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... , ... ,"'"'' is such a routine of everyday

and acceptance are ordiAlthough a user may, money must come as a result of economic on1,;u,H" or, perhaps, as an outgrowth Government operation, how this

all too

urr"·U'h,,,,'" is to help provide an

the mechanics of money crea-

tion. While the process is not a one, It IS

that careful reader will gain a clearer

of the nature of money and

how the money system in the United States works.

"".,,,.-.,u as a tool used to those media that for goods, servneed to be considered. stones to cigarettes-have the

States, there are

two kinds of money in use in amounts

-currency money and coins in the

the and demand

The amount of currency in use at any time

on the Since

currency and demand are freely convertible into each other at the option of the both are money to an equal specific transactions, one

may be more than the other. When

a depositor a check, he reduces the

amount of deposits and increases the amount

currency in circulation. when

more currency is in circulation than is needed, some is returned to the banks in exchange for deposits. Currency held in bank vaults is not a part of the money supply available for snenning by the nonbank public.

While currency is used for a great variety small transactions, most of the dollar volume of money payments in our economy is made by check. per cent, or $112 billion, of the

billion total money at the

of 1961 was in the form of demand deposits.

as amount.

paper money and vV"HD~'·"""'.v face value in

uses? Mainly, it is the confidence people have that will be able to exchange such money for real goods and services whenever they choose to do so> This is partly a matter of law; currency has been designated "legal tender" by the Government. Paper currency is a liability of the Government, and demand deposits are liabilities of the commercial banks which stand ready to convert such deposits into currency or transfer their ownership at the request of depositors. Confidence in these forms of money seems also to be tied in some way to the fact that there are assets on the books of the Government and the banks equal to the amount of money outstanding, even though most of these assets themselves are no more than pieces of paper (such as customers' promissory notes) and it is well understood that money is not redeemable in them>

But the real source of money's value is neither its commodity content nor what people think stands behind it. Commodities or services are more or less valuable because there are more or less of them relative to the amounts people want. Money, like anything else, derives its value from its scarcity in relation to its usefulness. 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 is needed depends on the total volume of transactions in the economy at any given time and the amount of money individuals and businesses want to on hand to take care of unexpected or future transactions.

In order to keep the value of money stable, it is essential that the quantity be controlled. Money's value can be measured in terms of what it will buy. Therefore, changes in its value vary inversely with the level of prices. If the volume of money rises faster (assuming a constant rate of use) than the production of real goods and services grows under the limitations of time and physical facilities, prices win rise because there is more money per unit of goods. Such a development would reduce the

value of money even

were backed and redeematue

assets growth in the supply of money does pace with the either prices will fall or, more some resources and production facilities will be less than fully employed.

Just how large the stock of money needs to be in order to handle the work of the economy without exerting undue influence on the

level depends on how intensively the supply is

used. All demand deposits currency

are a part of somebody's spendable funds at any given time, moving from one owner to another as transactions take Some holders spend money quickly after they get making these dollars available for other uses. Others, however, hold dollars for longer periods. Obviously, when dollars move into hands where they do little or no work more of them are needed to accomplish any given volume of transactions.

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

The actual process of money creation takes place in the commercial banks. As noted earlier, the demand liabilities of commercial banks are money. They are book entries which result

the of deposits of currency and checks and the proceeds of loans and investments to customers' accounts. Banks can build up de-

by loans and investments so

long as enough currency on hand to

redeem whatever amounts the holders of deposits want to convert into currency.

This unique attribute of the business

was discovered several centuries ago. At one


time bankers were made a profit by brought to them for

were them could go to the banker for metallic money,

bankers discovered that could

make loans by giving borrowers their promises to pay (bank notes). 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 anyone time. Enough metallic money had to be kept on hand, of course, to redeem whatever volume of notes was presented for payment.

Deposits are the modern counterpart of bank notes. It was a small step from printing notes to making book entries to the credit of borrowers which could be spent by the use of checks.

If deposit money can be created so easily,

w ha t is to banks from too

i.e., more than is needed to handle the volume

of transactions from optimum use of

the nation's resources at stable

prices'? Like its the modern bank

must keep a considerable amount of currency (or balances with on hand. It


do operating needs and legal requirements affect the amount deposits that the commercial banking system can create? The public's demand for currency varies greatly, but generally follows a seasonal pattern which is

predictable. The effects of these swings are usually offset by central bank action and are thus prevented from causing large temporary fluctuations in the quantity of money. Moreover, for all banks taken together, there is no net drain of funds through clearings. A check drawn on one bank will normally be deposited to the credit of another account in the same or another bank. The main factor, therefore, which limits the ability of the banking system to increase demand deposits by expanding loans and investments is the reserves that banks must hold against deposits.

Growth of deposits can continue only to the point where existing reserves are just sufficient to satisfy legal requirements. If reserves of 20 per cent are required, for example, total deposits can expand only until they are five times as large as reserves. Ten million dollars of "excess" reserves, i.e., reserves in excess of the 20 per cent requirement, could support up to $50 million of additional deposits. The lower the percentage requirement, the greater the expansion power of each reserve dollar. It is this "fractional-reserve system" that sets the potentials and the limits to money creation.

Currency held in member bank vaults may be counted as legal reserves. The major part of member bank reserves, however, is in the form of deposits (reserve balances) at the Federal Reserve Banks. A bank can always obtain re-

"Throughcut this booklet, for reasons of simplicity, all commercial banks are assumed to be members of the Federal Reserve System.

serve balances by sending currency to the Reserve Bank and can obtain currency by drawing on its reserve balance. Because either can be used to support a much larger volume of ordinary bank deposits, currency and member bank reserve balances together are often referred to as "high-powered money."

