[PDF]Modern Money Mechanics

Modern Money Mechanics


AWorkbook on Bank Reserves and Deposit Expansion


Federal Reserve Bank of Chicago


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Modern Money Mechanics


The purpose of this booklet is to describe the basic
process of money creation in a ‘fractional reserve” bank-
ing 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 relation-
ship 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 fol-
lowing 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 sec-
tion deals with some of the elements that modify, at least
in the short run, the simple mechanical relationship
between bank reserves and deposit money.


Modern Money Mechanics


Money is such a routine part of everyday living that
its existence and acceptance ordinarily are taken for grant-
ed. 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 con-
vertible 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. Trea-
sury, 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 desig-
nated as M1 in the Federal Reserve’s money stock statis-
tics. 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
acash 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 re-
turned to banks in exchange for deposits.


While currency is used for a great variety of small
transactions, most of the dollar amount of money pay-
ments 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 money
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 ser-
vices 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 unexpect-
ed transactions, and the foregone earnings of holding
financial assets in the form of money rather than some
other asset.


Control of the guantity of money is essential if its
value is to be kept stable. Money’s real value can be mea-
sured 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 be-
cause 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 nation’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 a part of some-
body’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.' As noted earlier, checkable liabilities
of banks are money. These liabilities are customers’ ac-
counts. 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 busi-
ness 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 ac-
ceptable 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 what-
ever 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 mak-
ing book entries crediting deposits of borrowers, which the
borrowers in turn could “spend” by writing checks, thereby
“printing” their own money.


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 permit-
ted to offer interest-bearing transaction accounts to certain customers.
Transaction accounts (interest-bearing as well as demand deposits on
which payment of interest is still legally prohibited) at all depository
institutions are subject to the reserve requirements set by the Federal
Reserve. Thus all such institutions, not just commercial banks, have the
potential for creating money.


Introduction


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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 suffi-
cient to keep the nation’s productive resources fully em-
ployed 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 deposi-
tors 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 predict-
able. 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 ex-
pansion 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 require-
ments 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 mil-
lion. The lower the percentage requirement, the greater
the deposit expansion that can be supported by each addi-
tional reserve dollar. Thus, the Jegal 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 refer-
red 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.


Modern Money Mechanics


For individual banks, reserve accounts also serve as
working balances.? 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
the 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 consider-
ation, of course, any changes in the pace at which money
is being used and changes in the public’s demands for
cash balances.


The reader should be mindful that deposits and
reserves tend to expand simultaneously and that the Fed-
eral 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
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