[Federal Reserve Bank of Chicago]Modern Money Mechanics

AWorkbookonBankReservesandDepositExpansion

FederalReserveBankofChicago

Introduction

Thepurposeofthisbookletistodescribethebasicprocessofmoneycreationina

\"fractionalreserve\"bankingsystem.TheapproachtakenillustratesthechangesinbankbalancesheetsthatoccurwhendepositsinbankschangeasaresultofmonetaryactionbytheFederalReserveSystem-thecentralbankoftheUnitedStates.Therelationshipsshownarebasedonsimplifyingassumptions.Forthesakeofsimplicity,therelationshipsareshownasiftheyweremechanical,buttheyarenot,asisdescribedlaterinthebooklet.Thus,theyshouldnotbeinterpretedtoimplyacloseandpredictable

relationshipbetweenaspecificcentralbanktransactionandthequantityofmoney.TheintroductorypagescontainabriefgeneraldescriptionofthecharacteristicsofmoneyandhowtheU.S.moneysystemworks.Theillustrationsinthefollowingtwo

sectionsdescribetwoprocesses:first,howbankdepositsexpandorcontractinresponsetochangesintheamountofreservessuppliedbythecentralbank;andsecond,howthosereservesareaffectedbybothFederalReserveactionsandotherfactors.Afinalsectiondealswithsomeoftheelementsthatmodify,atleastintheshortrun,thesimplemechanicalrelationshipbetweenbankreservesanddepositmoney.

Moneyissucharoutinepartofeverydaylivingthatitsexistenceandacceptanceordinarilyaretakenforgranted.Ausermaysensethatmoneymustcomeintobeingeitherautomaticallyasaresultofeconomicactivityorasanoutgrowthofsomegovernmentoperation.Butjusthowthishappensalltoooftenremainsamystery.WhatisMoney?

Ifmoneyisviewedsimplyasatoolusedtofacilitatetransactions,onlythosemediathatarereadilyacceptedinexchangeforgoods,services,andotherassetsneedtobeconsidered.Manythings-fromstonestobaseballcards-haveservedthismonetaryfunctionthroughtheages.Today,intheUnitedStates,moneyusedintransactionsismainlyofthreekinds-currency(papermoneyandcoinsinthepocketsandpursesofthepublic);demanddeposits(non-interestbearingcheckingaccountsinbanks);andothercheckabledeposits,suchasnegotiableorderofwithdrawal(NOW)accounts,atalldepositoryinstitutions,includingcommercialandsavingsbanks,savingsandloanassociations,andcreditunions.Travelerschecksalsoareincludedinthedefinitionoftransactionsmoney.Since$1incurrencyand$1incheckabledepositsarefreelyconvertibleintoeachotherandbothcanbeuseddirectlyforexpenditures,theyare

moneyinequaldegree.However,onlythecashandbalancesheldbythenonbankpublicarecountedinthemoneysupply.DepositsoftheU.S.Treasury,depositoryinstitutions,

foreignbanksandofficialinstitutions,aswellasvaultcashindepositoryinstitutionsareexcluded.

ThistransactionsconceptofmoneyistheonedesignatedasM1intheFederalReserve'smoneystockstatistics.Broaderconceptsofmoney(M2andM3)includeM1aswellascertainotherfinancialassets(suchassavingsandtimedepositsatdepositoryinstitutionsandsharesinmoneymarketmutualfunds)whicharerelativelyliquidbutbelievedtorepresentprincipallyinvestmentstotheirholdersratherthanmediaofexchange.Whilefundscanbeshiftedfairlyeasilybetweentransactionbalancesandtheseotherliquidassets,themoney-creationprocesstakesplaceprincipallythroughtransactionaccounts.Intheremainderofthisbooklet,\"money\"meansM1.

Thedistributionbetweenthecurrencyanddepositcomponentsofmoneydependslargelyonthepreferencesofthepublic.Whenadepositorcashesacheckormakesacash

withdrawalthroughanautomatictellermachine,heorshereducestheamountofdepositsandincreasestheamountofcurrencyheldbythepublic.Conversely,whenpeoplehavemorecurrencythanisneeded,someisreturnedtobanksinexchangefordeposits.Whilecurrencyisusedforagreatvarietyofsmalltransactions,mostofthedollaramountofmoneypaymentsinoureconomyaremadebycheckorbyelectronictransferbetweendepositaccounts.Moreover,currencyisarelativelysmallpartofthemoneystock.About69percent,or$623billion,ofthe$8billiontotalstockinDecember1991,wasintheformoftransactiondeposits,ofwhich$290billionweredemandand$333billionwereothercheckabledeposits.WhatMakesMoneyValuable?

IntheUnitedStatesneitherpapercurrencynordepositshavevalueascommodities.Intrinsically,adollarbillisjustapieceofpaper,depositsmerelybookentries.Coinsdohavesomeintrinsicvalueasmetal,butgenerallyfarlessthantheirfacevalue.

What,then,makestheseinstruments-checks,papermoney,andcoins-acceptableatfacevalueinpaymentofalldebtsandforothermonetaryuses?Mainly,itisthe

confidencepeoplehavethattheywillbeabletoexchangesuchmoneyforotherfinancialassetsandforrealgoodsandserviceswhenevertheychoosetodoso.

Money,likeanythingelse,derivesitsvaluefromitsscarcityinrelationtoitsusefulness.Commoditiesorservicesaremoreorlessvaluablebecausetherearemoreorlessofthemrelativetotheamountspeoplewant.Money'susefulnessisitsuniqueabilitytocommandothergoodsandservicesandtopermitaholdertobeconstantlyreadytodoso.Howmuchmoneyisdemandeddependsonseveralfactors,suchasthetotalvolumeoftransactionsintheeconomyatanygiventime,thepaymentshabitsofthesociety,theamountofmoneythatindividualsandbusinesseswanttokeeponhandtotakecareofunexpectedtransactions,andtheforgoneearningsofholdingfinancialassetsintheformofmoneyratherthansomeotherasset.