For individual banks, reserve balances serve as clearing accounts. Member banks may increase their reserve balances by depositing checks, as well as currency. Banks may draw down these balances by writing checks on them or by authorizing a debit to them in payment for currency or remittance for customers' checks.

Despite the fact that reserve accounts are used as working balances, over every reserve period (one week for city banks and two weeks for country banks) each bank must maintain average reserve balances and vault cash which together are equal to the percentage of its deposit liabilities required by law.

Changes in bank reserves reflect the net effect of a number of factors discussed later in this booklet. But the essential point from the standpoint of money creation is that the reserves of commercial banks are, for the most part, liabilities of the Federal Reserve Banks and that their volume is largely determined by actions of the Federal Reserve System. Thus, the Reserve System, through its ability to vary both the total volume of reserves and the required ratio of reserves to deposit liabilities, influences the amount of bank assets and deposits. One of the major responsibilities of the Federal Reserve System is to provide a sufficient but not excessive amount of reserves to permit deposit expansion at a rate that will serve the needs of a growing economy while maintaining

reasonable into consideration, of course, the pace at which money is


But a given increase in bank reserves does

not necessarily cause an expansion in money

supply equal to the theoretical potential as termined by the legal ratio of reserves to demand deposits. What happens to the money supply will vary, depending upon the reaction of the commercial banks and the public. A number of leakages may occur. How many reserves will be drained into the public's currency holdings? To what extent will the increase in the reserve base remain unused as excess reserves? Which banks will gain the reserves? How much will be absorbed time deposits against which, though they are not money, banks must also hold reserves? The answers to these questions hold the explanation as to why deposit changes may be smaller than expected or may develop only with a considerable time lag.

In the succeeding pages, the way in which various transactions change the quantity of money is described and illustrated. The basic working tool employed is the "T" account, which provides a simple means of tracing, step by step, the effects of these transactions on 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 anyone transaction, of course, there must be at least two entries in order to maintain the balance between assets and liabilities.

The illustrations are grouped into three sections: (1) How bank deposits can respond to reserve changes originating from Federal Reserve actions or other sources; (2) how the public's demand for currency and other factors, such as gold inflow or outflow, affect bank reserves; and (3) how equal changes in bank reserves may sometimes result in widely different effects on the supply of money.


us assume that expansion money

supply is desired. One way the central bank can such an expansion is through purchases of securities in open market, thus adding to the reserves of member banks. Such purchases (and sales) are called "open market operations."

How do open market purchases add to bank reserves and deposits? The Federal Reserve System, through its New York office, buys $1,000,000 of Treasury bills from a Government securities dealer in New York. The Federal Reserve pays for the securities with a check issued on itself (and signed by one of its officers). The dealer deposits this check in his account with a commercial bank (Bank A) which sends it for collection and immediate credit to its reserve account at the Federal Reserve Bank of New York. The Federal Reserve System has added $1,000,000 of securities to its assets which it has paid for in effect by creating member bank reserves. On the commercial bank's books these reserves are matched by $1,000,000 or additional demand deposits (money) which did not exist before. [See illustration (1).J

If the process there be no

"multiple" expansion, i.e., deposits and bank reserves have by the same amount. However, member banks are required to maintain reserves equal to only a fraetion of their deposits. Reserves in excess of this amount

may be used to assets-loans

and Under current regulations,

banks in large are required to have a

higher percentage of reserves demand

deposits than are banks communi-

ties, but the average for all member banks is

15 per cent. Assuming, for simplicity, a uniform 15 per cent reserve ratio and further assuming that all commercial banks attempt to remain invested, we can now trace the process expansion in demand deposits which can take place on the basis of the additional reserves provided as a result of the Federal




The expansion process mayor may not beg-in with Bank A, depending on what the dealer does with the money received from the sale of securities. If he immediately writes >VU'C;""Kj,O for $1,000,000 and all of 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 purchase. However, other banks have received them. Most likely, part of the deposits will remain with Bank A and a will be a number of other banks as the dealer's checks clear.

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 $1,000,000 of deposits and reserves that did not have before. However, they are not required to keep $1,000,000 of reserves against the $1,000,000 of deposits. All they need to retain, under a 15 per cent reserve requirement, is $150,000. The remainder, $850,000, is "excess reserves." This amount can be loaned or invested. [See illustration (2).J

If business is active, these banks will probably have opportunities to loan $850,000. Of course, do not really make loans out of the money they receive as deposits. If they did they would be acting just like financial intermediaries and no additional money would be created. What they do when make loans is to accept promissory notes in exchange they make to the borrowers' deposit accounts. Loans (assets) and deposits (liabilities) both rise by $850,000. Reserves are un-

changed the loan transactions. But the de-

posit new additions to the

total [See


This is the beginning of the deposit expansion process. In the first of the process total loans and deposits of the commercial banks rise by an amount to the excess reserves existing any loans were made

The amounts in

following illustrations are


(2) Some banks now have "excess" reserves on the basis of which deposit expansion con take place.

Tetcl rElserves gained from new deposits. , . . . . . . . . . . . . . . . .. '1,000 Required against new (at ; 5%). . . . . . . . . . . . . . . . . . . . 150

Excess reserves .


cent of

end of have

$850,000, in addition to' the original $1,000,- 000 provided by the Federal Reserve's action, and $127,500 (15% of $850,000) of excess reserves have been absorbed by this additional deposit growth. [See illustration (4).]

