deposits want to convert into currency. This unique attribute of the banking
business was discovered many centuries ago.

It started with goldsmiths. As early bankers, they initially provided safekeeping services,
making a profit from vault storage fees for gold and coins deposited with them. People would
redeem their "deposit receipts" whenever they needed gold or coins to purchase something,
and physically take the gold or coins to the seller who, in turn, would deposit them for
safekeeping, often with the same banker. Everyone soon found that it was a lot easier simply
to use the deposit receipts directly as a means of payment. These receipts, which became
known as notes, were acceptable as money since whoever held them could go to the banker
and exchange them for metallic money.

Then, bankers discovered that they could make loans merely by giving their promises to pay,
or bank notes, to borrowers. In this way, banks began to create money. More notes could be
issued than the gold and coin on hand because only a portion of the notes outstanding would
be presented for payment at any one time. Enough metallic money had to be kept on hand, of
course, to redeem whatever volume of notes was presented for payment.

Transaction deposits are the modern counterpart of bank notes. It was a small step from
printing notes to making book entries crediting deposits of borrowers, which the borrowers in
turn could "spend" by writing checks, thereby "printing" their own money.

What Limits the Amount of Money Banks Can Create?

If deposit money can be created so easily, what is to prevent banks from making too much -
more than sufficient to keep the nation's productive resources fully employed without price
inflation? Like its predecessor, the modern bank must keep available, to make payment on
demand, a considerable amount of currency and funds on deposit with the central bank. The
bank must be prepared to convert deposit money into currency for those depositors who
request currency. It must make remittance on checks written by depositors and presented for
payment by other banks (settle adverse clearings). Finally, it must maintain legally required
reserves, in the form of vault cash and/or balances at its Federal Reserve Bank, equal to a
prescribed percentage of its deposits.

The public's demand for currency varies greatly, but generally follows a seasonal pattern that
is quite predictable. The effects on bank funds of these variations in the amount of currency
held by the public usually are offset by the central bank, which replaces the reserves absorbed
by currency withdrawals from banks. (Just how this is done will be explained later.) For all
banks taken together, there is no net drain of funds through clearings. A check drawn on one
bank normally will be deposited to the credit of another account, if not in the same bank, then
in some other bank.

These operating needs influence the minimum amount of reserves an individual bank will
hold voluntarily. However, as long as this minimum amount is less than what is legally
required, operating needs are of relatively minor importance as a restraint on aggregate
deposit expansion in the banking system. Such expansion cannot continue beyond the point
where the amount of reserves that all banks have is just sufficient to satisfy legal
requirements under our "fractional reserve" system. For example, if reserves of 20 percent
were required, deposits could expand only until they were five times as large as reserves.
Reserves of $10 million could support deposits of $50 million. The lower the percentage
requirement, the greater the deposit expansion that can be supported by each additional
reserve dollar. Thus, the legal reserve ratio together with the dollar amount of bank reserves
are the factors that set the upper limit to money creation.

What Are Bank Reserves?

Currency held in bank vaults may be counted as legal reserves as well as deposits (reserve
balances) at the Federal Reserve Banks. Both are equally acceptable in satisfaction of reserve
requirements. A bank can always obtain reserve balances by sending currency to its Reserve
Bank and can obtain currency by drawing on its reserve balance. Because either can be used
to support a much larger volume of deposit liabilities of banks, currency in circulation and
reserve balances together are often referred to as "high-powered money" or the "monetary
base." Reserve balances and vault cash in banks, however, are not counted as part of the
money stock held by the public.

For individual banks, reserve accounts also serve as working balances.(2) Banks may
increase the balances in their reserve accounts by depositing checks and proceeds from
electronic funds transfers as well as currency. Or they may draw down these balances by
writing checks on them or by authorizing a debit to them in payment for currency, customers'
checks, or other funds transfers.

Although reserve accounts are used as working balances, each bank must maintain, on the
average for the relevant reserve maintenance period, reserve balances at their Reserve Bank
and vault cash which together are equal to its required reserves, as determined by the amount
of its deposits in the reserve computation period.

Where Do Bank Reserves Come From?

Increases or decreases in bank reserves can result from a number of factors discussed later in
this booklet. From the standpoint of money creation, however, the essential point is that the
reserves of banks are, for the most part, liabilities of the Federal Reserve Banks, and net
changes in them are largely determined by actions of the Federal Reserve System. Thus, the
Federal Reserve, through its ability to vary both the total volume of reserves and the required
ratio of reserves to deposit liabilities, influences banks' decisions with respect to their assets
and deposits. One of the major responsibilities of the Federal Reserve System is to provide
the total amount of reserves consistent with the monetary needs of the economy at reasonably
stable prices. Such actions take into consideration, of course, any changes in the pace at
which money is being used and changes in the public's demand for cash balances.

The reader should be mindful that deposits and reserves tend to expand simultaneously and
that the Federal Reserve's control often is exerted through the market place as individual
banks find it either cheaper or more expensive to obtain their required reserves, depending on
the willingness of the Fed to support the current rate of credit and deposit expansion.

While an individual bank can obtain reserves by bidding them away from other banks, this
cannot be done by the banking system as a whole. Except for reserves borrowed temporarily
from the Federal Reserve's discount window, as is shown later, the supply of reserves in the
banking system is controlled by the Federal Reserve.

Moreover, a given increase in bank reserves is not necessarily accompanied by an expansion

in money equal to the theoretical potential based on the required ratio of reserves to deposits.
What happens to the quantity of money will vary, depending upon the reactions of the banks
and the public. A number of slippages may occur. What amount of reserves will be drained
into the public's currency holdings? To what extent will the increase in total reserves remain
unused as excess reserves? How much will be absorbed by deposits or other liabilities not
defined as money but against which banks might also have to hold reserves? How sensitive
are the banks to policy actions of the central bank? The significance of these questions will be
discussed later in this booklet. The answers indicate why changes in the money supply may
be different than expected or may respond to policy action only after considerable time has
elapsed.

In the succeeding pages, the effects of various transactions on the quantity of money are
described and illustrated. The basic working tool is the "T" account, which provides a simple
means of tracing, step by step, the effects of these transactions on both the asset and liability
sides of bank balance sheets. Changes in asset items are entered on the left half of the "T" and
changes in liabilities on the right half. For any one transaction, of course, there must be at
least two entries in order to maintain the equality of assets and liabilities.

1 In order to describe the money-creation process as simply as possible, the term "bank" used in this booklet should be understood to encompass all
depository institutions. Since the Depository Institutions Deregulation and Monetary Control Act of 1980, all depository institutions have been
permitted to offer interest bearing transaction accounts to certain customers. Transaction accounts (interest bearing as well as demand deposits on
which payment of interest is still legally prohibited) at all depository institutions are subject to the reserve requirements set by the Federal Reserve.
Thus all such institutions, not just commercial banks, have the potential for creating money. back

2Part of an individual bank's reserve account may represent its reserve balance used to meet its reserve requirements while another part may be its
required clearing balance on which earnings credits are generated to pay for Federal Reserve Bank services. back

Bank Deposits - How They Expand or Contract

Let us assume that expansion in the money stock is desired by the Federal Reserve to achieve
its policy objectives. One way the central bank can initiate such an expansion is through
purchases of securities in the open market. Payment for the securities adds to bank reserves.
Such purchases (and sales) are called "open market operations."
How do open market purchases add to bank reserves and deposits? Suppose the Federal
Reserve System, through its trading desk at the Federal Reserve Bank of New York, buys
$10,000 of Treasury bills from a dealer in U. S. government securities.(3) In today's world of
computerized financial transactions, the Federal Reserve Bank pays for the securities with an
"telectronic" check drawn on itself.(4) Via its "Fedwire" transfer network, the Federal
Reserve notifies the dealer's designated bank (Bank A) that payment for the securities should
be credited to (deposited in) the dealer's account at Bank A. At the same time, Bank A's
reserve account at the Federal Reserve is credited for the amount of the securities purchase.
The Federal Reserve System has added $10,000 of securities to its assets, which it has paid
for, in effect, by creating a liability on itself in the form of bank reserve balances. These
reserves on Bank A's books are matched by $10,000 of the dealer's deposits that did not exist
before. See illustration 1.

How the Multiple Expansion Process Works

If the process ended here, there would be no "multiple" expansion, i.e., deposits and bank
reserves would have changed by the same amount. However, banks are required to maintain
reserves equal to only a fraction of their deposits. Reserves in excess of this amount may be
used to increase earning assets - loans and investments. Unused or excess reserves earn no
interest. Under current regulations, the reserve requirement against most transaction accounts
is 10 percent.(5) Assuming, for simplicity, a uniform 10 percent reserve requirement against
all transaction deposits, and further assuming that all banks attempt to remain fully invested,
we can now trace the process of expansion in deposits which can take place on the basis of
the additional reserves provided by the Federal Reserve System's purchase of U. S.
government securities.

The expansion process may or may not begin with Bank A, depending on what the dealer
does with the money received from the sale of securities. If the dealer immediately writes
checks for $10,000 and all of them are deposited in other banks, Bank A loses both deposits
and reserves and shows no net change as a result of the System's open market purchase.
However, other banks have received them. Most likely, a part of the initial deposit will
remain with Bank A, and a part will be shifted to other banks as the dealer's checks clear.

It does not really matter where this money is at any given time. The important fact is that
these deposits do not disappear. They are in some deposit accounts at all times. All banks
together have $10,000 of deposits and reserves that they did not have before. However, they
are not required to keep $10,000 of reserves against the $10,000 of deposits. All they need to
retain, under a 10 percent reserve requirement, is $1000. The remaining $9,000 is "excess
reserves." This amount can be loaned or invested. See illustration 2.

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

3Dollar amounts used in the various illustrations do not necessarily bear any resemblance to actual transactions. For example, open market
operations typically are conducted with many dealers and in amounts totaling several billion dollars. back

4Indeed, many transactions today are accomplished through an electronic transfer of funds between accounts rather than through issuance of a paper
check. Apart from the time of posting, the accounting entries are the same whether a transfer is made with a paper check or electronically. The term
"check," therefore, is used for both types of transfers. back

5 For each bank, the reserve requirement is 3 percent on a specified base amount of transaction accounts and 10 percent on the amount above this
base. Initially, the Monetary Control Act set this base amount - called the "low reserve tranche" - at $25 million, and provided for it to change
annually in line with the growth in transaction deposits nationally. The low reserve tranche was $41.1 million in 1991 and $42.2 million in 1992. The
Garn-St. Germain Act of 1982 further modified these requirements by exempting the first $2 million of reservable liabilities from reserve
requirements. Like the low reserve tranche, the exempt level is adjusted each year to reflect growth in reservable liabilities. The exempt level was
$3.4 million in 1991 and $3.6 million in 1992. back

Deposit Expansion

1. When the Federal Reserve Bank purchases government securities, bank reserves
increase. This happens because the seller of the securities receives payment through a credit
to a designated deposit account at a bank (Bank A) which the Federal Reserve effects by
crediting the reserve account of Bank A.