Controlofthequantityofmoneyisessentialifitsvalueistobekeptstable.Money'srealvaluecanbemeasuredonlyintermsofwhatitwillbuy.Therefore,itsvaluevaries

inverselywiththegenerallevelofprices.Assumingaconstantrateofuse,ifthevolumeofmoneygrowsmorerapidlythantherateatwhichtheoutputofrealgoodsandservicesincreases,priceswillrise.Thiswillhappenbecausetherewillbemoremoneythantherewillbegoodsandservicestospenditonatprevailingprices.Butif,ontheotherhand,growthinthesupplyofmoneydoesnotkeeppacewiththeeconomy'scurrent

production,thenpriceswillfall,thenations'slaborforce,factories,andotherproductionfacilitieswillnotbefullyemployed,orboth.

Justhowlargethestockofmoneyneedstobeinordertohandlethetransactionsoftheeconomywithoutexertingundueinfluenceonthepriceleveldependsonhowintensivelymoneyisbeingused.Everytransactiondepositbalanceandeverydollarbillispartofsomebody'sspendablefundsatanygiventime,readytomovetootherownersas

transactionstakeplace.Someholdersspendmoneyquicklyaftertheygetit,makingthesefundsavailableforotheruses.Others,however,holdmoneyforlongerperiods.

Obviously,whensomemoneyremainsidle,alargertotalisneededtoaccomplishanygivenvolumeoftransactions.WhoCreatesMoney?

ChangesinthequantityofmoneymayoriginatewithactionsoftheFederalReserveSystem(thecentralbank),depositoryinstitutions(principallycommercialbanks),orthepublic.Themajorcontrol,however,restswiththecentralbank.

Theactualprocessofmoneycreationtakesplaceprimarilyinbanks.(1)Asnotedearlier,checkableliabilitiesofbanksaremoney.Theseliabilitiesarecustomers'accounts.Theyincreasewhencustomersdepositcurrencyandchecksandwhentheproceedsofloansmadebythebanksarecreditedtoborrowers'accounts.

Intheabsenceoflegalreserverequirements,bankscanbuildupdepositsbyincreasingloansandinvestmentssolongastheykeepenoughcurrencyonhandtoredeemwhateveramountstheholdersofdepositswanttoconvertintocurrency.Thisuniqueattributeofthebankingbusinesswasdiscoveredmanycenturiesago.

Itstartedwithgoldsmiths.Asearlybankers,theyinitiallyprovidedsafekeepingservices,makingaprofitfromvaultstoragefeesforgoldandcoinsdepositedwiththem.Peoplewouldredeemtheir\"depositreceipts\"whenevertheyneededgoldorcoinstopurchasesomething,andphysicallytakethegoldorcoinstothesellerwho,inturn,woulddepositthemforsafekeeping,oftenwiththesamebanker.Everyonesoonfoundthatitwasaloteasiersimplytousethedepositreceiptsdirectlyasameansofpayment.Thesereceipts,whichbecameknownasnotes,wereacceptableasmoneysincewhoeverheldthemcouldgotothebankerandexchangethemformetallicmoney.

Then,bankersdiscoveredthattheycouldmakeloansmerelybygivingtheirpromisestopay,orbanknotes,toborrowers.Inthisway,banksbegantocreatemoney.Morenotes

couldbeissuedthanthegoldandcoinonhandbecauseonlyaportionofthenotes

outstandingwouldbepresentedforpaymentatanyonetime.Enoughmetallicmoneyhadtobekeptonhand,ofcourse,toredeemwhatevervolumeofnoteswaspresentedforpayment.

Transactiondepositsarethemoderncounterpartofbanknotes.Itwasasmallstepfromprintingnotestomakingbookentriescreditingdepositsofborrowers,whichthe

borrowersinturncould\"spend\"bywritingchecks,thereby\"printing\"theirownmoney.WhatLimitstheAmountofMoneyBanksCanCreate?

Ifdepositmoneycanbecreatedsoeasily,whatistopreventbanksfrommakingtoomuch-morethansufficienttokeepthenation'sproductiveresourcesfullyemployedwithoutpriceinflation?Likeitspredecessor,themodernbankmustkeepavailable,tomakepaymentondemand,aconsiderableamountofcurrencyandfundsondepositwiththecentralbank.Thebankmustbepreparedtoconvertdepositmoneyintocurrencyforthosedepositorswhorequestcurrency.Itmustmakeremittanceoncheckswrittenbydepositorsandpresentedforpaymentbyotherbanks(settleadverseclearings).Finally,itmustmaintainlegallyrequiredreserves,intheformofvaultcashand/orbalancesatitsFederalReserveBank,equaltoaprescribedpercentageofitsdeposits.

Thepublic'sdemandforcurrencyvariesgreatly,butgenerallyfollowsaseasonalpatternthatisquitepredictable.Theeffectsonbankfundsofthesevariationsintheamountofcurrencyheldbythepublicusuallyareoffsetbythecentralbank,whichreplacesthereservesabsorbedbycurrencywithdrawalsfrombanks.(Justhowthisisdonewillbeexplainedlater.)Forallbankstakentogether,thereisnonetdrainoffundsthrough

clearings.Acheckdrawnononebanknormallywillbedepositedtothecreditofanotheraccount,ifnotinthesamebank,theninsomeotherbank.

Theseoperatingneedsinfluencetheminimumamountofreservesanindividualbankwillholdvoluntarily.However,aslongasthisminimumamountislessthanwhatislegallyrequired,operatingneedsareofrelativelyminorimportanceasarestraintonaggregatedepositexpansioninthebankingsystem.Suchexpansioncannotcontinuebeyondthepointwheretheamountofreservesthatallbankshaveisjustsufficienttosatisfylegalrequirementsunderour\"fractionalreserve\"system.Forexample,ifreservesof20

percentwererequired,depositscouldexpandonlyuntiltheywerefivetimesaslargeasreserves.Reservesof$10millioncouldsupportdepositsof$50million.Thelowerthepercentagerequirement,thegreaterthedepositexpansionthatcanbesupportedbyeachadditionalreservedollar.Thus,thelegalreserveratiotogetherwiththedollaramountofbankreservesarethefactorsthatsettheupperlimittomoneycreation.WhatAreBankReserves?

Currencyheldinbankvaultsmaybecountedaslegalreservesaswellasdeposits(reservebalances)attheFederalReserveBanks.Bothareequallyacceptableinsatisfactionofreserverequirements.Abankcanalwaysobtainreservebalancesby

sendingcurrencytoitsReserveBankandcanobtaincurrencybydrawingonitsreservebalance.Becauseeithercanbeusedtosupportamuchlargervolumeofdepositliabilitiesofbanks,currencyincirculationandreservebalancestogetherareoftenreferredtoas\"high-poweredmoney\"orthe\"monetarybase.\"Reservebalancesandvaultcashinbanks,however,arenotcountedaspartofthemoneystockheldbythepublic.