The lending banks, however, do not expect to' retain the deposits they created through their loan operations. Borrowers write checks which will probably be deposited in other banks. As these are cleared the Federal Reserve Banks debit the reserve accounts of the paying banks (Stage 1 banks) and credit those of the receiving banks. [See illustration (5).J

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. Because the lending banks expect to lose these deposits and an equal amount of reserves they are not likely to lend more than their excess reserves. Like the original $1,000,000 deposit, the loan-created deposits may be transferred to other banks, but they remain somewhere in the banking system. Whichever banks hold them also have equal amounts of reserves, of which all except 15 per cent will be "excess."

Assuming that the banks holding the $850,000 of deposits created in Stage 1 in turn make loans equal to their excess reserves, then loans and deposits will rise by a further $722,500 in the second stage of expansion, This process can continue until deposits have risen to the point where all the reserves provided by the purchase of Government securities by the Federal Reserve System are just sufficient to satisfy reserve requirements against those deposits. [See pages 10 and 11.]

An individual banker, of course, is not concerned as to the stages of expansion in which he may be participating. In his operations he is constantly experiencing inflows and outflows of deposits. Any deposit he receives is new money to' him, regardless of its ultimate source,


but if he maintains a policy of loans

and investments to whatever reserves

he has in excess of his he

will be on the CAp"".""'JlVll

The total amount of expansion that can take place is illustrated on page 11. Carried through to theoretical limits, the initial $1,000,000 of reserves is distributed throughout the banking system, gives rise to an expansion of $5,666,- 667 of commercial bank credit (loans and investments) and supports a total of $6,666,667 of deposits under a 15 per cent reserve requirement. The expansion factor for a given amount of excess reserves is thus the reciprocal of the required reserve percentage (1/15% 6%).

Although an individual bank can expand its loans only by the amount of its excess reserves, commercial banks as a group can expand credit by a multiple of any addition to their reserves. This is 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 total deposits or reserves.

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 are customers, the banks would make payment by crediting the customers' demand deposits; deposit liabilities would rise just as they did when loans were 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 the loan operations described above.


As a result of the process so jar, total assets and total liabilities of all commercial banks together have risen 1,850.

Reserves with Deposits:
F. R. Banks +1,000 Initial +1,000
Stage 1 +850
Loans +850
Total +1,850 Total +1,850 (4) Excess reserves have been reduced by the amount required against the deposits created by the loans made in Stage 1.

Total reserves gained from initial deposits .

Required against initial deposits. . . . . . . . . . . . . . . . . . . .. 150 Required against Stage 1 deposits................... 128

Excess reserves .


.zzs, 722





Now the banking system's assets and liabilities have risen by a total of 2,.572.

Reserves with F. R. Bank Loans:

Stage 1 Stage 2



+1,000 initial

Stage 1

+850 Stage 2


+2,572 Total

+1,000 +850 +722


(7) But there are still 614 of excess reserves in the banking system.

Total reserves gained from initial deposits. . . . . . . . . . . . 1,000

Required against initial deposits.................... 150 Required against Stage 1 deposits................... 128

Required against Stage 2 deposits. . . . . . . . . . . . . . . . . .. 1 08 ~

Excess reserves .



to Stage 3


(8) 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 1,000 of reserves has been absorbed by deposit growth. As is apparent from the summary table on page 11, more than four-fifths of the expansion potential is reached after the first ten stages.


loans and Demand
Initial reserves provided ... 1,000 150 S50 t,OOO
Expansion - Stage 1. " ... '1,000 278 722 850
Stage 2 ...... 1,000 386 614 ;,572
Stage 3 ...... 1,000 478 522 2,186 3,'186
Stage 4 ...... 1,000 556 444 2,708 3,708
Stage 5 ... .. 1,000 623 377 3, !52 4,152
Stage 0 ...... i,OOO 680 320 3,529 4,529
Stage 7 ...... 1,000 728 272 3,849 4,849
Stage 8 ...... 1,000 769 231 4,121 5,121
Stage 9 ...... 1,000 803 197 4,352 5,352
Stage 10 ..... 1,000 8"''' 167 4,549 5,549
~~ o



Stage 20 .....





Final stage ....





cumulative expansion in deposits on basis of 1,000 of new reserves and reserve requirements

of 15 per cent






expansion stages


Now suppose some reduction in the money supply is desired. 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 supply by absorbing bank reserves. The process is essentially the reverse of the expansion steps just described.

The Federal Reserve System sells a $1,000,- 000 Treasury bill to a dealer in Government securities and receives in payment a check drawn on Commercial Bank A. When the check clears, Bank A's reserve account at a Federal Reserve Bank is reduced $1,000,000. As a result, the Federal Reserve System's holdings of securities and the reserve deposits of member banks are both reduced $1,000,000.

The $1,000,000 reduction in Bank A's deposits constitutes a decline in the money supply. [See illustration (1).]

While Bank A may have regained deposits from other banks as a result of interbank deposit flows, all commercial banks taken together have $1,000,000 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 $150,000 (15 per cent of $1,000,000). Unless these banks had excess reserves, they are left with a reserve deficiency of $850,000 [see illustration (2)]. 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.

The easiest way for a bank to obtain the reserves it needs is by selling securities [see illustration (3) J. But as the buyers of the securities pay for them with checks drawn on their deposit accounts (in the same or other


banks), the net result is an $850,000 decline in and deposits in the first stage of the contraction process [see illustration (4)]. Now deposits have been reduced by a total of $1,850,000, but there is a reserve deficiency of $722,500 at banks whose depositors drew down their accounts to purchase the securities. As these banks, in turn, make up this deficiency by selling securities or reducing loans, further deposit contraction takes place.

It is now clear that the 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 applied in the case of deposit expansion. Under a 15 per cent reserve requirement, a $1,000,000 reduction in reserves would ultimately entail reductions of $6,666,667 in deposits and $5,666,667 in loans and investments.