FR BANK BANK A
Assets Liabilities Assets Liabilities
US govt Reserve acct. Reserves with Customer
securities.. +10,000 Bank A.. +10,000 FR Banks.. +10,000 deposit.. +10,000

The customer deposit at Bank A likely will be transferred, in part, to other banks and quickly
loses its identity amid the huge interbank flow of deposits. back

2.As a result, all banks taken together Total reserves gained from new deposits.......10,000
less: required against new deposits (at 10%)... 1,000
now have "excess" reserves on which
equals: Excess reserves . . . . . . . . . . . . . . . . . 9,000
deposit expansion can take place.

back
 Expansion - Stage 1

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

STAGE 1 BANKS
Assets Liabilities
Loans....... +9,000 Borrower deposits.... +9,000

This is the beginning of the deposit expansion process. In the first stage of the process, total
loans and deposits of the banks rise by an amount equal to the excess reserves existing before
any loans were made (90 percent of the initial deposit increase). At the end of Stage 1,
deposits have risen a total of $19,000 (the initial $10,000 provided by the Federal Reserve's
action plus the $9,000 in deposits created by Stage 1 banks). See illustration 4. However,
only $900 (10 percent of $9000) of excess reserves have been absorbed by the additional
deposit growth at Stage 1 banks. See illustration 5.

The lending banks, however, do not expect to retain the deposits they create through their
loan operations. Borrowers write checks that probably will be deposited in other banks. As
these checks move through the collection process, the Federal Reserve Banks debit the
reserve accounts of the paying banks (Stage 1 banks) and credit those of the receiving banks.
See illustration 6.

Whether Stage 1 banks actually do lose the deposits to other banks or whether any or all of
the borrowers' checks are redeposited in these same banks makes no difference in the
expansion process. If the lending banks expect to lose these deposits - and an equal amount of
reserves - as the borrowers' checks are paid, they will not lend more than their excess
reserves. Like the original $10,000 deposit, the loan-credited deposits may be transferred to
other banks, but they remain somewhere in the banking system. Whichever banks receive
them also acquire equal amounts of reserves, of which all but 10 percent will be "excess."

Assuming that the banks holding the $9,000 of deposits created in Stage 1 in turn make loans
equal to their excess reserves, then loans and deposits will rise by a further $8,100 in the
second stage of expansion. This process can continue until deposits have risen to the point
where all the reserves provided by the initial purchase of government securities by the
Federal Reserve System are just sufficient to satisfy reserve requirements against the newly
created deposits.(See pages10 and 11.)

The individual bank, of course, is not concerned as to the stages of expansion in which it may
be participating. Inflows and outflows of deposits occur continuously. Any deposit received
is new money, regardless of its ultimate source. But if bank policy is to make loans and
investments equal to whatever reserves are in excess of legal requirements, the expansion
process will be carried on.

How Much Can Deposits Expand in the Banking System?

The total amount of expansion that can take place is illustrated on page 11. Carried through to
theoretical limits, the initial $10,000 of reserves distributed within the banking system gives
rise to an expansion of $90,000 in bank credit (loans and investments) and supports a total of
$100,000 in new deposits under a 10 percent reserve requirement. The deposit expansion
factor for a given amount of new reserves is thus the reciprocal of the required reserve
percentage (1/.10 = 10). Loan expansion will be less by the amount of the initial injection.
The multiple expansion is possible because the banks as a group are like one large bank in
which checks drawn against borrowers' deposits result in credits to accounts of other
depositors, with no net change in the total reserves.

Expansion through Bank Investments

Deposit expansion can proceed from investments as well as loans. Suppose that the demand
for loans at some Stage 1 banks is slack. These banks would then probably purchase
securities. If the sellers of the securities were customers, the banks would make payment by
crediting the customers' transaction accounts, deposit liabilities would rise just as if loans had
been made. More likely, these banks would purchase the securities through dealers, paying
for them with checks on themselves or on their reserve accounts. These checks would be
deposited in the sellers' banks. In either case, the net effects on the banking system are
identical with those resulting from loan operations.

4 As a result of the process so far, total assets and total liabilities of all banks together have
risen 19,000. back

ALL BANKS
Assets Liabilities
Reserves with F. R. Banks...+10,000 Deposits: Initial. . . .+10,000
Loans . . . . . . . . . . . . . . . . . + 9,000 Stage 1 . . . . . . . . . + 9,000
Total . . . . . . . . . . . . . . . . . +19,000 Total . . . . . . . . . . .+19,000

5Excess reserves have been reduced by the amount required against the deposits created by
the loans made in Stage 1. back

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

less: Required against initial deposits . . . . . . . . -1,000
less: Required against Stage 1 requirements . . . . -900
equals: Excess reserves. . . . . . . . . . . . . . . . . . . . 8,100

Why do these banks stop increasing their loans

and deposits when they still have excess reserves?

6 ...because borrowers write checks on their accounts at the lending banks. As these checks
are deposited in the payees' banks and cleared, the deposits created by Stage 1 loans and an
equal amount of reserves may be transferred to other banks. back

STAGE 1 BANKS
Assets Liabilities
Reserves with F. R. Banks . -9000 Borrower deposits . . . -9,000
(matched under FR bank (shown as additions to
liabilities) other bank deposits)
FEDERAL RESERVE BANK
Assets Liabilities
Reserve accounts: Stage 1 banks . -9,000
Other banks. . . . . . . . . . . . . . . . . +9,000
OTHER BANKS
Assets Liabilities
Reserves with F. R. Banks .
Deposits . . . . . . . . . +9,000
+9,000

Deposit expansion has just begun!

Page 10.

7Expansion continues as the banks that have excess reserves increase their loans by that
amount, crediting borrowers' deposit accounts in the process, thus creating still more money.

STAGE 2 BANKS
Assets Liabilities
Loans . . . . . . . . + 8100 Borrower deposits . . . +8,100
8Now the banking system's assets and liabilities have risen by 27,100.
ALL BANKS
Assets Liabilities
Reserves with F. R. Banks . +10,000 Deposits: Initial . . . . +10,000
Loans: Stage 1 . . . . . . . . . . .+ 9,000 Stage 1 . . . . . . . . . . . +9,000
Stage 2 . . . . . . . . . . . . . . . . + 8,100 Stage 2 . . . . . . . . . . . +8,100
Total. . . . . . . . . . . . . . . . . . +27,000 Total . . . . . . . . . . . . +27,000

9 But there are still 7,290 of excess reserves in the banking system.
Total reserves gained from initial deposits . . . . . 10,000
less: Required against initial deposits . -1,000
less: Required against Stage 1 deposits . -900
less: Required against Stage 2 deposits . -810 . . . 2,710
equals: Excess reserves . . . . . . . . . . . . . . . . . . . . 7,290 --> to Stage 3 banks

10 As borrowers make payments, these reserves will be further dispersed, and the process
can continue through many more stages, in progressively smaller increments, until the entire
10,000 of reserves have been absorbed by deposit growth. As is apparent from the summary
table on page 11, more than two-thirds of the deposit expansion potential is reached after the
first ten stages.

It should be understood that the stages of expansion occur neither simultaneously nor in
the sequence described above. Some banks use their reserves incompletely or only after a
considerable time lag, while others expand assets on the basis of expected reserve growth.
The process is, in fact, continuous and may never reach its theoretical limits.

End page 10. back

Page 11.

Thus through stage after stage of expansion,

"money" can grow to a total of 10 times the new
reserves supplied to the banking system....
 Assets Liabilities
[ Reserves ]
Loans and
Total (Required) (Excess) Deposits
Investments
Reserves
10,000 1,000 9,000 - 10,000
provided
Exp. Stage 1 10,000 1900 8,100 9,000 19,000
Stage2 10,000 2,710 7,290 17,100 27,100
Stage 3 10,000 3,439 6,561 24,390 34,390
Stage 4 10,000 4,095 5,905 30,951 40,951
Stage 5 10,000 4,686 5,314 36,856 46,856
Stage 6 10,000 5,217 4,783 42,170 52,170
Stage 7 10,000 5,695 4,305 46,953 56,953
Stage 8 10,000 6,126 3,874 51,258 61,258
Stage 9 10,000 6,513 3,487 55,132 65,132
Stage 10 10,000 6,862 3,138 58,619 68,619
... ... ... ... ... ...
... ... ... ... ... ...
... ... ... ... ... ...
Stage 20 10,000 8,906 1,094 79,058 89,058
... ... ... ... ... ...
... ... ... ... ... ...
... ... ... ... ... ...
Final Stage 10,000 10,000 0 90,000 100,000

...as the new deposits created by loans

at each stage are added to those created at all
earlier stages and those supplied by the initial
reserve-creating action.
 End page 11. back

Page 12.

How Open Market Sales Reduce bank Reserves and Deposits

Now suppose some reduction in the amount of money is desired. Normally this would reflect
temporary or seasonal reductions in activity to be financed since, on a year-to-year basis, a
growing economy needs at least some monetary expansion. Just as purchases of government
securities by the Federal Reserve System can provide the basis for deposit expansion by
adding to bank reserves, sales of securities by the Federal Reserve System reduce the money
stock by absorbing bank reserves. The process is essentially the reverse of the expansion
steps just described.

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

Contraction Also Is a Cumulative Process

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

One way for a bank to obtain the reserves it needs is by selling securities. But, as the buyers
of the securities pay for them with funds in their deposit accounts in the same or other banks,
the net result is a $9,000 decline in securities and deposits at all banks. See illustration 13. At
the end of Stage 1 of the contraction process, deposits have been reduced by a total of
$19,000 (the initial $10,000 resulting from the Federal Reserve's action plus the $9,000 in
deposits extinguished by securities sales of Stage 1 banks). See illustration 14.

However, there is now a reserve deficiency of $8,100 at banks whose depositors drew down
their accounts to purchase the securities from Stage 1 banks. As the new group of reserve-
deficient banks, in turn, makes up this deficiency by selling securities or reducing loans,
further deposit contraction takes place.

Thus, contraction proceeds through reductions in deposits and loans or investments in one
stage after another until total deposits have been reduced to the point where the smaller
volume of reserves is adequate to support them. The contraction multiple is the same as that
which applies in the case of expansion. Under a 10 percent reserve requirement, a $10,000
reduction in reserves would ultimately entail reductions of $100,000 in deposits and $90,000
in loans and investments.