Forindividualbanks,reserveaccountsalsoserveasworkingbalances.(2)Banksmayincreasethebalancesintheirreserveaccountsbydepositingchecksandproceedsfromelectronicfundstransfersaswellascurrency.Ortheymaydrawdownthesebalancesbywritingchecksonthemorbyauthorizingadebittotheminpaymentforcurrency,customers'checks,orotherfundstransfers.

Althoughreserveaccountsareusedasworkingbalances,eachbankmustmaintain,ontheaveragefortherelevantreservemaintenanceperiod,reservebalancesattheirReserveBankandvaultcashwhichtogetherareequaltoitsrequiredreserves,asdeterminedbytheamountofitsdepositsinthereservecomputationperiod.WhereDoBankReservesComeFrom?

Increasesordecreasesinbankreservescanresultfromanumberoffactorsdiscussedlaterinthisbooklet.Fromthestandpointofmoneycreation,however,theessentialpointisthatthereservesofbanksare,forthemostpart,liabilitiesoftheFederalReserve

Banks,andnetchangesinthemarelargelydeterminedbyactionsoftheFederalReserveSystem.Thus,theFederalReserve,throughitsabilitytovaryboththetotalvolumeofreservesandtherequiredratioofreservestodepositliabilities,influencesbanks'

decisionswithrespecttotheirassetsanddeposits.OneofthemajorresponsibilitiesoftheFederalReserveSystemistoprovidethetotalamountofreservesconsistentwiththemonetaryneedsoftheeconomyatreasonablystableprices.Suchactionstakeintoconsideration,ofcourse,anychangesinthepaceatwhichmoneyisbeingusedandchangesinthepublic'sdemandforcashbalances.

ThereadershouldbemindfulthatdepositsandreservestendtoexpandsimultaneouslyandthattheFederalReserve'scontroloftenisexertedthroughthemarketplaceasindividualbanksfinditeithercheaperormoreexpensivetoobtaintheirrequired

reserves,dependingonthewillingnessoftheFedtosupportthecurrentrateofcreditanddepositexpansion.

Whileanindividualbankcanobtainreservesbybiddingthemawayfromotherbanks,thiscannotbedonebythebankingsystemasawhole.ExceptforreservesborrowedtemporarilyfromtheFederalReserve'sdiscountwindow,asisshownlater,thesupplyofreservesinthebankingsystemiscontrolledbytheFederalReserve.

Moreover,agivenincreaseinbankreservesisnotnecessarilyaccompaniedbyanexpansioninmoneyequaltothetheoreticalpotentialbasedontherequiredratioofreservestodeposits.Whathappenstothequantityofmoneywillvary,dependinguponthereactionsofthebanksandthepublic.Anumberofslippagesmayoccur.What

amountofreserveswillbedrainedintothepublic'scurrencyholdings?Towhatextentwilltheincreaseintotalreservesremainunusedasexcessreserves?Howmuchwillbeabsorbedbydepositsorotherliabilitiesnotdefinedasmoneybutagainstwhichbanksmightalsohavetoholdreserves?Howsensitivearethebankstopolicyactionsofthecentralbank?Thesignificanceofthesequestionswillbediscussedlaterinthisbooklet.Theanswersindicatewhychangesinthemoneysupplymaybedifferentthanexpectedormayrespondtopolicyactiononlyafterconsiderabletimehaselapsed.

Inthesucceedingpages,theeffectsofvarioustransactionsonthequantityofmoneyaredescribedandillustrated.Thebasicworkingtoolisthe\"T\"account,whichprovidesasimplemeansoftracing,stepbystep,theeffectsofthesetransactionsonboththeassetandliabilitysidesofbankbalancesheets.Changesinassetitemsareenteredonthelefthalfofthe\"T\"andchangesinliabilitiesontherighthalf.Foranyonetransaction,ofcourse,theremustbeatleasttwoentriesinordertomaintaintheequalityofassetsandliabilities.

1Inordertodescribethemoney-creationprocessassimplyaspossible,theterm\"bank\"usedinthisbookletshouldbeunderstoodto

encompassalldepositoryinstitutions.SincetheDepositoryInstitutionsDeregulationandMonetaryControlActof1980,alldepositoryinstitutionshavebeenpermittedtoofferinterestbearingtransactionaccountstocertaincustomers.Transactionaccounts(interestbearingaswellasdemanddepositsonwhichpaymentofinterestisstilllegallyprohibited)atalldepositoryinstitutionsaresubjecttothereserverequirementssetbytheFederalReserve.Thusallsuchinstitutions,notjustcommercialbanks,havethepotentialforcreatingmoney.back2Partofanindividualbank'sreserveaccountmayrepresentitsreservebalanceusedtomeetitsreserverequirementswhileanotherpartmaybeitsrequiredclearingbalanceonwhichearningscreditsaregeneratedtopayforFederalReserveBankservices.backBankDeposits-HowTheyExpandorContract

LetusassumethatexpansioninthemoneystockisdesiredbytheFederalReservetoachieveitspolicyobjectives.Onewaythecentralbankcaninitiatesuchanexpansionisthroughpurchasesofsecuritiesintheopenmarket.Paymentforthesecuritiesaddstobankreserves.Suchpurchases(andsales)arecalled\"openmarketoperations.\"

Howdoopenmarketpurchasesaddtobankreservesanddeposits?SupposetheFederalReserveSystem,throughitstradingdeskattheFederalReserveBankofNewYork,buys$10,000ofTreasurybillsfromadealerinU.S.governmentsecurities.(3)Intoday'sworldofcomputerizedfinancialtransactions,theFederalReserveBankpaysforthesecuritieswithan\"telectronic\"checkdrawnonitself.(4)Viaits\"Fedwire\"transfer

network,theFederalReservenotifiesthedealer'sdesignatedbank(BankA)thatpaymentforthesecuritiesshouldbecreditedto(depositedin)thedealer'saccountatBankA.Atthesametime,BankA'sreserveaccountattheFederalReserveiscreditedfortheamountofthesecuritiespurchase.TheFederalReserveSystemhasadded$10,000ofsecuritiestoitsassets,whichithaspaidfor,ineffect,bycreatingaliabilityonitselfintheformof

bankreservebalances.ThesereservesonBankA'sbooksarematchedby$10,000ofthedealer'sdepositsthatdidnotexistbefore.Seeillustration1.HowtheMultipleExpansionProcessWorks