As in the case of deposit expansion, contraction of demand deposits may take place as a result of either commercial bank sales of investments or reduction of loans. While some adjustments of both kinds undoubtedly would be made, the initial impact is likely to be reflected in sales of Government securities. In addition, although most types of outstanding loans cannot be called for payment prior to their due dates, the bank may cease to make new loans or renew outstanding ones to replace those currently maturing. Thus, deposits built up for the purpose of loan retirement are extinguished as loans are repaid.

There is, however, 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 commercial 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 reserves are utilized) to the point where the required ratio of reserves to deposits is restored.

(2) The reduction in deposits may be spread among a number of banks through interbank deposit flows. But some banks now have reserve deficiencies:

Total reserves lost from deposit withdrawal .

Reserves freed by deposit decline (at 15%) .

Deficiency in reserves against remaining deposits .

1,000 150 850

As a result of the process so far, assets and total deposits of all commercial banks are down 1,850. Stage 1 contraction has freed 128 of reserves, but there is still a reserve deficiency of 722 .

Reserves with Deposits:
F. R. Bank -1,000 Initial -1,000
Stage 1 -850
U. S. Government
securities -850
Total -1,850 Total -1,850 13

Since changes in follow from '"'U'''Ulo''''

in bank reserves, to understand what is ,,~"'¥~ •• to the nation's money we must understand what causes bank reserves to

Money has been defined mand

the sum of de-


everyone uses it every when most people think of money,

think of currency. to this popu-

demand deposits are of the money CH'VUO<H currency on hand to handle small face-to-face transactions, but they write checks to cover most

Most businesses

hold even smaller

amounts of currency in relation to their total transactions.

Since variable in over-all

quantity of money, is demand deposits, control-

the money is a matter

of controlling the of those deposits. As

indicated in the section of this book-

deposit growth can take place only if banks have excess reserves and contraction must occur if reserves decline. It is by influencing bank reserves that the Reserve System is able to influence the quantity of money.

The above illustrations the and

contraction processes demonstrate how the cen-

tral by and sale of Government

can change bank re-

serves in order to affect deposits. But open

market are one of a number of

kinds transactions or developments

cause changes in reserves. nate from actions by the the Treasury or and international institutions; but some of them arise from the service functions and operating needs of the Reserve Banks themselves.

The various factors that provide and absorb reserve funds, together with symbols the direction of their effects, are listed on the opposite page. This tabulation also indicates the nature of the balancing entry on the Federal


the extent the

Federal Reserve's books are

It is

that member bank reserves

are affected in several ways that are maepencent the control of the central bank. Most

collection process, rise to an automatic increase in Federal Reserve credit in the form

of "float." Other as gold inflows

or may for indefinite

Still other variations in bank reserves result

the mechanics ar-

among the , the Federal

and the commercial banks. The Treasury, for example, keeps most of its working balance on deposit commercial banks, which fractional reserve requirements

apply. But disbursements are made from

its balances in the Reserve trans-

deposrts to the Reserve Banks

the causes a

for-dollar drain on member bank reserves.

In contrast to these that affect reserves are the policy "'"'~'V'H0

the Federal Reserve System and sales of securities affect reserves has already been described. In addi-

there are two other ways in which the

"'''co-."...., can act to affect bank reserves

and potential volume:

loans to member banks; and in reserve course, do not the total volume reserves but do change the amount of deposits that a given amount €.)f reserves can support.

reserve change has the same potential effect on deposits regardless of its origin.

in order achieve the net reserve

effects consistent with its and

objectives, the Federal Reserve System must continuously take account what the independent factors are doing to reserves and through its policy or supplement them as the situation may require.

aucmons to bank reserves from other sources that would cause in credit availability.

In the following section of kinds of transactions ket operations, have important effects on the reserves of the commercia are traced in detail. Other factors normally have only a small influence on bank reserves are described briefly on page 31.

far the largest portion of the System's action, particularly its open market operations, is undertaken to offset drains from or

Fadors Changing Bank Reserves - Independent and

Public Operations

Increase in currency holdings .

Decrease in currency holdings .

Treasury and Foreign Operations

Increase in Treasury deposits in F. R. Banks .

Decrease in Treasury deposits in F. R. Banks .

Gold purchases (inflow) .

Gold sales (outflow) .

Increase in Treasury currency outstanding .

Decrease in Treasury currency outstanding .

Increase in Treasury cash holdings .

Decrease in Treasury cash holdings .

increase in foreign and other deposits in F. R. Banks .

Decrease in foreign and other deposits in F. R. Banks .

Federal Reserve Operations

Increase in Federal Reserve float .

Decrease in Federal Reserve float .

*Increase in other assets .

*Decrease in other assets .

*Increase in other liabilities .

*Decrease in other liabilities .

*increase in capitol accounts ',' .

*Decrease in capital accounts .

Federal Reserve Banks


* Included in "Other Federal Reserve accounts (net)" as described on page 31. t Effect on excess reserves. Total reserves are unchanged.

Note: To the extent reserve changes are in the form of vcult cash, federal Reserve accounts are nat affected.


Changes in the Amount or Currency Held by the Public

Major changes in the amount of currency in the hands of the public occur over holiday periods and during the Christmas shopping season, when people find it convenient to keep more "pocket" money on hand. As noted earlier, the public acquires currency from the banks by "cashing" checks. When deposits, which are fractional reserve money, are exchanged for currency, which is 100 per cent reserve money, six and two-thirds times as many reserves (based on a 15 per cent requirement) are absorbed. A given amount of bank reserves can support almost seven times as much in deposits but can meet only an equal amount of currency demand. This reflects- the fact that the commercial bank, like its medieval predecessor, is still the middleman between the issuers of currency (the central banks and the Treasury) and the public. The currency it uses to meet customers' needs comes, dollar-for-dollar, from its own reserves.