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

There is one important difference between the expansion and contraction processes. When the
Federal Reserve System adds to bank reserves, expansion of credit and deposits may take
place up to the limits permitted by the minimum reserve ratio that banks are required to
maintain. But when the System acts to reduce the amount of bank reserves, contraction of
credit and deposits must take place (except to the extent that existing excess reserve balances
and/or surplus vault cash are utilized) to the point where the required ratio of reserves to
deposits is restored. But the significance of this difference should not be overemphasized.
Because excess reserve balances do not earn interest, there is a strong incentive to convert
them into earning assets (loans and investments).

End of page 12. forward

 Page 13.

Deposit Contraction

11When the Federal Reserve Bank sells government securities, bank reserves decline. This
happens because the buyer of the securities makes payment through a debit to a designated
deposit account at a bank (Bank A), with the transfer of funds being effected by a debit to
Bank A's reserve account at the Federal Reserve Bank. back

FEDERAL RESERVE BANK BANK A

Assets Liabilities Assets Liabilities
U.S govt Reserve Accts. Reserves with Customer
securities....-10,000 Bank A....-10,000 F.R. Banks....-10,000 deposts.....-10,000

This reduction in the customer deposit at Bank A may be spread

among a number of banks through interbank deposit flows.

12 The loss of reserves means that all banks taken together now have a reserve deficiency.
back

Total reserves lost from deposit withdrawal . . . . . . . . . . . . . 10,000

less: Reserves freed by deposit decline(10%). . . . . . . . . . . . . 1,000
equals: Deficiency in reserves against remaining deposits . . 9,000

Contraction - Stage 1

13 The banks with the reserve deficiencies (Stage 1 banks) can sell government securities
to acquire reserves, but this causes a decline in the deposits and reserves of the buyers' banks.
back

STAGE 1 BANKS
Assets Liabilities
U.S.government securities...-9,000
Reserves with F.R. Banks..+9,000
FEDERAL RESERVE BANK
 Assets Liabilities
Reserve Accounts:
Stage 1 banks........+9,000
Other banks............-9,000
OTHER BANKS
Assets Liabilities
Reserves with F.R. Banks . . -
Deposits . . . . -9,000
9,000

14 As a result of the process so far, assets and total deposits of all banks together have
declined 19,000. Stage 1 contraction has freed 900 of reserves, but there is still a reserve
deficiency of 8,100. back

ALL BANKS
Assets Liabilities
Deposits:
Reserves with F.R. Banks . . -10,000
Initial . . . . . . . -10,000
U.S. government securities . . -9,000
Stage 1 . . . . . . -9,000
Total . . . . .-19,000
Total . . . . . . . -19,000

Further contraction must take place!

End of page 13. forward

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
FEDERAL RESERVE BANKS
Assets Liabilities
Reserve
Other
balances
Public actions
Increase in currency holdings............... - +
Decrease in currency holdings............. + -
Treasury, bank, and foreign actions
Increase in Treasury deposits in F.R. Banks...... - +
Decrease in Treasury deposits in F.R. Banks..... + -
Gold purchases (inflow) or increase in official
+ -
valuation*..
Gold sales (outflows)*....................... - +
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 balances/adjustments..... - +
Decrease in service-related balances/adjustments....... + -
Increase in foreign and other deposits in F.R. - +
Banks........
Decrease in foreign and other deposits in F.R.
+ -
Banks....
Federal Reserve actions
Purchases of securities.................................... + +
Sales of securities................................... - -
Loans to depository institutions........... + +
Repayment of loans to depository institutions......... - -
Increase in Federal Reserve float.................. + +
Decrease in Federal Reserve float...................... - -
Increase in assets denominated in foreign currency
+ +
......
Decrease in assets denominated in foreign currency
- -
......
Increase in other assets**..................................... + +
Decrease in other assets**..................................... - -
Increase in other liabilities**..................................... - +
Decrease in other liabilities**.................................. + -
Increase in capital accounts**............................. - +
Decrease in capital accounts**.......................... + -
Increase in reserve requirements................. -***
Decrease in reserve requirements................. +***

* These factors represent assets and liabilities of the Treasury. Changes in them typically affect reserve balances through a related change in the
Federal Reserve Banks' liability "Treasury deposits."
** Included in "Other Federal Reserve accounts" as described on page 35.
*** Effect on excess reserves. Total reserves are unchanged.
Note: To the extent that reserve changes are in the form of vault cash, Federal Reserve accounts are not affected. back

Forward

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
BANK A
Assets Liabilities
Vault cash reserves . . -100 Deposits . . . . -100
(Required . . -10)
(Deficit . . . . 90)

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

FEDERAL RESERVE BANK

Assets Liabilities
Reserve accounts: Bank A . . . -
100
F.R. notes . . . +100
BANK A
Assets Liabilities
Vault cash . . . . . . . . +100
Reserves with F.R. Banks . -100
17 When currency comes back to the banks, both deposits and vault cash reserves rise.
back

BANK A
Assets Liabilities
Vault cash reserves . . +100 Deposits . . . . +100
(Required . . . +10)
(Excess . . . . +90)

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

FEDERAL RESERVE BANK

Assets Liabilities
Reserve accounts: Bank A . . +100
F.R. notes . . . . . -100
BANK A
Assets Liabilities
Vault cash . . . . . -100
Reserves with F.R. Banks . . .
+100

Page 18

Changes in U.S. Treasury Deposits in Federal Reserve

Banks
Reserve accounts of depository institutions constitute the bulk of the deposit liabilities of the
Federal Reserve System. Other institutions, however, also maintain balances in the Federal
Reserve Banks - mainly the U.S. Treasury, foreign central banks, and international financial
institutions. In general, when these balances rise, bank reserves fall, and vice versa. This
occurs because the funds used by these agencies to build up their deposits in the Reserve
Banks ultimately come from deposits in banks. Conversely, recipients of payments from
these agencies normally deposit the funds in banks. Through the collection process these
banks receive credit to their reserve accounts.
The most important nonbank depositor is the
U.S. Treasury. Part of the Treasury's operating
cash balance is kept in the Federal Reserve
Banks; the rest is held in depository
institutions all over the country, in so-called
"Treasury tax and loan" (TT&L) note
accounts. (See chart.) Disbursements by the
Treasury, however, are made against its
balances at the Federal Reserve. Thus,
transfers from banks to Federal Reserve Banks
are made through regularly scheduled "calls"
on TT&L balances to assure that sufficient
funds are available to cover Treasury checks
as they are presented for payment. (8)

Bank Reserves Decline as the Treasury's Deposits at the Reserve Banks

Increase

Calls on TT&L note accounts drain reserves from the banks by the full amount of the transfer
as funds move from the TT&L balances (via charges to bank reserve accounts) to Treasury
balances at the Reserve Banks. Because reserves are not required against TT&L note
accounts, these transfers do not reduce required reserves.(9)

Suppose a Treasury call payable by Bank A amounts to $1,000. The Federal Reserve Banks
are authorized to transfer the amount of the Treasury call from Bank A's reserve account at
the Federal Reserve to the account of the U.S. Treasury at the Federal Reserve. As a result of
the transfer, both reserves and TT&L note balances of the bank are reduced. On the books of
the Reserve Bank, bank reserves decline and Treasury deposits rise. See illustration 19. This
withdrawal of Treasury funds will cause a reserve deficiency of $1,000 since no reserves are
released by the decline in TT&L note accounts at depository institutions.

Bank Reserves Rise as the Treasury's Deposits at the Reserve Banks Decline

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

Suppose a government employee deposits a $1,000 expense check in Bank A. The bank sends
the check to its Federal Reserve Bank for collection. The Reserve Bank then credits Bank A's
reserve account and charges the Treasury's account. As a result, the bank gains both reserves
and deposits. While there is no change in the assets or total liabilities of the Reserve Banks,
the funds drawn away from the Treasury's balances have been shifted to bank reserve
accounts. See illustration 20.

One of the objectives of the TT&L note program, which requires depository institutions that
want to hold Treasury funds for more than one day to pay interest on them, is to allow the
Treasury to hold its balance at the Reserve Banks to the minimum consistent with current
payment needs. By maintaining a fairly constant balance, large drains from or additions to
bank reserves from wide swings in the Treasury's balance that would require extensive
offsetting open market operations can be avoided. Nevertheless, there are still periods when
these fluctuations have large reserve effects. In 1991, for example, week-to-week changes in
Treasury deposits at the Reserve Banks averaged only $56 million, but ranged from -$4.15
billion to +$8.57 billion.

8When the Treasury's balance at the Federal Reserve rises above expected payment needs, the Treasury may place the excess funds in TT&L note
accounts through a "direct investment." The accounting entries are the same, but of opposite signs, as those shown when funds are transferred from
TT&L note accounts to Treasury deposits at the Fed. back

9Tax payments received by institutions designated as Federal tax depositories initially are credited to reservable demand deposits due to the U.S.
government. Because such tax payments typically come from reservable transaction accounts, required reserves are not materially affected on this
day. On the next business day, however, when these funds are placed either in a nonreservable note account or remitted to the Federal Reserve for
credit to the Treasury's balance at the Fed, required reserves decline. back

End page 18. forward

Page 19.

19 When the Treasury builds up its deposits at the Federal Reserve through "calls" on
TT&L note balances, reserve accounts are reduced. back

FEDERAL RESERVE BANK

Assets Liabilities
Reserve accounts: Bank A . . -
1,000
U.S. Treasury deposits . . +1,000
BANK A
Assets Liabilities
Treasury tax and loan note
Reserves with F.R. Banks . . -
account
1,000
. . -1,000
(Required . . . . 0)
(Deficit . . 1,000)
20 Checks written on the Treasury's account at the Federal Reserve Bank are deposited in
banks. As these are collected, banks receive credit to their reserve accounts at the Federal
Reserve Banks. back

FEDERAL RESERVE BANK

Assets Liabilities
Reserve accounts: Bank A . . +1,000
U.S. Treasury deposits . . . -1,000
BANK A
Assets Liabilities
Reserves with F.R. Banks . .
Private deposits . . +1,000
+1,000
(Required . . . +100)
(Excess . . . . . +900)

End of page 19. forward

Changes in Federal Reserve Float

A large proportion of checks drawn on banks and deposited in other banks is cleared
(collected) through the Federal Reserve Banks. Some of these checks are credited
immediately to the reserve accounts of the depositing banks and are collected the same day
by debiting the reserve accounts of the banks on which the checks are drawn. All checks are
credited to the accounts of the depositing banks according to availability schedules related to
the time it normally takes the Federal Reserve to collect the checks, but rarely more than two
business days after they are received at the Reserve Banks, even though they may not yet
have been collected due to processing, transportation, or other delays.

The reserve credit given for checks not yet collected is included in Federal Reserve
"float."(10) On the books of the Federal Reserve Banks, balance sheet float, or statement float
as it is sometimes called, is the difference between the asset account "items in process of
collection," and the liability account "deferred credit items." Statement float is usually
positive since it is more often the case that reserve credit is given before the checks are
actually collected than the other way around.