Iftheprocessendedhere,therewouldbeno\"multiple\"expansion,i.e.,depositsandbankreserveswouldhavechangedbythesameamount.However,banksarerequiredtomaintainreservesequaltoonlyafractionoftheirdeposits.Reservesinexcessofthisamountmaybeusedtoincreaseearningassets-loansandinvestments.Unusedorexcessreservesearnnointerest.Undercurrentregulations,thereserverequirementagainstmosttransactionaccountsis10percent.(5)Assuming,forsimplicity,auniform10percentreserverequirementagainstalltransactiondeposits,andfurtherassumingthatallbanksattempttoremainfullyinvested,wecannowtracetheprocessofexpansionindepositswhichcantakeplaceonthebasisoftheadditionalreservesprovidedbytheFederalReserveSystem'spurchaseofU.S.governmentsecurities.

TheexpansionprocessmayormaynotbeginwithBankA,dependingonwhatthedealerdoeswiththemoneyreceivedfromthesaleofsecurities.Ifthedealerimmediatelywriteschecksfor$10,000andallofthemaredepositedinotherbanks,BankAlosesbothdepositsandreservesandshowsnonetchangeasaresultoftheSystem'sopenmarketpurchase.However,otherbankshavereceivedthem.Mostlikely,apartoftheinitialdepositwillremainwithBankA,andapartwillbeshiftedtootherbanksasthedealer'schecksclear.

Itdoesnotreallymatterwherethismoneyisatanygiventime.Theimportantfactisthatthesedepositsdonotdisappear.Theyareinsomedepositaccountsatalltimes.Allbankstogetherhave$10,000ofdepositsandreservesthattheydidnothavebefore.However,theyarenotrequiredtokeep$10,000ofreservesagainstthe$10,000ofdeposits.Alltheyneedtoretain,undera10percentreserverequirement,is$1000.Theremaining$9,000is\"excessreserves.\"Thisamountcanbeloanedorinvested.Seeillustration2.Ifbusinessisactive,thebankswithexcessreservesprobablywillhaveopportunitiestoloanthe$9,000.Ofcourse,theydonotreallypayoutloansfromthemoneytheyreceiveasdeposits.Iftheydidthis,noadditionalmoneywouldbecreated.Whattheydowhentheymakeloansistoacceptpromissorynotesinexchangeforcreditstotheborrowers'transactionaccounts.Loans(assets)anddeposits(liabilities)bothriseby$9,000.

Reservesareunchangedbytheloantransactions.Butthedepositcreditsconstitutenewadditionstothetotaldepositsofthebankingsystem.Seeillustration3.

3Dollaramountsusedinthevariousillustrationsdonotnecessarilybearanyresemblancetoactualtransactions.Forexample,openmarketoperationstypicallyareconductedwithmanydealersandinamountstotalingseveralbilliondollars.back4Indeed,manytransactionstodayareaccomplishedthroughanelectronictransferoffundsbetweenaccountsratherthanthroughissuanceofa

papercheck.Apartfromthetimeofposting,theaccountingentriesarethesamewhetheratransferismadewithapapercheckorelectronically.Theterm\"check,\"therefore,isusedforbothtypesoftransfers.back5Foreachbank,thereserverequirementis3percentonaspecifiedbaseamountoftransactionaccountsand10percentontheamountabove

thisbase.Initially,theMonetaryControlActsetthisbaseamount-calledthe\"lowreservetranche\"-at$25million,andprovidedforitto

changeannuallyinlinewiththegrowthintransactiondepositsnationally.Thelowreservetranchewas$41.1millionin1991and$42.2millionin1992.TheGarn-St.GermainActof1982furthermodifiedtheserequirementsbyexemptingthefirst$2millionofreservableliabilitiesfromreserverequirements.Likethelowreservetranche,theexemptlevelisadjustedeachyeartoreflectgrowthinreservableliabilities.Theexemptlevelwas$3.4millionin1991and$3.6millionin1992.

backDepositExpansion

1.WhentheFederalReserveBankpurchasesgovernmentsecurities,bankreserves

increase.Thishappensbecausethesellerofthesecuritiesreceivespaymentthroughacredittoadesignateddepositaccountatabank(BankA)whichtheFederalReserveeffectsbycreditingthereserveaccountofBankA.

FRBANK

Assets

USgovt

securities..+10,000

LiabilitiesReserveacct.BankA..+10,000

Assets

Reserveswith

FRBanks..+10,000

BANKA

LiabilitiesCustomer

deposit..+10,000

ThecustomerdepositatBankAlikelywillbetransferred,inpart,tootherbanksandquicklylosesitsidentityamidthehugeinterbankflowofdeposits.backTotalreservesgainedfromnewdeposits.......10,000Asaresult,allbankstaken

less:requiredagainstnewdeposits(at10%)...

together

1,000

nowhave\"excess\"reservesonwhich

equals:Excessreserves.................

depositexpansioncantakeplace.

9,000

2.

backExpansion-Stage1

3.Expansiontakesplaceonlyifthebanksthatholdtheseexcessreserves(Stage1

banks)increasetheirloansorinvestments.Loansaremadebycreditingtheborrower'saccount,i.e.,bycreatingadditionaldepositmoney.backSTAGE1BANKS

Assets

Loans.......+9,000Liabilities

Borrowerdeposits....+9,000

Thisisthebeginningofthedepositexpansionprocess.Inthefirststageoftheprocess,totalloansanddepositsofthebanksrisebyanamountequaltotheexcessreservesexistingbeforeanyloansweremade(90percentoftheinitialdepositincrease).AttheendofStage1,depositshaverisenatotalof$19,000(theinitial$10,000providedbytheFederalReserve'sactionplusthe$9,000indepositscreatedbyStage1banks).Seeillustration4.However,only$900(10percentof$9000)ofexcessreserveshavebeenabsorbedbytheadditionaldepositgrowthatStage1banks.Seeillustration5.