Suppose a bank customer draws a $100 check on his account in exchange for currency needed for a weekend holiday. Commercial bank deposits decline $100 since the customer paid for the currency by a check on his demand deposit; and the bank's currency (vault cash) is also reduced $100. [See illustration (1).J

Now the bank has less currency. It may replenish this (or may have provided for anticipated seasonal needs in advance) by ordering currency from its Federal Reserve Bankmaking payment by authorizing a charge to its reserve balance.

On the Reserve Bank's books, the charge against the member's reserve balance is offset by an increase in the liability item "Federal Reserve notes outstanding" [see illustration (2)]. The shipment might consist, at least in part, of Treasury currency rather than Federal Reserve notes. Qoins and some small denomination bills are obligations of the Treasury. To the extent that shipments of cash to commercial banks are in this form, the offsetting entry on the Reserve Bank's books is a decline in its holdings of Treasury currency (included in the asset item "other cash").


The public now has the same volume of money as before, except that more is in the form of currency and less in demand deposits. Under 15 per cent reserve requirements the amount of reserves required against the $100 of deposits was only $15, while $100 of reserves has been used up by the payment of currency. Thus, if the commercial bank had no excess reserves, the $100 withdrawal in currency would cause a reserve deficiency of $85. 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 $567. until the required reserve ratio is re-established."

After holiday periods currency returns to the banks. The customer who "cashed" a check to cover anticipated cash expenditures may later redeposit any currency he still has beyond his normal pocket-money needs. Most of it probably will have changed hands. It will be deposited by owners 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' commercial banks gain reserves as 100 per bent reserve money is converted back into fractional- reserve money.

VVhen $100 of currency is returned to the banks, deposits and vault cash are increased [see illustration (3) J. The commercial banks can keep the currency as vault cash which also counts as reserves; or more likely, the currency will be shipped to the Federal Reserve Banks. The Reserve Banks credit member bank reserve accounts and reduce Federal Reserve note liabilities [see illustration (4)]. (Or, if Treasury currency is involved, "other cash" assets of the Reserve Banks will rise.) Since only $15 must be held against the new $100 deposits, $85 is excess reserves and can give rise to $567 of additional deposits.

Changes in the Amount of Currency Held by the Public



Besides banks, whose reserve ac-

counts constitute the bulk of the deposit liabilities of the Federal Reserve System, there are a few other institutions that maintain balances in the Federal Reserve Banks-mainly the U. S. Treasury, foreign central banks and international institutions. In general, when these balances rise, member bank reserves fall, and vice versa. This reflects the fact that the funds used by these agencies to build up their deposits in the Reserve Banks ultimately come from deposits in commercial banks. Conversely, checks written on these Reserve Bank balances are normally deposited by the payees in commercial banks which receive credit to their reserve accounts through the collection process.

The most important nonmember bank depositor is the Treasury. Only a small part of the Treasury's working balance is kept in the Federal Reserve Banks; the rest is held in depositary commercial banks, in so-called "tax and loan" accounts, all over the country. As has already been indicated, most of the Treasury's payments are made against its Federal Reserve balances. Thus, transfers from commercial banks to Federal Reserve Banks (according to scheduled calls on tax and loan accounts) are made regularly to assure that sufficient funds are available to cover Treasury checks as they are presented for payment. Such transfers, in much the same way as the cashing of checks by the public, in effect change fractional-reserve money into 100 per cent reserve money. This is because the Treasury's balances in commercial banks, like other demand deposits, absorb reserves only to the extent of about 15 per cent of their volume, but when they are moved to the Federal Reserve Banks, member bank reserves fall by the full amount of the transfer.

Suppose a Treasury call, payable by a member bank, amounts to $100. The Federal Reserve Banks are authorized to transfer the amount of the Treasury call from the reserve balances of member banks (both for themselves and for their nonmember correspondents) to the account of the U. S. Treasury. As a result of the


in Federal Reserve Banks

both reserves and Government de-

of the member bank are On the

books of the Reserve member bank reserve deposits decline and the balance rises. [See illustration (1).]

Just as in the case of the currency withdrawal, this withdrawal of Treasury funds win cause a reserve deficiency of $85 since the total amount of reserves lost is that much larger than the reserves released the decline in its deposits.

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 commercial banks. The latter receive reserve credit equal to the fun amount of these deposits although the corresponding increase in their required reserves is only 15 per cent of this amount.

Suppose a Government salary check for $100 is deposited by the payee in a commercial bank. The bank sends the check to its Federal Reserve Bank for collection. The Reserve Bank then credits the sender's reserve account and charges the Treasury's account. As a result, the commercial bank gains both reserves and deposits. While there is no change in the assets or total liabilities of the Federal Reserve Banks, the funds drawn away the Treasury's balances have been shifted to member bank reserve deposits. [See illustration (2).J

In practice, the attempts to keep its

balances in the Reserve Banks fairly uniform so that fluctuations in bank reserves due to the mechanics of its expenditure process will be minimized. In recent years fluctuations have been significantly reduced by daily adjustments in tax and loan balances at the large commercial banks. Through this procedure either special withdrawals or redeposits are made as required to keep the Treasury's deposits in the Reserve Banks at the desired level.


Treasury Deposits in Federal Reserve Banks

The U. S. Treasury keeps most of its cosh bolcnce in "Tox and loan accounts" in commercia! banks. Transfers are made regularly from these accounts to the Treasury's deposits in Federal Reserve Banks, from which Treasury checks are paid.