Published data on Federal Reserve float are based on a "reserves-factor" framework rather
than a balance sheet accounting framework. As published, Federal Reserve float includes
statement float, as defined above, as well as float-related "as-of" adjustments.(11) These
adjustments represent corrections for errors that arise in processing transactions related to
Federal Reserve priced services. As-of adjustments do not change the balance sheets of either
the Federal Reserve Banks or an individual bank. Rather they are corrections to the bank's
reserve position, thereby affecting the calculation of whether or not the bank meets its reserve
requirements.

An Increase in Federal Reserve Float Increases Bank Reserves

As float rises, total bank reserves rise by the same amount. For example, suppose Bank A
receives checks totaling $100 drawn on Banks B, C, and D, all in distant cities. Bank A
increases the accounts of its depositors $100, and sends the items to a Federal Reserve Bank
for collection. Upon receipt of the checks, the Reserve Bank increases its own asset account
"items in process of collection," and increases its liability account "deferred credit items"
(checks and other items not yet credited to the sending bank's reserve accounts). As long as
these two accounts move together, there is no change in float or in total reserves from this
source. See illustration 21.

On the next business day (assuming Banks B, C, and D are one-day deferred availability
points), the Reserve Bank pays Bank A. The Reserve Bank's "deferred credit items" account
is reduced, and Bank A's reserve account is increased $100. If these items actually take more
than one business day to collect so that "items in process of collection" are not reduced that
day, the credit to Bank A represents an addition to total bank reserves since the reserve
accounts of Banks B, C, and D will not have been commensurately reduced.(12) See
illustration 22.

A Decline in Federal Reserve Float Reduces Bank Reserves

Only when the checks are actually collected from Banks B, C, and D does the float involved
in the above example disappear - "items in process of collection" of the Reserve Bank decline
as the reserve accounts of Banks B, C, and D
are reduced. See illustration 23.

On an annual average basis, Federal Reserve

float declined dramatically from 1979 through
1984, in part reflecting actions taken to
implement provisions of the Monetary Control
Act that directed the Federal Reserve to
reduce and price float. (See chart.) Since
1984, Federal Reserve float has been fairly
stable on an annual average basis, but often
fluctuates sharply over short periods. From the
standpoint of the effect on bank reserves, the
significant aspect of float is not that it exists
but that its volume changes in a difficult-to-predict way. Float can increase unexpectedly, for
example, if weather conditions ground planes transporting checks to paying banks for
collection. However, such periods typically are followed by ones where actual collections
exceed new items being received for collection. Thus, reserves gained from float expansion
usually are quite temporary.

10Federal Reserve float also arises from other funds transfer services provided by the Fed, and automatic clearinghouse transfers. back

11As-of adjustments also are used as one means of pricing float, as discussed on page 22, and for nonfloat related corrections, as discussed on
page 35. back

12 If the checks received from Bank A had been erroneously assigned a two-day deferred availability, then neither statement float nor reserves would
increase, although both should. Bank A's reserve position and published Federal Reserve float data are corrected for this and similar errors through as-
of adjustments. back

21 When a bank receives deposits in the form of checks drawn on other banks, it can send
them to the Federal Reserve Bank for collection. (Required reserves are not affected
immediately because requirements apply to net transaction accounts, i.e., total transaction
accounts minus both cash items in process of collection and deposits due from domestic
depository institutions.) back

FEDERAL RESERVE BANK

Assets Liabilities
Items in process of collection . .
Deferred credit items . . +100
+100
BANK A
Assets Liabilities
Cash items in process of collection . . +100 Deposits . . . . . . . +100

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

FEDERAL RESERVE BANK

Assets Liabilities
Deferred credit items . . -100
Reserve account: Bank A . . +100
BANK A
Assets Liabilities
 Cash items in process of collection . . -
100
Reserves with F.R. Banks . . . +100
(Required . . . . +10)
(Excess. . . . . . +90)

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

FEDERAL RESERVE BANK

Assets Liabilities
Items in process Reserve accounts:
of collection . . . . . . -100 Banks B, C, and D . . . . . -100
BANK B, C, and D
Assets Liabilities
Reserves with F.R.Banks . . -100 Deposits . . . . . . -100
(Required . . . -10)
(Deficit . . . . . 90)

Page 22.

Changes in Service-Related Balances and Adjustments

In order to foster a safe and efficient payments system, the Federal Reserve offers banks a
variety of payments services. Prior to passage of the Monetary Control Act in 1980, the
Federal Reserve offered its services free, but only to banks that were members of the Federal
Reserve System. The Monetary Control Act directed the Federal Reserve to offer its services
to all depository institutions, to charge for these services, and to reduce and price Federal
Reserve float.(13) Except for float, all services covered by the Act were priced by the end of
1982. Implementation of float pricing essentially was completed in 1983.

The advent of Federal reserve priced services led to several changes that affect the use of
funds in banks' reserve accounts. As a result, only part of the total balances in bank reserve
accounts is identified as "reserve balances" available to meet reserve requirements. Other
balances held in reserve accounts represent "service-related balances and adjustments (to
compensate for float)." Service-related balances are "required clearing balances" held by
banks that use Federal Reserve services while "adjustments" represent balances held by banks
that pay for float with as-of adjustments.

An Increase in Required Clearing Balances Reduces Reserve Balances

Procedures for establishing and maintaining clearing balances were approved by the Board of
Governors of the Federal Reserve System in February of 1981. A bank may be required to
hold a clearing balance if it has no required reserve balance or if its required reserve balance
(held to satisfy reserve requirements) is not large enough to handle its volume of clearings.
Typically a bank holds both reserve balances and required clearing balances in the same
reserve account. Thus, as required clearing balances are established or increased, the amount
of funds in reserve accounts identified as reserve balances declines.

Suppose Bank A wants to use Federal Reserve services but has a reserve balance requirement
that is less than its expected operating needs. With its Reserve Bank, it is determined that
Bank A must maintain a required clearing balance of $1,000. If Bank A has no excess reserve
balance, it will have to obtain funds from some other source. Bank A could sell $1,000 of
securities, but this will reduce the amount of total bank reserve balances and deposits. See
illustration 24.

Banks are billed each month for the Federal Reserve services they have used with payment
collected on a specified day the following month. All required clearing balances held
generate "earnings credits" which can be used only to offset charges for Federal Reserve
services.(14) Alternatively, banks can pay for services through a direct charge to their reserve
accounts. If accrued earnings credits are used to pay for services, then reserve balances are
unaffected. On the other hand, if payment for services takes the form of a direct charge to the
bank's reserve account, then reserve balances decline. See illustration 25.

Float Pricing As-Of Adjustments Reduce Reserve Balances

In 1983, the Federal Reserve began pricing explicitly for float,(15) specifically
"interterritory" check float, i.e., float generated by checks deposited by a bank served by one
Reserve Bank but drawn on a bank served by another Reserve Bank. The depositing bank has
three options in paying for interterritory check float it generates. It can use its earnings
credits, authorize a direct charge to its reserve account, or pay for the float with an as-of
adjustment. If either of the first two options is chosen, the accounting entries are the same as
paying for other priced services. If the as-of adjustment option is chosen, however, the
balance sheets of the Reserve Banks and the bank are not directly affected. In effect what
happens is that part of the total balances held in the bank's reserve account is identified as
being held to compensate the Federal reserve for float. This part, then, cannot be used to
satisfy either reserve requirements or clearing balance requirements. Float pricing as-of
adjustments are applied two weeks after the related float is generated. Thus, an individual
bank has sufficient time to obtain funds from other sources in order to avoid any reserve
deficiencies that might result from float pricing as-of adjustments. If all banks together have
no excess reserves, however, the float pricing as-of adjustments lead to a decline in total bank
reserve balances.
Week-to-week changes in service-related
balances and adjustments can be volatile,
primarily reflecting adjustments to
compensate for float. (See chart. ) Since these
changes are known in advance, any undesired
impact on reserve balances can be offset easily
through open market operations.

13The Act specified that fee schedules cover services such as check
clearing and collection, wire transfer, automated clearinghouse,
settlement, securities safekeeping, noncash collection, Federal Reserve
float, and any new services offered. back

14"Earnings credits" are calculated by multiplying the actual average

clearing balance held over a maintenance period, up to that required plus the clearing balance band, times a rate based on the average federal funds
rate. The clearing balance band is 2 percent of the required clearing balance or $25,000, whichever amount is larger. back

15While some types of float are priced directly, the Federal Reserve prices other types of float indirectly, for example, by including the cost of float
in the per-item fees for the priced service. back

End of page 22. back

24 When Bank A establishes a required clearing balance at a Federal Reserve Bank by

selling securities, the reserve balances and deposits of other banks decline. back

BANK A
Assets Liabilities
U.S. government securities . . -
1,000
Reserve account with F.R.
Banks:
Required clearing balance . .
+1000
FEDERAL RESERVE BANK
Assets Liabilities
Reserve accounts:
Required clearing
balances Bank A . . . . +1000
Reserve balances:
Other banks . . . . . . . . -1000
OTHER BANKS
 Assets Liabilities
Reserve accounts with F.R.
Banks: Deposits . . . . . . . -1,000
Reserve balances . . . . -1,000
(Required . . . -100)
(Deficit . . . . . 900)

25 When Bank A is billed monthly for Federal Reserve services used, it can pay for these
services by having earnings credits applied and/or by authorizing a direct charge to its reserve
account. Suppose Bank A has accrued earnings credits of $100 but incurs fees of $125. Then
both methods would be used. On the Federal Reserve Bank's books, the liability account
"earnings credits due to depository institutions" declines by $100 and Bank A's reserve
account is reduced by $25. Offsetting these entries is a reduction in the Fed's (other) asset
account "accrued service income." On Bank A's books, the accounting entries might be a
$100 reduction to its asset account "earnings credit due from Federal Reserve Banks" and a
$25 reduction in its reserve account, which are offset by a $125 decline in its liability
"accounts payable." While an individual bank may use different accounting entries, the net
effect on reserves is a reduction of $25, the amount of billed fees that were paid through a
direct charge to Bank A's reserve account. back

FEDERAL RESERVE BANK

Assets Liabilities
Accrued service income . . . . . - Earnings credits due to depository
125 institutions . . . . . . . . -100
Reserve accounts: Bank A . . -25
BANK A
Assets Liabilities
Earnings credits due from F.R.
Accounts payable . . . . . -125
Banks . . -100
Reserves with F.R. Banks . . . . . -
25

Changes in Loans to Depository Institutions

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

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

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

Suppose a customer of Bank A wants to borrow $100. On the basis of the managements's
judgment that the bank's reserves will be sufficient to provide the necessary funds, the
customer is accommodated. The loan is made by increasing "loans" and crediting the
customer's deposit account. Now Bank A's deposits have increased by $100. However, if
reserves are insufficient to support the higher deposits, Bank A will have a $10 reserve
deficiency, assuming requirements of 10 percent. See illustration 26. Bank A may
temporarily borrow the $10 from its Federal Reserve Bank, which makes a loan by increasing
its asset item "loans to depository institutions" and crediting Bank A's reserve account. Bank
A gains reserves and a corresponding liability "borrowings from Federal Reserve Banks." See
illustration 27.