Thelendingbanks,however,donotexpecttoretainthedepositstheycreatethroughtheirloanoperations.Borrowerswritechecksthatprobablywillbedepositedinotherbanks.Asthesechecksmovethroughthecollectionprocess,theFederalReserveBanksdebitthereserveaccountsofthepayingbanks(Stage1banks)andcreditthoseofthereceivingbanks.Seeillustration6.

WhetherStage1banksactuallydolosethedepositstootherbanksorwhetheranyoralloftheborrowers'checksareredepositedinthesesamebanksmakesnodifferenceintheexpansionprocess.Ifthelendingbanksexpecttolosethesedeposits-andanequal

amountofreserves-astheborrowers'checksarepaid,theywillnotlendmorethantheirexcessreserves.Liketheoriginal$10,000deposit,theloan-crediteddepositsmaybetransferredtootherbanks,buttheyremainsomewhereinthebankingsystem.Whicheverbanksreceivethemalsoacquireequalamountsofreserves,ofwhichallbut10percentwillbe\"excess.\"

Assumingthatthebanksholdingthe$9,000ofdepositscreatedinStage1inturnmakeloansequaltotheirexcessreserves,thenloansanddepositswillrisebyafurther$8,100inthesecondstageofexpansion.ThisprocesscancontinueuntildepositshaverisentothepointwhereallthereservesprovidedbytheinitialpurchaseofgovernmentsecuritiesbytheFederalReserveSystemarejustsufficienttosatisfyreserverequirementsagainstthenewlycreateddeposits.(Seepages10and11.)

Theindividualbank,ofcourse,isnotconcernedastothestagesofexpansioninwhichitmaybeparticipating.Inflowsandoutflowsofdepositsoccurcontinuously.Anydepositreceivedisnewmoney,regardlessofitsultimatesource.Butifbankpolicyistomakeloansandinvestmentsequaltowhateverreservesareinexcessoflegalrequirements,theexpansionprocesswillbecarriedon.

HowMuchCanDepositsExpandintheBankingSystem?

Thetotalamountofexpansionthatcantakeplaceisillustratedonpage11.Carried

throughtotheoreticallimits,theinitial$10,000ofreservesdistributedwithinthebankingsystemgivesrisetoanexpansionof$90,000inbankcredit(loansandinvestments)andsupportsatotalof$100,000innewdepositsundera10percentreserverequirement.Thedepositexpansionfactorforagivenamountofnewreservesisthusthereciprocalofthe

requiredreservepercentage(1/.10=10).Loanexpansionwillbelessbytheamountoftheinitialinjection.Themultipleexpansionispossiblebecausethebanksasagrouparelikeonelargebankinwhichchecksdrawnagainstborrowers'depositsresultincreditstoaccountsofotherdepositors,withnonetchangeinthetotalreserves.ExpansionthroughBankInvestments

Depositexpansioncanproceedfrominvestmentsaswellasloans.SupposethatthedemandforloansatsomeStage1banksisslack.Thesebankswouldthenprobably

purchasesecurities.Ifthesellersofthesecuritieswerecustomers,thebankswouldmakepaymentbycreditingthecustomers'transactionaccounts,depositliabilitieswouldrisejustasifloanshadbeenmade.Morelikely,thesebankswouldpurchasethesecuritiesthroughdealers,payingforthemwithchecksonthemselvesorontheirreserveaccounts.Thesecheckswouldbedepositedinthesellers'banks.Ineithercase,theneteffectsonthebankingsystemareidenticalwiththoseresultingfromloanoperations.

4Asaresultoftheprocesssofar,totalassetsandtotalliabilitiesofallbankstogether

haverisen19,000.backALLBANKS

AssetsLiabilities

ReserveswithF.R.Banks...+10,000Deposits:Initial....+10,000Loans.................+9,000Stage1.........+9,000Total.................+19,000Total...........+19,000

5Excessreserveshavebeenreducedbytheamountrequiredagainstthedepositscreated

bytheloansmadeinStage1.backTotalreservesgainedfrominitialdeposits....10,000less:Requiredagainstinitialdeposits........-1,000less:RequiredagainstStage1requirements....-900equals:Excessreserves....................8,100

Whydothesebanksstopincreasingtheirloansanddepositswhentheystillhaveexcessreserves?

6...becauseborrowerswritechecksontheiraccountsatthelendingbanks.Asthese

checksaredepositedinthepayees'banksandcleared,thedepositscreatedbyStage1loansandanequalamountofreservesmaybetransferredtootherbanks.backSTAGE1BANKS

AssetsLiabilities

ReserveswithF.R.Banks.-9000Borrowerdeposits...-9,000

(matchedunderFRbank(shownasadditionsto

liabilities)otherbankdeposits)

FEDERALRESERVEBANK

Assets

Liabilities

Reserveaccounts:Stage1banks.-9,000

Otherbanks.................

+9,000OTHERBANKS

Assets

ReserveswithF.R.Banks.

+9,000

Liabilities

Deposits.........+9,000

Depositexpansionhasjustbegun!

Page10.

7Expansioncontinuesasthebanksthathaveexcessreservesincreasetheirloansbythat

amount,creditingborrowers'depositaccountsintheprocess,thuscreatingstillmoremoney.

STAGE2BANKS

Assets

Loans........+8100

Liabilities

Borrowerdeposits...+8,100

8Nowthebankingsystem'sassetsandliabilitieshaverisenby27,100.

ALLBANKS

AssetsLiabilities

ReserveswithF.R.Banks.+10,000Deposits:Initial....+10,000Loans:Stage1...........+9,000Stage1...........+9,000Stage2................+8,100Stage2...........+8,100Total..................+27,000Total............+27,000

9Buttherearestill7,290ofexcessreservesinthebankingsystem.

Totalreservesgainedfrominitialdeposits.....10,000less:Requiredagainstinitialdeposits.-1,000less:RequiredagainstStage1deposits.-900

less:RequiredagainstStage2deposits.-810...2,710

equals:Excessreserves....................7,290-->toStage3banks

10Asborrowersmakepayments,thesereserveswillbefurtherdispersed,andthe

processcancontinuethroughmanymorestages,inprogressivelysmallerincrements,untiltheentire10,000ofreserveshavebeenabsorbedbydepositgrowth.Asisapparentfromthesummarytableonpage11,morethantwo-thirdsofthedepositexpansionpotentialisreachedafterthefirsttenstages.