Deposits in:

F. R. Banks

TI:I)( and loan accounts Other cash

500 Miscellaneo!ls liabi!ities 100
800 Balance 5,400
6,500 6,500 19

Treasury Purchases Sales

of Gold Change Bonk Reserves

Since it is unlawful for individuals and businesses to hold gold, except as it is used industrially and in token amounts, freshly mined gold or gold coming into the country from abroad generally is sold to the Treasury. This gold then becomes part of our monetary gold stock and bank reserves are expanded by an identical amount.

(L) When the Treasury buys gold, the seller check is collected. .






Let us assume that the buys gold.

Payment for $100 of gold is made with a check drawn on its deposit in the Federal Reserve Banks. The recipient of this check deposits it in a commercial bank. Both reserves and deposit liabilities of the bank are thereby increased by like amounts. [See illustration (l).J

Deposits in F. ·R. Banks

But now the Treasury's balance has been depleted. To replenish it the Treasury issues gold certificates to the Federal Reserve Banks and receives a credit to its deposit balance [see illustration (2)]. The net result of these transactions is an increase of $100 in both reserves and deposits of commercial banks.




Deposits In r. R. Banks


+ 100 certificates


The sale of gold by the Treasury, of course, has the opposite effect. Buyers of gold make payment by checks on balances with commercial banks, and the Treasury sends the checks to a Federal Reserve Bank for collection. The commercial bank's reserves are reduced, and the Treasury's balance is increased. [See illustration (3).J

(3) When the Treosury sells gold, the buyer peys decline when this check is collected.



N ow the Treasury draws on its balance in the Reserve Banks to retire gold certificates equal to the amount of gold sold [see illustration (4)]. As a net result, commercial bank deposits and reserves are reduced.

.. 100

Oeposlts in F. fL Banks


Purchases and sales of gold take place mainly at the initiative of foreign central banks and governments. Such flows, however, may exert perverse effects on money and credit conditions. In time of recession, outflows reduce reserves that may be needed to promote the growth of the domestic economy; in time of boom, inflows create reserves that may dangerously inflate the money supply unless offsetting actions are taken.




Deposits in F, it Banks


-iOO certificates ··100


Treasury Purchases and Sales of Gold



in float or in total member bank reserves from this source. [See illustration (1).]

Federal Reserve Bank Float

A proportion of checks drawn on banks

and deposited in other banks are cleared (collected) through the Federal Reserve Banks. Some of these checks-those drawn on nearby

banks-are credited immediately to reserve

account of the depositing bank debited to

the reserve account the bank on which the check was drawn. All checks are credited to the account of the depositing bank no later than two days after they are received at the Reserve Banks, even though the check may not yet have been collected, i.e., before the reserves of the bank upon which the check was drawn have been debited.

The reserve credit given for checks not yet collected is caned "float." On the books of the Federal Reserve Banks, float represents the difference between the asset item, "cash items in process of collection," and the liability item, "deferred availability cash items." This difference is always positive because there are many checks that cannot be collected with the twoday-maximum time schedule. The amount of the difference-volume of ft.oat-is quite stable on an annual average basis but often fluctuates sharply over short periods.

As float rises, the total reserves member

banks rise by the same amount. Suppose, for example, Commercial Bank A receives checks totaling $100 drawn on Banks B, C and D, all in distant cities. It credits the accounts of its depositors, debits "cash items in process of collection" and sends the items to a Federal Reserve Bank for collection.

The Federal Reserve Bank, upon receipt of the checks, debits its own asset account, "cash items in process of collection," and credits "deferred availability cash items" (checks not yet credited to the sending bank). So long as these two accounts move together, there is no change


At the end of two days (assuming B, C and D have a two-day collection schedule), the Reserve Bank's "deferred availability" account is reduced and Bank A's reserve balance is increased by $100. If these items actually take more than two days to collect, credit to Bank A represents an addition to the total reserves of the banking system. [See illustration (2) .J

Only when the checks are actually o;;Utu::o;;l.,CU from Banks B, C and D does the float involved in the processing of these checks disappear"cash items in process of collection" of the Reserve Bank declines as the reserve balances of Banks B, C and D are reduced. [See illustration (3) .J

The significant aspect, from the standpoint of the effect on bank reserves, is not that float exists but that its volume changes. Major changes in float occur in a fairly regular pattern, with increases at midmonth and at year end. Such increases reflect the larger volume of check transactions taking place at these times. Any special circumstances causing delays in the

of mail can provide a boost in

float and hence in bank reserves. For example, weather conditions that ground planes or strikes that affect almost any segment the transportation industry often give rise to increases in float as checks en route to paying collection are slowed down.

On the other hand, when actual collections are larger than the new items that are being received for collection, float goes down. This usually occurs following periods of increase. Reserves gained from float expansion are thus likely to be quite temporary.

Changes in Federal Reserve Float



Reserve Requirements

Thus far we have described transactions that affect the volume of bank reserves and their impact upon the capacity of the commercial banks to expand their assets and deposits. It is also possible to influence deposit expansion or contraction by changing the percentage of deposits which must be held as reserves.

The authority to vary required reserve percentages for member banks was first granted to the Federal Reserve System in 1933. The range within which this authority can be exercised has been changed at infrequent intervals to conform with major changes in reserve conditions. As of the beginning of 1961 the limits prescribed by law by class of bank and type of deposits were as follows:

On demand deposits:

Reserve and Central Reserve

City banks. . .. 10 to 22 per cent

Country banks.. 7 to 14 per cent

On time deposits:

All banks .

3 to 6 per cent

Changes in requirements within these limits are made at the discretion of the Board of Governors of the Federal Reserve System. Such changes may be applied differently between classes of banks but must be uniform for banks within a class.

When reserve requirements are lowered, a portion of banks' existing holdings of required reserves become excess reserves and may be loaned or invested.