To repay borrowing, a bank must gain reserves through either deposit growth or asset
liquidation. See illustration 28. A bank makes payment by authorizing a debit to its reserve
account at the Federal Reserve Bank. Repayment of borrowing, therefore, reduces both
reserves and "borrowings from Federal Reserve Banks." See illustration 29.
Unlike loans made under the seasonal and extended credit programs, adjustment credit loans
to banks generally must be repaid within a short time since such loans are made primarily to
cover needs created by temporary fluctuations in deposits and loans relative to usual patterns.
Adjustments, such as sales of securities, made by some banks to "get out of the window" tend
to transfer reserve shortages to other banks and may force these other banks to borrow,
especially in periods of heavy credit demands. Even at times when the total volume of
adjustment credit borrowing is rising, some individual banks are repaying loans while others
are borrowing. In the aggregate, adjustment credit borrowing usually increases in periods of
rising business activity when the public's demands for credit are rising more rapidly than
nonborrowed reserves are being provided by System open market operations.

Discount Window as a Tool of Monetary Policy

Although reserve expansion through borrowing is initiated by banks, the amount of reserves
that banks can acquire in this way ordinarily is limited by the Federal Reserve's
administration of the discount window and by its control of the rate charged banks for
adjustment credit loans - the discount rate.(17) Loans are made only for approved purposes,
and other reasonably available sources of funds must have been fully used. Moreover, banks
are discouraged from borrowing adjustment credit too frequently or for extended time
periods. Raising the discount rate tends to restrain borrowing by increasing its cost relative to
the cost of alternative sources of reserves.

Discount window administration is an important adjunct to the other Federal Reserve tools of
monetary policy. While the privilege of borrowing offers a "safety valve" to temporarily
relieve severe strains on the reserve positions of individual banks, there is generally a strong
incentive for a bank to repay borrowing before adding further to its loans and investments.

16Adjustment credit is short-term credit available to meet temporary needs for funds. Seasonal credit is available for longer periods to smaller
institutions having regular seasonal needs for funds. Extended credit may be made available to an institution or group of institutions experiencing
sustained liquidity pressures. The reserves provided through extended credit borrowing typically are offset by open market operations. back

17Flexible discount rates related to rates on money market sources of funds currently are charged for seasonal credit and for extended credit
outstanding more than 30 days. back

26 A bank may incur a reserve deficiency if it makes loans when it has no excess reserves.
back

BANK A
Assets Liabilities
Loans . . . . . . . . . +100 Deposits . . . . . . . . +100
Reserves with F. R. Banks . . no
change
 (Required . . . . +10)
(Deficit . . . . . . . 10)

27 Borrowing from a Federal Reserve Bank to cover such a deficit is accompanied by a

direct credit to the bank's reserve account. back

FEDERAL RESERVE BANK

Assets Liabilities
Loans to depository institution:
Reserve accounts: Bank A . . +10
Bank A . . . . . . . . +10
BANK A
Assets Liabilities
Borrowings from F.R.Banks . .
Reserves with F.R. Banks . . +10
+10

No further expansion can take place on the new reserves because they are all needed against
the deposits created in (26).

28 Before a bank can repay borrowings, it must gain reserves from some other source.
back

BANK A
Assets Liabilities
Securities . . . . . . . -10
Reserves with F.R. Banks . . . +10

29 Repayment of borrowings from the Federal Reserve Bank reduces reserves. back
FEDERAL RESERVE BANK
Assets Liabilities
Loans to depository institutions:
Reserve accounts: Bank A . . . -10
Bank A . . . . . . . . . -10
BANK A
 Assets Liabilities
Reserves with F.R. Bank . . -10 Borrowings from F.R. Bank . . -10

Changes in Reserve Requirements

Thus far we have described transactions that affect the volume of bank reserves and the
impact these transactions have upon the capacity of the banks to expand their assets and
deposits. It is also possible to influence deposit expansion or contraction by changing the
required minimum ratio of reserves to deposits.

The authority to vary required reserve percentages for banks that were members of the
Federal Reserve System (member banks) was first granted by Congress to the Federal
Reserve Board of Governors in 1933. The ranges within which this authority can be exercised
have been changed several times, most recently in the Monetary Control Act of 1980, which
provided for the establishment of reserve requirements that apply uniformly to all depository
institutions. The 1980 statute established the following limits:

On transaction accounts
first $25 million . . . . . . . . . 3%
above $25 million . . . . . 8% to 14%

On nonpersonal time deposits . . . . 0% to 9%

The 1980 law initially set the requirement against transaction accounts over $25 million at 12
percent and that against nonpersonal time deposits at 3 percent. The initial $25 million "low
reserve tranche" was indexed to change each year in line with 80 percent of the growth in
transaction accounts at all depository institutions. (For example, the low reserve tranche was
increased from $41.1 million for 1991 to $42.2 million for 1992.) In addition, reserve
requirements can be imposed on certain nondeposit sources of funds, such as Eurocurrency
liabilities.(18) (Initially the Board set a 3 percent requirement on Eurocurrency liabilities.)

The Garn-St. Germain Act of 1982 modified these provisions somewhat by exempting from
reserve requirements the first $2 million of total reservable liabilities at each depository
institution. Similar to the low reserve tranche adjustment for transaction accounts, the $2
million "reservable liabilities exemption amount" was indexed to 80 percent of annual
increases in total reservable liabilities. (For example, the exemption amount was increased
from $3.4 million for 1991 to $3.6 million for 1992.)

The Federal Reserve Board is authorized to change, at its discretion, the percentage
requirements on transaction accounts above the low reserve tranche and on nonpersonal time
deposits within the ranges indicated above. In addition, the Board may impose differing
reserve requirements on nonpersonal time deposits based on the maturity of the deposit. (The
Board initially imposed the 3 percent nonpersonal time deposit requirement only on such
deposits with original maturities of under four years.)
During the phase-in period, which ended in 1984 for most member banks and in 1987 for
most nonmember institutions, requirements changed according to a predetermined schedule,
without any action by the Federal Reserve Board. Apart from these legally prescribed
changes, once the Monetary Control Act provisions were implemented in late 1980, the
Board did not change any reserve requirement ratios until late 1990. (The original maturity
break for requirements on nonpersonal time deposits was shortened several times, once in
1982, and twice in 1983, in connection with actions taken to deregulate rates paid on
deposits.) In December 1990, the Board reduced reserve requirements against nonpersonal
time deposits and Eurocurrency liabilities from 3 percent to zero. Effective in April 1992, the
reserve requirement on transaction accounts above the low reserve tranche was lowered from
12 percent to 10 percent.

When reserve requirements are lowered, a portion of banks' existing holdings of required
reserves becomes excess reserves and may be loaned or invested. For example, with a
requirement of 10 percent, $10 of reserves would be required to support $100 of deposits. See
illustration 30. But a reduction in the legal requirement to 8 percent would tie up only $8,
freeing $2 out of each $10 of reserves for use in creating additional bank credit and deposits.
See illustration 31.

An increase in reserve requirements, on the other hand, absorbs additional reserve funds, and
banks which have no excess reserves must acquire reserves or reduce loans or investments to
avoid a reserve deficiency. Thus an increase in the requirement from 10 percent to 12 percent
would boost required reserves to $12 for each $100 of deposits. Assuming banks have no
excess reserves, this would force them to liquidate assets until the reserve deficiency was
eliminated, at which point deposits would be one-sixth less than before. See illustration 32.

Reserve Requirements and Monetary Policy

The power to change reserve requirements, like purchases and sales of securities by the
Federal Reserve, is an instrument of monetary policy. Even a small change in requirements -
say, one-half of one percentage point - can have a large and widespread impact. Other
instruments of monetary policy have sometimes been used to cushion the initial impact of a
reserve requirement change. Thus, the System may sell securities (or purchase less than
otherwise would be appropriate) to absorb part of the reserves released by a cut in
requirements.

It should be noted that in addition to their initial impact on excess reserves, changes in
requirements alter the expansion power of every reserve dollar. Thus, such changes affect the
leverage of all subsequent increases or decreases in reserves from any source. For this reason,
changes in the total volume of bank reserves actually held between points in time when
requirements differ do not provide an accurate indication of the Federal Reserve's policy
actions.

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

18 The 1980 statute also provides that "under extraordinary circumstances" reserve requirements can be imposed at any level on any liability of
depository institutions for as long as six months; and, if essential for the conduct of monetary policy, supplemental requirements up to 4 percent of
transaction accounts can be imposed. back

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

BANK A
Assets Liabilities
Loans and investments . . . 90 Deposits . . . . . . . 100
Reserves . . . . . . . . 10
(Required . . . . 10)
(Excess. . . . . . . 0)

31 With a reduction in requirements from 10 percent to 8 percent, fewer reserves are

required against the same volume of deposits so that excess reserves are created. These can
be loaned or invested. back

BANK A
Assets Liabilities
Loans and investments . . . . . 90 Deposits . . . . . . . 100
Reserves . . . . . . . . 10
(Required . . . . . 8)
(Excess . . . . . . 2)
FEDERAL RESERVE BANK
Assets Liabilities
No change No change

There is no change in the total amount of reserves.

32 With an increase in requirements from 10 percent to 12 percent, more reserves are

required against the same volume of deposits. The resulting deficiencies must be covered by
liquidation of loans or investments... back
 BANK A
Assets Liabilities
Loans and investments . . . . . 90 Deposits . . . . . . . . . 100
Reserves . . . . . . . . . 10
(Required. . . . . 12)
(Deficit . . . . . . . 2)
FEDERAL RESERVE BANK
Assets Liabilities
No change No change

...because the total amount of bank reserves remains unchanged.

Changes in Foreign-Related Factors

The Federal Reserve has engaged in foreign currency operations for its own account since
1962. In addition, it acts as the agent for foreign currency transactions of the U.S. Treasury,
and since the 1950s has executed transactions for customers such as foreign central banks.
Perhaps the most publicized type of foreign currency transaction undertaken by the Federal
Reserve is intervention in foreign exchange markets. Intervention, however, is only one of
several foreign-related transactions that have the potential for increasing or decreasing
reserves of banks, thereby affecting money and credit growth.

Several foreign-related transactions and their effects on U.S. bank reserves are described in
the next few pages. Included are some but not all of the types of transactions used. The key
point to remember, however, is that the Federal Reserve routinely offsets any undesired
change in U.S. bank reserves resulting from foreign-related transactions. As a result, such
transactions do not affect money and credit growth in the United States.