Itshouldbeunderstoodthatthestagesofexpansionoccurneithersimultaneouslynorinthesequencedescribedabove.Somebanksusetheirreservesincompletelyoronlyafteraconsiderabletimelag,whileothersexpandassetsonthebasisofexpectedreserve

growth.

Theprocessis,infact,continuousandmayneverreachitstheoreticallimits.

Endpage10.backPage11.

Thusthroughstageafterstageofexpansion,\"money\"cangrowtoatotalof10timesthenewreservessuppliedtothebankingsystem....

Assets

[

Total

Reserves(Required)

(Excess)

]

LoansandInvestments

DepositsLiabilities

ReservesprovidedExp.Stage1Stage2Stage3Stage4Stage5Stage6Stage7Stage8Stage9Stage10.........

Stage20.........

FinalStage

10,0001,0009,000-10,00019008,1009,00010,0002,7107,29017,10010,0003,4396,56124,39010,0004,0955,90530,95110,0004,6865,31436,85610,0005,2174,78342,17010,0005,6954,30546,95310,0006,1263,87451,25810,0006,5133,48755,13210,000

6,8623,13858,619

....................................10,000

8,9061,09479,058

....................................10,000

10,000

0

90,000

...asthenewdepositscreatedbyloansateachstageareaddedtothosecreatedatallearlierstagesandthosesuppliedbytheinitial

reserve-creatingaction.

10,00019,00027,10034,39040,95146,85652,17056,95361,25865,13268,619

.........,058

.........100,000

Endpage11.backPage12.

HowOpenMarketSalesReducebankReservesandDeposits

Nowsupposesomereductionintheamountofmoneyisdesired.Normallythiswouldreflecttemporaryorseasonalreductionsinactivitytobefinancedsince,onayear-to-yearbasis,agrowingeconomyneedsatleastsomemonetaryexpansion.JustaspurchasesofgovernmentsecuritiesbytheFederalReserveSystemcanprovidethebasisfordepositexpansionbyaddingtobankreserves,salesofsecuritiesbytheFederalReserveSystemreducethemoneystockbyabsorbingbankreserves.Theprocessisessentiallythereverseoftheexpansionstepsjustdescribed.

SupposetheFederalReserveSystemsells$10,000ofTreasurybillstoaU.S.governmentsecuritiesdealerandreceivesinpaymentan\"electronic\"checkdrawnonBankA.Asthispaymentismade,BankA'sreserveaccountataFederalReserveBankisreducedby$10,000.Asaresult,theFederalReserveSystem'sholdingsofsecuritiesandthereserveaccountsofbanksarebothreduced$10,000.The$10,000reductioninBankA'sdepostliabilitiesconstitutesadeclineinthemoneystock.Seeillustration11.ContractionAlsoIsaCumulativeProcess

WhileBankAmayhaveregainedpartoftheinitialreductionindepositsfromother

banksasaresultofinterbankdepositflows,allbankstakentogetherhave$10,000lessinbothdepositsandreservesthantheyhadbeforetheFederalReserve'ssalesofsecurities.

Theamountofreservesfreedbythedeclineindeposits,however,isonly$1,000(10percentof$10,000).Unlessthebanksthatlosethereservesanddepositshadexcessreserves,theyareleftwithareservedeficiencyof$9,000.Seeillustration12.AlthoughtheymayborrowfromtheFederalReserveBankstocoverthisdeficiencytemporarily,soonerorlaterthebankswillhavetoobtainthenecessaryreservesinsomeotherwayorreducetheirneedsforreserves.

Onewayforabanktoobtainthereservesitneedsisbysellingsecurities.But,asthebuyersofthesecuritiespayforthemwithfundsintheirdepositaccountsinthesameorotherbanks,thenetresultisa$9,000declineinsecuritiesanddepositsatallbanks.Seeillustration13.AttheendofStage1ofthecontractionprocess,depositshavebeenreducedbyatotalof$19,000(theinitial$10,000resultingfromtheFederalReserve'sactionplusthe$9,000indepositsextinguishedbysecuritiessalesofStage1banks).Seeillustration14.

However,thereisnowareservedeficiencyof$8,100atbankswhosedepositorsdrewdowntheiraccountstopurchasethesecuritiesfromStage1banks.Asthenewgroupofreserve-deficientbanks,inturn,makesupthisdeficiencybysellingsecuritiesorreducingloans,furtherdepositcontractiontakesplace.

Thus,contractionproceedsthroughreductionsindepositsandloansorinvestmentsinonestageafteranotheruntiltotaldepositshavebeenreducedtothepointwherethesmallervolumeofreservesisadequatetosupportthem.Thecontractionmultipleisthesameasthatwhichappliesinthecaseofexpansion.Undera10percentreserverequirement,a$10,000reductioninreserveswouldultimatelyentailreductionsof$100,000indepositsand$90,000inloansandinvestments.

Asinthecaseofdepositexpansion,contractionofbankdepositsmaytakeplaceasaresultofeithersalesofsecuritiesorreductionsofloans.Whilesomeadjustmentsofbothkindsundoubtedlywouldbemade,theinitialimpactprobablywouldbereflectedinsalesofgovernmentsecurities.Mosttypesofoutstandingloanscannotbecalledforpaymentpriortotheirduedates.Butthebankmayceasetomakenewloansorrefusetorenewoutstandingonestoreplacethosecurrentlymaturing.Thus,depositsbuiltupby

borrowersforthepurposeofloanretirementwouldbeextinguishedasloanswererepaid.Thereisoneimportantdifferencebetweentheexpansionandcontractionprocesses.

WhentheFederalReserveSystemaddstobankreserves,expansionofcreditanddepositsmaytakeplaceuptothelimitspermittedbytheminimumreserveratiothatbanksarerequiredtomaintain.ButwhentheSystemactstoreducetheamountofbankreserves,contractionofcreditanddepositsmusttakeplace(excepttotheextentthatexistingexcessreservebalancesand/orsurplusvaultcashareutilized)tothepointwheretherequiredratioofreservestodepositsisrestored.Butthesignificanceofthisdifferenceshouldnotbeoveremphasized.Becauseexcessreservebalancesdonotearninterest,thereisastrongincentivetoconvertthemintoearningassets(loansandinvestments).

Endofpage12.forwardPage13.

DepositContraction

11WhentheFederalReserveBanksellsgovernmentsecurities,bankreservesdecline.