For example, at an average requirement of 20 per cent, $20 of reserves would be required to support $100 of deposits. But a reduction in the legal requirement to 15 per cent would tie up only $15, freeing $5 out of each $20 of reserves for use in the creation of additional bank credit and deposits. [See illustration (Lr.]

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 20 to 25 per cent would boost required reserves to $25 for each $100 of deposits. Assuming banks have no excess reserves, this would force them to liquidate assets until deposits fall to a level in line with the existing amount of reserves-one-fifth less than before. [See illustration (2).J

The power to change reserve requirements, like purchases and sales of securities by the Reserve Banks, is an instrument of credit control. Even a small change in requirements, say one-half percentage point, has a large and widespread impact. The tool is usually employed, therefore, only when large reserve effects are desired. Other instruments of monetary control are sometimes used to cushion the initial impact of a reserve requirement change. Thus, the System may sell securities to absorb temporarily 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 an subsequent increases or decreases in reserves from any source. For this reason movements in the total volume of bank reserves, over periods when requirements differ, do not provide an accurate indication of the Federal Reserve System's actions to influence the money supply.

The volume of bank reserves may be affected also by changes in the kinds of assets designated as reserve eligible. Under the 1959 amendments to the Federal Reserve Act, member banks are permitted to count their vault cash, as well as reserve balances, as legally required reserves. To the extent that some vault cash serves a double purpose-both to meet currency withdrawals and reserve requirements -commercial banks can operate with a somewhat lower ratio of total cash assets (currency plus reserve balances) to deposits.

Changes in Reserve Requirements


Under a 20 per cent requirement, $20 of reserves are needed to support each $100 of deposits.




[Required 20 l _Excess OJ

80 20

loans and investments





the Federal Reserve Banks

When a member bank borrows its Fed-

eral Reserve Bank it borrows reserves. The acquisition of reserves in this manner

in an important way from the cases already illustrated. Banks normally borrow only to make up reserve deficiencies, not to obtain excess reserves. Borrowed reserves, therefore, are reserves on which expansion has taken place. How can this happen?

In their efforts to accommodate customers as well as to keep fully invested, banks sometimes make loans in anticipation of deposit inflows that fail to materialize or do so less rapidly than expected. These new loans add to bank deposits but not to bank reserves. Unless ex-

cess reserves can be tapped, will not be

enough reserves to meet reserve

ments against the new deposits. dividual banks may incur 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. In either case, a member bank may borrow reserves temporarily from its Reserve Bank.

Suppose a customer of Bank A wants to borrow $100. On the basis of the management's judgment that the bank's reserves will rise sufficiently to provide the necessary funds, customer is accommodated. The loan is made by debiting "loans" and crediting the customer's deposit account. Now Bank A's deposits are increased by $100. if reserves have not

risen as expected, Bank A will have a re-

serve deficiency, assuming of 15

per cent illustration (1)]. It borrows that amount from its Federal Reserve Bank which makes a loan by giving the bank credit in its reserve account and counts and advances." The member

reserves and a corresponding "bills

(2)]. Since only enough reserves were borrowed to support deposits already in existence, no further expansion on these reserves is possible.


Federal Reserve loans to member banks are

extended to

needs. Borrowed reserves repaid within a relatively short period of time. Even in periods when the total volume of member bank borrowing is some individual banks are repaying debt while others are borrowing.

To repay borrowing, a bank must have gained reserves through either growth or asset illustration (3)]. A bank makes payment by a debit to its reserve account at the Federal Reserve Bank. of borrowing, therefore, reduces both reserves and "bills payable" illustration (4)].

The adjustments made by some banks to get out of debt, such as sales of securities, tend to transfer reserve shortages to other banks and may force them to borrow, especially in periods heavy credit demands. In the aggre-

borrowing usually increases in periods of

business activity when the public's demands for credit are rising more rapidly than reserves are being provided by the System 'in other ways.

Although reserve expansion through borrow-

is member banks, the amount

of reserves that banks can in this way is limited by Federal Reserve discount administration and by control of the rate charged banks on these loans-the discount rate. Loans are made for purposes, and bor-

is ~

higher discount rate tends to restrain borrow-

by its cost.

is an to the Reserve tools of control. While of

severe strains on

the reserve of individual there

incentive to repay before

to and


Repayment of Borrowing


What actually happens to the supply of money when bank reserves are expanded or reduced? In an earlier section of this booklet the process of deposit expansion and contraction was outlined under simplified conditions: that all banks maintain uniform reserve ratios, that all are fully invested at all times and that the public holds all funds created through the expansion process in the form of demand deposits.

While these assumptions are appropriate to illustrate the potential effects of Federal Reserve actions, they do not necessarily represent the actual money supply changes that take place as a result of any specific injection or withdrawal of reserves. This is especially true in the short run. Several kinds of "leakages" may take place in varying degrees over time. As a result, diverse monetary effects may ensue from equivalent reserve changes.

Reserve ratios are not uniform among banks.

There are differences in legal reserve requirements between classes of banks and types of deposits, and different banks have varying proportions of demand and time liabilities.

A wide range of effects on the volume of currency or deposits is possible. Only a dollarfor-dollar increase in money supply win result if the new reserves are paid out in currency to the public. At the other extreme, a dollar of new reserves can support $20 of time deposits (at 5 per cent requirements), but none of this would count as an addition to the money supply as we have defined it. [See Diagram L]

The smaller the ratio of required reserves to total deposits, the more demand deposits can grow. Differences in this ratio are likely to be most marked between city and country banks, reflecting both the large proportion of demand deposits at city banks and the higher legal reserve requirements against demand deposits in these centers, Thus, the deposit volume resulting from a given addition to reserves will vary


depending on which banks participate in the expansion process.