Foreign Exchange Intervention for the Federal Reserve's Own Account

When the Federal Reserve intervenes in foreign exchange markets to sell dollars for its own
account,(19) it acquires foreign currency assets and reserves of U.S. banks initially rise. In
contrast, when the Fed intervenes to buy dollars for its own account, it uses foreign currency
assets to pay for the dollars purchased and reserves of U.S. banks initially fall.

Consider the example where the Federal Reserve intervenes in the foreign exchange markets
to sell $100 of U.S. dollars for its own account. In this transaction, the Federal Reserve buys
a foreign-currency-denominated deposit of a U.S. bank held at a foreign commercial
bank,(20) and pays for this foreign currency deposit by crediting $100 to the U.S. bank's
reserve account at the Fed. The Federal Reserve deposits the foreign currency proceeds in its
account at a Foreign Central Bank, and as this transaction clears, the foreign bank's reserves
at the Foreign Central Bank decline. See illustration 33. Initially, then, the Fed's intervention
sale of dollars in this example leads to an increase in Federal Reserve Bank assets
denominated in foreign currencies and an increase in reserves of U.S. banks.

Suppose instead that the Federal Reserve intervenes in the foreign exchange markets to buy
$100 of U.S. dollars, again for its own account. The Federal Reserve purchases a dollar-
denominated deposit of a foreign bank held at a U.S. bank, and pays for this dollar deposit by
drawing on its foreign currency deposit at a Foreign Central Bank. (The Federal Reserve
might have to sell some of its foreign currency investments to build up its deposits at the
Foreign Central Bank, but this would not affect U.S. bank reserves.) As the Federal Reserve's
account at the Foreign Central Bank is charged, the foreign bank's reserves at the Foreign
Central Bank increase. In turn, the dollar deposit of the foreign bank at the U.S. bank declines
as the U.S bank transfers ownership of those dollars to the Federal Reserve via a $100 charge
to its reserve account at the Federal Reserve. See illustration 34. Initially, then, the Fed's
intervention purchase of dollars in this example leads to a decrease in Federal Reserve Bank
assets denominated in foreign currencies and a decrease in reserves of U.S. banks.

As noted earlier, the Federal Reserve offsets

or "sterilizes" any undesired change in U.S.
bank reserves stemming from foreign
exchange intervention sales or purchases of
dollars. For example, Federal Reserve Bank
assets denominated in foreign currencies rose
dramatically in 1989, in part due to significant
U.S. intervention sales of dollars. (See chart.)
Total reserves of U.S. banks, however,
declined slightly in 1989 as open market
operations were used to "sterilize" the initial
intervention-induced increase in reserves.

Monthly Revaluation of Foreign Currency Assets

Another set of accounting transactions that affects Federal Reserve Bank assets denominated
in foreign currencies is the monthly revaluation of such assets. Two business days prior to the
end of the month, the Fed's foreign currency assets are increased if their market value has
appreciated or decreased if their value has depreciated. The offsetting accounting entry on the
Fed's balance sheet is to the "exchange-translation account" included in "other F.R.
liabilities." These changes in the Fed's balance sheet do not alter bank reserves directly.
However, since the Federal Reserve turns over its net earnings to the Treasury each week, the
revaluation affects the amount of the Fed's payment to the Treasury, which in turn influences
the size of TT&L calls and bank reserves. (See explanation on pages 18 and 19.

Foreign-Related Transactions for the Treasury

U.S. intervention in foreign exchange markets by the Federal Reserve usually is divided
between its own account and the Treasury's Exchange Stabilization Fund (ESF) account. The
impact on U.S. bank reserves from the intervention transaction is the same for both - sales of
dollars add to reserves while purchases of dollars drain reserves. See illustration 35.
Depending upon how the Treasury pays for, or finances, its part of the intervention, however,
the Federal Reserve may not need to conduct offsetting open market operations.

The Treasury typically keeps only minimal balances in the ESF's account at the Federal
Reserve. Therefore, the Treasury generally has to convert some ESF assets into dollar or
foreign currency deposits in order to pay for its part of an intervention transaction. Likewise,
the dollar or foreign currency deposits acquired by the ESF in the intervention typically are
drawn down when the ESF invests the proceeds in earning assets.

For example, to finance an intervention sale of dollars (such as that shown in illustration 35),
the Treasury might redeem some of the U.S. government securities issued to the ESF,
resulting in a transfer of funds from the Treasury's (general account) balances at the Federal
Reserve to the ESF's account at the Fed. (On the Federal Reserve's balance sheet, the ESF's
account is included in the liability category "other deposits.") The Treasury, however, would
need to replenish its Fed balances to desired levels, perhaps by increasing the size of TT&L
calls - a transaction that drains U.S. bank reserves. The intervention and financing
transactions essentially occur simultaneously. As a result, U.S. bank reserves added in the
intervention sale of dollars are offset by the drain in U.S. bank reserves from the TT&L call.
See illustrations 35 and 36. Thus, no Federal Reserve offsetting actions would be needed if
the Treasury financed the intervention sale of dollars through a TT&L call on banks.

Offsetting actions by the Federal Reserve would be needed, however, if the Treasury restored
deposits affected by foreign-related transactions through a number of transactions involving
the Federal Reserve. These include the Treasury's issuance of SDR or gold certificates to the
Federal Reserve and the "warehousing" of foreign currencies by the Federal Reserve.

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

If the ESF uses these dollar deposits directly in an intervention sale of dollars, then the
intervention-induced increase in U.S. bank reserves is not altered. See illustrations 35 and 37.
If not needed immediately for an intervention transaction, the ESF might use the dollar
deposits from issuance of SDR certificates to buy securities from the Treasury, resulting in a
transfer of funds from the ESF's account at the Federal Reserve to the Treasury's account at
the Fed. U.S. bank reserves would then increase as the Treasury spent the funds or transferred
them to banks through a direct investment to TT&L note accounts.
Gold stock and gold certificates. Changes in
the U.S. monetary gold stock used to be an
important factor affecting bank reserves.
However, the gold stock and gold certificates
issued to the Federal Reserve in "monetizing"
gold, have not changed significantly since the
early 1970s. (See chart.)

Prior to August 1971, the Treasury bought and

sold gold for a fixed price in terms of U.S.
dollars, mainly at the initiative of foreign
central banks and governments. Gold
purchases by the Treasury were added to the
U.S. monetary gold stock, and paid for from its account at the Federal Reserve. As the sellers
deposited the Treasury's checks in banks, reserves increased. To replenish its balance at the
Fed, the Treasury issued gold certificates to the Federal Reserve and received a credit to its
deposit balance.

Treasury sales of gold have the opposite effect. Buyers' checks are credited to the Treasury's
account and reserves decline. Because the official U.S. gold stock is now fully "monetized,"
the Treasury currently has to use its deposits to retire gold certificates issued to the Federal
Reserve whenever gold is sold. However, the value of gold certificates retired, as well as the
net contraction in bank reserves, is based on the official gold price. Proceeds from a gold sale
at the market price to meet demands of domestic buyers likely would be greater. The
difference represents the Treasury's profit, which, when spent, restores deposits and bank
reserves by a like amount.

While the Treasury no longer purchases gold and sales of gold have been limited, increases in
the official price of gold have added to the value of the gold stock. (The official gold price
was last raised from $38.00 to $42.22 per troy ounce, in 1973.)

Warehousing. The Treasury sometimes acquires dollar deposits at the Federal Reserve by
"warehousing" foreign currencies with the Fed. (For example, $7 billion of foreign currencies
were warehoused in 1989.) The Treasury or ESF acquires foreign currency assets as a result
of transactions such as intervention sales of dollars or sales of U.S government securities
denominated in foreign currencies. When the Federal Reserve warehouses foreign currencies
for the Treasury,(22) "Federal Reserve Banks assets denominated in foreign currencies"
increase as do Treasury deposits at the Fed. As these deposits are spent, reserves of U.S.
banks rise. In contrast, the Treasury likely will have to increase the size of TT&L calls - a
transaction that drains reserves - when it repurchases warehoused foreign currencies from the
Federal Reserve. (In 1991, $2.5 billion of warehoused foreign currencies were repurchased.)
The repurchase transaction is reflected on the Fed's balance sheet as declines in both Treasury
deposits at the Federal Reserve and Federal Reserve Bank assets denominated in foreign
currencies.

Transactions for Foreign Customers

Many foreign central banks and governments
maintain deposits at the Federal Reserve to
facilitate dollar-denominated transactions.
These "foreign deposits" on the liability side
of the Fed's balance sheet typically are held at
minimal levels that vary little from week to
week. For example, foreign deposits at the
Federal Reserve averaged only $237 million
in 1991, ranging from $178 million to $319
million on a weekly average basis. Changes in
foreign deposits are small because foreign
customers "manage" their Federal Reserve
balances to desired levels daily by buying and
selling U.S. government securities. The extent
of these foreign customer "cash management" transactions is reflected, in part, by large and
frequent changes in marketable U.S. government securities held in custody by the Federal
Reserve for foreign customers. (See chart.) The net effect of foreign customers' cash
management transactions usually is to leave U.S. bank reserves unchanged.

Managing foreign deposits through sales of securities. Foreign customers of the Federal
Reserve make dollar-denominated payments, including those for intervention sales of dollars
by foreign central banks, by drawing down their deposits at the Federal Reserve. As these
funds are deposited in U.S. banks and cleared, reserves of U.S. banks rise. See illustration 38.
However, if payments from their accounts at the Federal Reserve lower balances to below
desired levels, foreign customers will replenish their Federal Reserve deposits by selling U.S.
government securities. Acting as their agent, the Federal Reserve usually executes foreign
customers' sell orders in the market. As buyers pay for the securities by drawing down
deposits at U.S. banks, reserves of U.S. banks fall and offset the increase in reserves from the
disbursement transactions. The net effect is to leave U.S. bank reserves unchanged when U.S.
government securities of customers are sold in the market. See illustrations 38 and 39.
Occasionally, however, the Federal Reserve executes foreign customers' sell orders with the
System's account. When this is done, the rise in reserves from the foreign customers'
disbursement of funds remains in place. See illustration 38 and 40. The Federal reserve might
choose to execute sell orders with the System's account if an increase in reserves is desired
for domestic policy reasons.

Managing foreign deposits through purchases of securitites. Foreign customers of the Federal
Reserve also receive a variety of dollar denominated payments, including proceeds from
intervention purchases of dollars by foreign central banks, that are drawn on U.S. banks. As
these funds are credited to foreign deposits at the Federal Reserve, reserves of U.S. banks
decline. But if receipts of dollar-denominated payments raise their deposits at the Federal
Reserve to levels higher than desired, foreign customers will buy U.S. government securities.
The net effect generally is to leave U.S. bank reserves unchanged when the U.S. government
securities are purchased in the market.