Thishappensbecausethebuyerofthesecuritiesmakespaymentthroughadebittoadesignateddepositaccountatabank(BankA),withthetransferoffundsbeingeffectedbyadebittoBankA'sreserveaccountattheFederalReserveBank.backFEDERALRESERVEBANKAssetsU.Sgovt

securities....-10,000

LiabilitiesReserveAccts.BankA....-10,000

BANKA

AssetsLiabilitiesReserveswithCustomer

F.R.Banks....-10,000deposts.....-10,000

ThisreductioninthecustomerdepositatBankAmaybespreadamonganumberofbanksthroughinterbankdepositflows.

12Thelossofreservesmeansthatallbankstakentogethernowhaveareserve

deficiency.backTotalreserveslostfromdepositwithdrawal.............10,000less:Reservesfreedbydepositdecline(10%).............1,000equals:Deficiencyinreservesagainstremainingdeposits..9,000

Contraction-Stage1

13Thebankswiththereservedeficiencies(Stage1banks)cansellgovernment

securitiestoacquirereserves,butthiscausesadeclineinthedepositsandreservesofthebuyers'banks.backSTAGE1BANKS

Assets

U.S.governmentsecurities...-9,000

ReserveswithF.R.Banks..+9,000

Liabilities

FEDERALRESERVEBANKAssets

LiabilitiesReserveAccounts:Stage1banks........+9,000Otherbanks............-9,000

OTHERBANKS

Assets

ReserveswithF.R.Banks..-9,000

Liabilities

Deposits....-9,000

14Asaresultoftheprocesssofar,assetsandtotaldepositsofallbankstogetherhave

declined19,000.Stage1contractionhasfreed900ofreserves,butthereisstillareservedeficiencyof8,100.backALLBANKS

Assets

ReserveswithF.R.Banks..-10,000U.S.governmentsecurities..-9,000

Total.....-19,000

LiabilitiesDeposits:

Initial.......-10,000Stage1......-9,000Total.......-19,000

Furthercontractionmusttakeplace!

Endofpage13.forwardBankReserves-HowTheyChange

Moneyhasbeendefinedasthesumoftransactionaccountsindepositoryinstitutions,andcurrencyandtravelerschecksinthehandsofthepublic.Currencyissomethingalmosteveryoneuseseveryday.Therefore,whenmostpeoplethinkofmoney,theythinkofcurrency.Contrarytothispopularimpression,however,transactiondepositsarethemostsignificantpartofthemoneystock.Peoplekeepenoughcurrencyonhandtoeffectsmallface-to-facetransactions,buttheywritecheckstocovermostlargeexpenditures.Mostbusinessesprobablyholdevensmalleramountsofcurrencyinrelationtotheirtotaltransactionsthandoindividuals.

Sincethemostimportantcomponentofmoneyistransactiondeposits,andsincethesedepositsmustbesupportedbyreserves,thecentralbank'sinfluenceovermoneyhinges

onitscontroloverthetotalamountofreservesandtheconditionsunderwhichbankscanobtainthem.

Theprecedingillustrationsoftheexpansionandcontractionprocesseshavedemonstratedhowthecentralbank,bypurchasingandsellinggovernmentsecurities,candeliberatelychangeaggregatebankreservesinordertoaffectdeposits.Butopenmarketoperationsareonlyoneofanumberofkindsoftransactionsordevelopmentsthatcausechangesinreserves.Somechangesoriginatefromactionstakenbythepublic,bytheTreasuryDepartment,bythebanks,orbyforeignandinternationalinstitutions.OtherchangesarisefromtheservicefunctionsandoperatingneedsoftheReserveBanksthemselves.Thevariousfactorsthatprovideandabsorbbankreservebalances,togetherwithsymbolsindicatingtheeffectsofthesedevelopments,arelistedontheoppositepage.ThistabulatonalsoindicatesthenatureofthebalancingentriesontheFederalReserve'sbooks.(Totheextentthattheimpactisabsorbedbychangesinbanks'vaultcash,theFederalReserve'sbooksareunaffected.)

IndependentFactorsVersusPolicyAction

Itisapparentthatbankreservesareaffectedinseveralwaysthatareindependentofthecontrolofthecentralbank.Mostofthese\"independent\"elementsarechangingmoreorlesscontinually.Sometimestheireffectsmaylastonlyadayortwobeforebeingreversedautomatically.Thishappens,forinstance,whenbadweatherslowsupthecheck

collectionprocess,givingrisetoanautomaticincreaseinFederalReservecreditintheformof\"float.\"Otherinfluences,suchaschangesinthepublic'scurrencyholdings,maypersistforlongerperiodsoftime.

StillothervariationsinbankreservesresultsolelyfromthemechanicsofinstitutionalarrangementsamongtheTreasury,theFederalReserveBanks,andthedepositoryinstitutions.TheTreasury,forexample,keepspartofitsoperatingcashbalanceondepositwithbanks.ButvirtuallyalldisbursementsaremadefromitsbalanceintheReserveBanks.Asisshownlater,anybuildupinbalancesattheReserveBankspriortoexpenditurebytheTreasurycausesadollar-for-dollardrainonbankreserves.

IncontrasttotheseindependentelementsthataffectreservesarethepolicyactionstakenbytheFederalReserveSystem.ThewaySystemopenmarketpurchasesandsalesofsecuritiesaffectreserveshasalreadybeendescribed.Inaddition,therearetwoother

waysinwhichtheSystemcanaffectbankreservesandpotentialdepositvolumedirectly;first,throughloanstodepositoryinstitutions,andsecond,throughchangesinreserverequirementpercentages.Achangeintherequiredreserveratio,ofcourse,doesnotalterthedollarvolumeofreservesdirectlybutdoeschangetheamountofdepositsthatagivenamountofreservescansupport.

Anychangeinreserves,regardlessofitsorigin,hasthesamepotentialtoaffectdeposits.Therefore,inordertoachievethenetreserveeffectsconsistentwithitsmonetarypolicyobjectives,theFederalReserveSystemcontinuouslymusttakeaccountofwhatthe

independentfactorsaredoingtoreservesandthen,usingitspolicytools,offsetorsupplementthemasthesituationmayrequire.