The assumption that all banks keep fully invested is likewise somewhat at odds with the facts. There are always some excess reserves over those needed to meet legal requirements, but more important is the fact that the volume of excess reserves varies from time to time. To the extent that new reserves provided are reflected in rising excess reserves, actual deposit growth will fall short of the theoretical maximum. Conversely, the contractive effects of reserve destruction by the Federal Reserve System may be partly offset by a reduction in the over-all volume of excess reserves.

Finally, the volume of deposit money at any given time may be higher or lower than its average relation to reserves because of unusually large shifts into or out of deposits that are not counted as a part of the active money supply, i.e., time and U. S. Government deposits at commercial banks.

The rate of growth in time deposits tends to vary inversely with the pace of business activity. Although the ratio of required reserves for such deposits is much lower than for demand deposits, a rapid rise in time balances during cyclical downswings can account for a significant leakage from the reserves being provided for expansion of the money supply.

As explained earlier, the United States Government keeps the largest part of its balances at commercial banks, transferring funds to the Federal Reserve Banks as needed to make current expenditures. These balances, which by definition are excluded from money supply, often rise sharply in periods of tax payments and security sales, with corresponding shrinkage in private demand deposits. Several weeks may elapse before these funds get back into private deposits as Government expenditures take place. Meanwhile, because reserve requirements are the same for all demand deposits,

$6.7 million demand deposits

$4 million

$1 million currency

$ 10 million demand deposits

100% reserves 25% reserves 15% reserves 10% reserves 5% reserves

bank reserves

Diagram 1

This diagram shows how the potential demand deposit expansion from a reserve injection of $1,000,000 at a 15 per cent reserve ratio (as in earlier illustrations) compares with potentials under various other possibilities as to the use of these reserves.

Diagram 2

This diagram shows actual differences in the amount and composition of deposits on two dates when member bonk reserves were approximately the same and there were no differences in reserve requirements. Data are for all member banks on two call dates, June 23, 1958, and December 31, 1959. Interbank deposits are excluded.


no reserves have been released that would percommercial banks to restore (money supply) deposits.

The total amount of bank reserves is not only distributed against demand, time and U. S. Government deposits in banks with different reserve ratios but also in proportions over time. As a result, a constant volume of reserves at different times may a quite different deposit volume and structure. [See Diagram 2.]

The differing responses to monetary action can be even more strikingly illustrated a comparison of deposit changes in two periods when reserve changes were equal, [See Diagram The time periods compared in this diagram were periods in which (1) changes in total member bank reserves were approximate-

the same .and (2) legal reserve requirements were identical. In both of these periods, member bank reserves rose by roughly $400,000,000. In the first period, demand deposits grew very rapidly, partly reflecting a shift from U. S. Government balances. In the second period, most of the expansion showed up in time and U. S. Government deposits.

Although the differences in these periods are unusually sharp, the comparison illustrates the difficulties in attempting to predict, at least in the short run, the magnitude of the change in money supply that will ensue from any given change in bank reserves.

in the long run, money and time deposits together closely parallel changes in bank loans




Diagram 3

Deposits may respond in various ways to equal changes in reserves.

period I

period :II

Note: Data are for all member banks. Period i covers the four months ended January 31, 1959. Period Ii covers the three months ended June 30, 1960.

rotio scole




Misceiianeous factors Affecting Member Bank Reserves

The on bank reserves of the factors

described below are negligible because changes in them either occur very slowly or tend to be offset by concurrent changes in other factors.

The amount of Treasury currency outstanding increases gradually over time, but shortrun changes are very small and their effects on bank reserves are indirect. Treasury currency consists of coins, silver certificates in denominations of five dollars and under, and other currency originally issued by commercial banks but for which the has redemption responsibility. New currency issued by the Treasury (say silver certificates against its free silver stocks) is shipped 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, as explained on pages 18 and 19, are paid out to the public, who deposits them in commercial banks, thus increasing bank reserves.

When Treasury currency is retired, bank reserves decline. Payment for currency turned in for redemption is made with checks on the Treasury's deposits in the Reserve Banks, and the immediate effect is a reduction in these balances. The latter must be replenished, however, by transfers from the deposits in commercial banks. Such transfers absorb bank reserves.

In addition to deposit balances in '-'V.iiWH""

and Federal Reserve the

some cash in its own vaults. Changes in

affect member bank reserves

in the

ings increase they do so at the expense deposits in commercial banks. As cash HVIUIHg

of the decline, on the other


these funds Inove into posits and increase member

Besides member banks and ury, foreign central banks, stitutions, and a few funds on deposit in the Federal Reserve Banks. In general, these balances are built up out funds transferred from member banks. transfers may take place either directly, where these groups also have deposits in U. S. com-

merical banks, or indirectly the

funds acquired from holders who do have commercial bank balances the Treasury,

banks or the general public.

When these groups draw on their Reserve balances, say to purchase these funds are paid to the public and deposited in commercial banks, increasing bank reserves.

Earlier in this booklet the way in which bank reserves increase when the Federal Reserve purchases securities and how they decline when securities are sold was illustrated. The same result follows from any Federal Reserve exor receipt. Every payment made the Reserve Banks in meeting expenses or acquiring any asset affects bank deposits reserves in the same way as does the payment to a dealer for Government securities. Similarly, Reserve Bank receipts of interest on loans and securities or capital absorb reserves

as do receipts from sales of securities.

"Other Federal Reserve accounts" represents a combination of the balance sheet items not already considered as separate factors affecting reserves. These accounts absorb reserves, on balance, since the sum of capital accounts and liabilities exceeds "other" assets. When

figure increases, as a re-

sult of net current

bank reserves are reduced. 'When it

drops, the market

funds and reserves rise.


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