Using the swap network. Occasionally, foreign central banks acquire dollar deposits by
activating the "swap" network, which consists of reciprocal short-term credit arrangements
between the Federal Reserve and certain foreign central banks. When a foreign central bank
draws on its swap line at the Federal Reserve, it immediately obtains a dollar deposit at the
Fed in exchange for foreign currencies, and agrees to reverse the exchange sometime in the
future. On the Federal Reserve's balance sheet, activation of the swap network is reflected as
an increase in Federal Reserve Bank assets denominated in foreign currencies and an increase
in the liability category "foreign deposits." When the swap line is repaid, both of these
accounts decline. Reserves of U.S. banks will rise when the foreign central bank spends its
dollar proceeds from the swap drawing. See illustration 41. In contrast, reserves of U.S.
banks will fall as the foreign central bank rebuilds its deposits at the Federal Reserve in order
to repay a swap drawing.

The accounting entries and impact of U.S. bank reserves are the same if the Federal Reserve
uses the swap network to borrow and repay foreign currencies. However, the Federal Reserve
has not activated the swap network in recent years.

19Overall responsibility for U.S. intervention in foreign exchange markets rests with the U.S Treasury. Foreign exchange transactions for the
Federal Reserve's account are carried out under directives issued by the Federal Reserve's Open Market Committee within the general framework of
exchange rate policy established by the U.S. Treasury in consultation with the Fed. They are implemented at the Federal Reserve Bank of New York,
typically at the same time that similar transactions are executed for the Treasury's Exchange Stabilization Fund. back

20 Americans traveling to foreign countries engage in "foreign exchange" transactions whenever they obtain foreign coins and paper currency in
exchange for U.S. coins and currency. However, most foreign exchange transactions do not involve the physical exchange of coins and currency.
Rather, most of these transactions represent the buying and selling of foreign currencies by exchanging one bank deposit denominated in one currency
for another bank deposit denominated in another currency. For ease of exposition, the examples assume that U.S. banks and foreign banks are the
market participants in the intervention transactions, but the impact on reserves would be the same if the U.S. or foreign public were involved. back

21SDRs were created in 1970 for use by governments in official balance of payments transactions. back

22Technically, warehousing consists of two parts: the Federal Reserve's agreement to purchase foreign currency assets from the Treasury or ESF for
dollar deposits now, and the Treasury's agreement to repurchase the foreign currencies sometime in the future. back

33 When the Federal Reserve intervenes to sell dollars for its own account, it pays for a
foreign-currency-denominated deposit of a U.S. bank at a foreign commercial bank by
crediting the reserve account of the U.S. bank, and acquires a foreign currency asset in the
form of a deposit at a Foreign Central Bank. The Federal Reserve, however, will offset the
increase in U.S. bank reserves if it is inconsistent with domestic policy objectives. back

FEDERAL RESERVE BANK

Assets Liabilities
Reserves: U.S. bank . .
Deposits at Foreign Central Bank . . +100
+100
 U. S. BANK
Assets Liabilities
Reserves with F.R. Bank . . +100
Deposits at foreign bank . . -100
FOREIGN BANK
Assets Liabilities
Reserves with
Foreign Central Bank . . -100 Deposits of U.S. bank . . -100
FOREIGN CENTRAL BANK
Assets Liabilities
Deposits of F.R. Banks . . . +100
Reserves of foreign bank . . . -100

34 When the Federal Reserve intervenes to buy dollars for its own account, it draws down
its foreign currency deposits at a foreign Central Bank to pay for a dollar-denominated
deposit of a foreign bank at a U.S. bank, which leads to a contraction in reserves of the U.S.
bank. This reduction in reserves will be offset by the Federal Reserve if it is inconsistent with
domestic policy objectives. back

FEDERAL RESERVE BANK

Assets Liabilities
Deposits at Foreign Central Bank . -
Reserves: U. S. bank . . -100
100
U. S. BANK
Assets Liabilities
Reserves with F.R. Bank . . -100 Deposits of foreign bank . . -100
FOREIGN BANK
Assets Liabilities
deposits at U.S. bank . . . -100
Reserves with Foreign Central Bank . +100
FOREIGN CENTRAL BANK
Assets Liabilities
Deposits of F.R. Banks . . -100
Reserves of foreign bank . . +100
35 In an intervention sale of dollars for the U.S. Treasury, deposits of the ESF at the
Federal Reserve are used to pay for a foreign currency deposit of a U.S. bank at a foreign
bank, and the foreign currency proceeds are deposited in an account at a Foreign Central
Bank. U.S. bank reserves increase as a result of this intervention transaction. back

ESF
Assets Liabilities
Deposits at F.R. Bank . . . . -100
Deposits at Foreign Central Bank . .
+100
U. S. Treasury
Assets Liabilities
No change No change
FEDERAL RESERVE BANK
Assets Liabilities
Reserves: U.S. bank . . . +100
Other deposits: ESF . . . -100
U. S. BANK
Assets Liabilities
Reserves with F.R. Bank . . . +100
Deposits at foreign bank . . . -100
FOREIGN BANK
Assets Liabilities
Deposits of U.S. bank . -
Reserves with Foreign Central Bank . -100
100
FOREIGN CENTRAL BANK
Assets Liabilities
Deposits of ESF . . . +100
Reserves of foreign bank . . -100

36 Concurrently, the Treasury must finance the intervention transaction in (35). The
Treasury might build up deposits in the ESF's account at the Federal Reserve by redeeming
securities issued to the ESF, and replenish its own (general account) deposits at the Federal
Reserve to desired levels by issuing a call on TT&L note accounts. This set of transactions
drains reserves of U.S. banks by the same amount as the intervention in (35) added to U.S.
bank reserves. back

ESF
Assets Liabilities
U.S govt. securities . . . -100
Deposits at F.R. Banks . . +100
U. S. Treasury
Assets Liabilities
TT&L accts . . . . . . . . . -100 Securities issued ESF . . . -100
Deposits at F.R. Banks . . . net 0
(from U.S bank . . +100)
(to ESF . . . . . . . . -100)
FEDERAL RESERVE BANK
Assets Liabilities
Reserves: U.S. bank . . . -100
Treas. deps: . . . . net 0
(from U.S. bank . +100)
(to ESF. . . . . . . . . -100)
Other deposits: ESF . . . . +100
U. S. BANK
Assets Liabilities
Reserves with F.R. Bank . . -100 TT&L accts . . . . . -100

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

ESF
Assets Liabilities
Deposits at F.R. Banks . . +100 SDR certificates issued to
F.R. Banks . . . . . . +100
U. S. Treasury
Assets Liabilities
No change No change
FEDERAL RESERVE BANK
 Assets Liabilities
SDR certificate account . . +100 Other deposits: ESF . . . +100
U. S. BANK
Assets Liabilities
No change No change

38 When a Foreign Central Bank makes a dollar-denominated payment from its account at
the Federal Reserve, the recipient deposits the funds in a U.S. bank. As the payment order
clears, U.S. bank reserves rise. back

FEDERAL RESERVE BANK

Assets Liabilities
Reserves: U.S. bank . . . +100
Foreign deposits . . . . -100
U. S. BANK
Assets Liabilities
Reserves with F.R. Banks . . +100 Deposits . . . . . . . . +100
FOREIGN CENTRAL BANK
Assets Liabilities
Deposits at F.R. Banks . . . . -100 Accounts payable . . . . . -100

39 If a decline in its deposits at the Federal Reserve lowers the balance below desired
levels, the Foreign Central Bank will request that the Federal Reserve sell U.S. government
securities for it. If the sell order is executed in the market, reserves of U.S. banks will fall by
the same smount as reserves were increased in (38). back

FEDERAL RESERVE BANK

Assets Liabilities
Reserves: U.S. bank . . . . -100
Foreign deposits . . . . . +100
U. S. BANK
Assets Liabilities
Deposits of securities buyer . . -
Reserves with F.R. Banks . . . -100
100
 FOREIGN CENTRAL BANK
Assets Liabilities
Deposits at F.R. Banks . . +100
U.S. govt. securities . . -100

40 If the sell order is executed with the Federal Reserve's account, however, the increase in
reserves from (38) will remain in place. The Federal Reserve might choose to execute the
foreign customer's sell order with the System's account if an increase in reserves is desired for
domestic policy reasons.

FEDERAL RESERVE BANK

Assets Liabilities
U.S. govt. securities . . . . +100 Foreign deposits . . . . +100
U. S. Bank
Assets Liabilities
No change No change
FOREIGN CENTRAL BANK
Assets Liabilities
Deposits at F.R. Banks . . . +100
U.S. govt. securities . . . . . -100

41 When a Foreign Central Bank draws on a "swap" line, it receives a credit to its dollar
deposits at the Federal Reserve in exchange for a foreign currency deposit credited to the
Federal Reserve's account. Reserves of U.S. banks are not affected by the swap drawing
transaction, but will increase as the Foreign Central Bank uses the funds as in (38). back

FEDERAL RESERVE BANK

Assets Liabilities
deposits at Foreign Central Bank . .
Foreign deposits . . . . +100
+100
U. S. Bank
Assets Liabilities
No change No change
FOREIGN CENTRAL BANK
 Assets Liabilities
Deposits at F.R. Banks . . . +100 Deposits of F.R. Banks . . . +100

Federal Reserve Actions Affecting Its Holdings of U. S.

Government Securities
In discussing various factors that affect reserves, it was often indicated that the Federal
Reserve offsets undesired changes in reserves through open market operations, that is, by
buying and selling U.S. government securities in the market. However, outright purchases
and sales of securities by the Federal Reserve in the market occur infrequently, and typically
are conducted when an increase or decrease in another factor is expected to persist for some
time. Most market actions taken to implement changes in monetary policy or to offset
changes in other factors are accomplished through the use of transactions that change reserves
temporarily. In addition, there are off-market transactions the Federal Reserve sometimes
uses to change its holdings of U.S. government securities and affect reserves. (Recall the
example in illustrations 38 and 40.) The impact on reserves of various Federal Reserve
transactions in U.S. government and federal agency securities is explained below. (See table
for a summary.)

Outright transactions. Ownership of securities is transferred permanently to the buyer in an

outright transaction, and the funds used in the transaction are transferred permanently to the
seller. As a result, an outright purchase of securities by the Federal Reserve from a dealer in
the market adds reserves permanently while an outright sale of securities to a dealer drains
reserves permanently. The Federal Reserve can achieve the same net effect on reserves
through off-market transactions where it executes outright sell and purchase orders from
customers internally with the System account. In contrast, there is no impact on reserves if
the Federal Reserve fills customers' outright sell and purchase orders in the market.

Temporary transactions. Repurchase agreements (RPs), and associated matched sale-

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

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

Impact on reserves of Federal Reserve transactions

in U.S. government and federal agency securities

Federal Reserve Transactions Reserve Impact

Outright purchase of Securities

- From dealer in market Permanent increase
- To fill customer sell orders Permanent increase
(If customer buy orders filled in market) (No impact)

Outright Sales of Securites

- To dealer in market Permanent decrease
- To fill customer buy orders internally Permanent decrease
(If customer buy orders filled in market) (No impact)

Repurchase Agreements (RPs)

- With dealer in market in System RP Temporary increase

Matched Sale-Purchase Agreements (MSPs)

- With dealer in market in a system MSP Temporary decrease
- To fill customer RP orders internally No impact*
(If customer RP orders passed to market
as customer related RPs) (Temporary increase*)

Redemption of Maturing Securities

- Replace total amount maturing No impact
- Redeem part of amount maturing Permanent decrease
- Buy more than amount maturing** Permanent increase**
___________________________________________________________________________
*Impact based on assumption that the amount of RP orders done
internally is the same as on the prior day.

**The Federal Reserve currently is prohibited by law from buying

securities directly from the Treasury, except to replace maturing
issues.

The Federal Reserve also uses MSPs to fill foreign customers' RP orders internally with the
System account. Considered in isolation, a Federal Reserve MSP transaction with customers
would drain reserves temporarily. However, these transactions occur every day, with the total
amount of RP orders being fairly stable from day to day. Thus, on any given day, the Fed
both buys back securities from customers to fulfill the prior day's MSP, and sells them about
the same amount of securities to satisfy that day's agreement. As a result, there generally is
little or no impact on reserves when the Fed uses MSPs to fill customer RP orders internally
with the System account. Sometimes, however, the Federal Reserve fills some of the RP
orders internally and the rest in the market. The part that is passed on to the market is known
as a "customer-related RP." The Fed ends up repurchasing more securities from customers to
complete the prior day's MSP than it sells to them in that day's MSP. As a result, customer-
related RPs add reserves temporarily.

Maturing securities. As securities held by the Federal Reserve mature, they are exchanged
for new securities. Usually the total amount maturing is replaced so that there is no impact on
reserves since the Fed's total holdings remain the same. Occasionally, however, the Federal
Reserve will exchange only part of the amount maturing. Treasury deposits decline as
payment for the redeemed securities is made, and reserves fall as the Treasury replenishes its
deposits at the Fed through TT&L calls. The reserve drain is permanent. If the Fed were to
buy more than the amount of securities maturing directly from the Treasury, then reserves
would increase permanently. However, the Federal Reserve currently is prohibited by law
from buying securities directly from the Treasury, except to replace maturing issues.

Page 35.

Miscellaneous Factors Affecting Bank Reserves

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

Treasury Currency Outstanding

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

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

When any type of Treasury currency is retired, bank reserves decline. As banks turn in
Treasury currency for redemption, they receive Federal Reserve notes or coin in exchange or
a credit to their reserve accounts, leaving their total reserves (reserve balances and vault cash)
initially unchanged. However, the Treasury's deposits in the Reserve Banks are charged when
Treasury currency is retired. Transfers from TT&L balances in banks to the Reserve Banks
replenish these deposits. Such transfers absorb reserves.
Treasury Cash Holdings

In addition to accounts in depository institutions and Federal Reserve Banks, the Treasury
holds some currency in its own vaults. Changes in these holdings affect bank reserves just
like changes in the Treasury's deposit account at the Reserve Banks. When Treasury holdings
of currency increase, they do so at the expense of deposits in banks. As cash holdings of the
Treasury decline, on the other hand, these funds move into bank deposits and increase bank
reserves.

Other Deposits in Reserve Banks

Besides U.S. banks, the U.S. Treasury, and foreign central banks and governments, there are
some international organizations and certain U.S. government agencies that keep funds on
deposit in the Federal Reserve Banks. In general, balances are built up through transfers of
deposits held at U.S. banks. Such transfers may take place either directly, where these
customers also have deposits in U.S. banks, or indirectly by the deposit of funds acquired
from others who do have accounts at U.S. banks. Such transfers into "other deposits" drain
reserves.

When these customers draw on their Federal Reserve balances (say, to purchase securities),
these funds are paid to the public and deposited in U.S. banks, thus increasing bank reserves.
Just like foreign customers, these "other" customers manage their balances at the Federal
Reserve closely so that changes in their deposits tend to be small and have minimal net
impact on reserves.

Nonfloat-Related Adjustments

Certain adjustments are incorporated into published data on reserve balances to reflect
nonfloat-related corrections. Such a correction might be made, for example, if an individual
bank had mistakenly reported fewer reservable deposits than actually existed and had held
smaller reserve balances than necessary in some past period. To correct for this error, a
nonfloat-related as-of adjustment will be applied to the bank's reserve position. This
essentially results in the bank having to hold higher balances in its reserve account in the
current and/or future periods than would be needed to satisfy reserve requirements in those
periods. Nonfloat-related as-of adjustments affect the allocation of funds in bank reserve
accounts but not the total amount in these accounts as reflected on Federal Reserve Bank and
individual bank balance sheets. Published data on reserve balances, however, are adjusted to
show only those reserve balances held to meet the current and/or future period reserve
requirements.

Other Federal Reserve Accounts

Earlier sections of this booklet described the way in which bank reserves increase when the
Federal Reserve purchases securities and decline when the Fed sells securities. The same
results follow from any Federal Reserve expenditure or receipt. Every payment made by the
Reserve Banks, in meeting expenses or acquiring any assets, affects deposits and bank
reserves in the same way as does payment to a dealer for government securities. Similarly,
Reserve Bank receipts of interest on loans and securities and increases in paid-in capital
absorb reserves.

End of page 35. back

The Reserve Multiplier - Why It Varies

The deposit expansion and contraction associated with a given change in bank reserves, as
illustrated earlier in this booklet, assumed a fixed reserve-to-deposit multiplier. That
multiplier was determined by a uniform percentage reserve requirement specified for
transaction accounts. Such an assumption is an oversimplification of the actual relationship
between changes in reserves and changes in money, especially in the short-run. For a number
of reasons, as discussed in this section, the quantity of reserves associated with a given
quantity of transaction deposits is constantly changing.

One slippage affecting the reserve multiplier is variation in the amount of excess reserves. In
the real world, reserves are not always fully utilized. There are always some excess reserves
in the banking system, reflecting frictions and lags as funds flow among thousands of
individual banks.

Excess reserves present a problem for monetary policy implementation only because the
amount changes. To the extent that new reserves supplied are offset by rising excess reserves,
actual money growth falls short of the theoretical maximum. Conversely, a reduction in
excess reserves by the banking system has the same effect on monetary expansion as the
injection of an equal amount of new reserves.

Slippages also arise from reserve requirements being imposed on liabilities not included in
money as well as differing reserve ratios being applied to transaction deposits according to
the size of the bank. From 1980 through 1990, reserve requirements were imposed on certain
nontransaction liabilities of all depository institutions, and before then on all deposits of
member banks. The reserve multiplier was affected by flows of funds between institutions
subject to differing reserve requirements as well as by shifts of funds between transaction
deposits and other liabilities subject to reserve requirements. The extension of reserve
requirements to all depository institutions in 1980 and the elimination of reserve requirements
against nonpersonal time deposits and Eurocurrency liabilities in late 1990 reduced, but did
not eliminate, this source of instability in the reserve multiplier. The deposit expansion
potential of a given volume of reserves still is affected by shifts of transaction deposits
between larger institutions and those either exempt from reserve requirements or whose
transaction deposits are within the tranche subject to a 3 percent reserve requirement.

In addition, the reserve multiplier is affected by conversions of deposits into currency or vice
versa. This factor was important in the 1980s as the public's desired currency holdings
relative to transaction deposits in money shifted considerably. Also affecting the multiplier
are shifts between transaction deposits included in money and other transaction accounts that
also are reservable but not included in money, such as demand deposits due to depository
institutions, the U.S. government, and foreign banks and official institutions. In the aggregate,
these non-money transaction deposits are relatively small in comparison to total transaction
accounts, but can vary significantly from week to week.

A net injection of reserves has widely different effects depending on how it is absorbed. Only
a dollar-for-dollar increase in the money supply would result if the new reserves were paid
out in currency to the public. With a uniform 10 percent reserve requirement, a $1 increase in
reserves would support $10 of additional transaction accounts. An even larger amount would
be supported under the graduated system where smaller institutions are subject to reserve
requirements below 10 percent. But, $1 of new reserves also would support an additional $10
of certain reservable transaction accounts that are not counted as money. (See chart below.)
Normally, an increase in reserves would be absorbed by some combination of these currency
and transaction deposit changes.

All of these factors are to some extent

predictable and are taken into account in
decisions as to the amount of reserves that
need to be supplied to achieve the desired rate
of monetary expansion. They help explain
why short-run fluctuations in bank reserves
often are disproportionate to, and sometimes
in the opposite direction from, changes in the
deposit component of money.

Money Creation and Reserve

Management

Another reason for short-run variation in the

amount of reserves supplied is that credit
expansion - and thus deposit creation - is
variable, reflecting uneven timing of credit
demands. Although bank loan policies
normally take account of the general
availability of funds, the size and timing of
loans and investments made under those
policies depend largely on customers' credit needs.

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

In February 1984, banks shifted to

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

On balance, however, variability in the reserve

multiplier has been reduced by the extension
of reserve requirements to all institutions in
1980, by the adoption of contemporaneous
reserve accounting in 1984, and by the
removal of reserve requirements against
nontransaction deposits and liabilities in late
1990. As a result, short-term changes in total
reserves and transaction deposits in money are
more closely related now than they were
before. (See charts on this page.) The
lowering of the reserve requirement against
transaction accounts above the 3 percent
tranche in April 1992 also should contribute to
stabilizing the multiplier, at least in theory.

Ironically, these modifications contributing to

a less variable relationship between changes in
reserves and changes in transaction deposits
occurred as the relationship between transactions money (M1) and the economy deteriorated.
Because the M1 measure of money has become less useful as a guide for policy, somewhat
greater attention has shifted to the broader measures M2 and M3. However, reserve multiplier
relationships for the broader monetary measures are far more variable than that for M1.

Although every bank must operate within the system where the total amount of reserves is
controlled by the Federal Reserve, its response to policy action is indirect. The individual
bank does not know today precisely what its reserve position will be at the time the proceeds
of today's loans are paid out. Nor does it know when new reserves are being supplied to the
banking system. Reserves are distributed among thousands of banks, and the individual
banker cannot distinguish between inflows originating from additons to reserves through
Federal reserve action and shifts of funds from other banks that occur in the normal course of
business.

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

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