ByfarthelargestnumberandamountoftheSystem'sgrossopenmarkettransactionsareundertakentooffsetdrainsfromoradditionstobankreservesfromnon-FederalReservesourcesthatmightotherwisecauseabruptchangesincreditavailability.Inaddition,FederalReservepurchasesand/orsalesofsecuritiesaremadetoprovidethereservesneededtosupporttherateofmoneygrowthconsistentwithmonetarypolicyobjectives.Inthissectionofthebooklet,severalkindsoftransactionsthatcanhaveimportantweek-to-weekeffectsonbankreservesaretracedindetail.Otherfactorsthatnormallyhaveonlyasmallinfluencearedescribedbrieflyonpage35.

FactorsChangingReserveBalances-IndependentandPolicyActions

FEDERALRESERVEBANKSAssets

LiabilitiesReservebalances

-+-++-+-+--+-

Other+-+--+-+-++-+

Publicactions

Increaseincurrencyholdings...............Decreaseincurrencyholdings.............Treasury,bank,andforeignactions

IncreaseinTreasurydepositsinF.R.Banks......DecreaseinTreasurydepositsinF.R.Banks.....Goldpurchases(inflow)orincreaseinofficialvaluation*..

Goldsales(outflows)*.......................

IncreaseinSDRcertificatesissued*....................DecreaseinSDRcertificatesissued*..................IncreaseinTreasurycurrencyoutstanding*...................

DecreaseinTreasurycurrencyoutstanding*...................

IncreaseinTreasurycashholdings*.........DecreaseinTreasurycashholdings*.........

Increaseinservice-relatedbalances/adjustments.....

Decreaseinservice-relatedbalances/adjustments.......

IncreaseinforeignandotherdepositsinF.R.Banks........

DecreaseinforeignandotherdepositsinF.R.Banks....

FederalReserveactions

Purchasesofsecurities....................................Salesofsecurities...................................Loanstodepositoryinstitutions...........

Repaymentofloanstodepositoryinstitutions.........IncreaseinFederalReservefloat..................DecreaseinFederalReservefloat......................Increaseinassetsdenominatedinforeigncurrency......

Decreaseinassetsdenominatedinforeigncurrency......

Increaseinotherassets**.....................................Decreaseinotherassets**.....................................Increaseinother

liabilities**.....................................

Decreaseinotherliabilities**..................................Increaseincapitalaccounts**.............................Decreaseincapitalaccounts**..........................Increaseinreserverequirements.................Decreaseinreserverequirements.................

+-+

+-+-+-+-+-+-+-+-+-+--+-+-***+***

-+-

+-+-

*ThesefactorsrepresentassetsandliabilitiesoftheTreasury.ChangesinthemtypicallyaffectreservebalancesthrougharelatedchangeintheFederalReserveBanks'liability\"Treasurydeposits.\"

**Includedin\"OtherFederalReserveaccounts\"asdescribedonpage35.***Effectonexcessreserves.Totalreservesareunchanged.

Note:Totheextentthatreservechangesareintheformofvaultcash,FederalReserveaccountsarenotaffected.backForwardChangesintheAmountofCurrencyHeldbythePublic

Changesintheamountofcurrencyheldbythepublic

typicallyfollowafairlyregularintramonthlypattern.MajorchangesalsooccuroverholidayperiodsandduringtheChristmasshoppingseason-timeswhenpeoplefindit

convenienttokeepmorepocketmoneyonhand.(Seechart.)Thepublicacquirescurrencyfrombanksbycashingchecks.(6)Whendeposits,whicharefractionalreservemoney,are

exchangedforcurrency,whichis100percentreservemoney,thebankingsystemexperiencesanetreservedrain.Undertheassumed10percentreserverequirement,agivenamountofbankreservescansupportdepositstentimesasgreat,butwhendrawnupontomeetcurrencydemand,theexchangeisonetoone.A$1increaseincurrencyusesup$1ofreserves.

Supposeabankcustomercasheda$100checktoobtaincurrencyneededforaweekendholiday.Bankdepositsdecline$100becausethecustomerpaysforthecurrencywithacheckonhisorhertransactiondeposit;andthebank'scurrency(vaultcashreserves)isalsoreduced$100.Seeillustration15.

Nowthebankhaslesscurrency.ItmayreplenishitsvaultcashbyorderingcurrencyfromitsFederalReserveBank-makingpaymentbyauthorizingachargetoitsreserve

account.OntheReserveBank'sbooks,thechargeagainstthebank'sreserveaccountisoffsetbyanincreaseintheliabilityitem\"FederalReservenotes.\"Seeillustration16.ThereserveBankshipmenttothebankmightconsist,atleastinpart,ofU.S.coinsratherthanFederalReservenotes.Allcoins,aswellasasmallamountofpapercurrencystilloutstandingbutnolongerissued,areobligationsoftheTreasury.Totheextentthatshipmentsofcashtobanksareintheformofcoin,theoffsettingentryontheReserveBank'sbooksisadeclineinitsassetitem\"coin.\"

Thepublicnowhasthesamevolumeofmoneyasbefore,exceptthatmoreisintheformofcurrencyandlessisintheformoftransactiondeposits.Undera10percentreserverequirement,theamountofreservesrequiredagainstthe$100ofdepositswasonly$10,whileafull$100ofreserveshavebeendrainedawaybythedisbursementof$100incurrency.Thus,ifthebankhadnoexcessreserves,the$100withdrawalincurrencycausesareservedeficiencyof$90.Unlessnewreservesareprovidedfromsomeothersource,bankassetsanddepositswillhavetobereduced(accordingtothecontractionprocessdescribedonpages12and13)byanadditional$900.Atthatpoint,thereservedeficiencycausedbythecashwithdrawalwouldbeeliminated.

WhenCurrencyReturnstoBanks,ReservesRise

Afterholidayperiods,currencyreturnstothebanks.Thecustomerwhocashedachecktocoveranticipatedcashexpendituresmaylaterredepositanycurrencystillheldthat'sbeyondnormalpocketmoneyneeds.Mostofitprobablywillhavechangedhands,anditwillbedepositedbyoperatorsofmotels,gasolinestations,restaurants,andretailstores.Thisprocessisexactlythereverseofthecurrencydrain,exceptthatthebankstowhichcurrencyisreturnedmaynotbethesamebanksthatpaiditout.Butintheaggregate,the

banksgainreservesas100percentreservemoneyisconvertedbackintofractionalreservemoney.

When$100ofcurrencyisreturnedtothebanks,depositsandvaultcashareincreased.Seeillustration17.Thebankscankeepthecurrencyasvaultcash,whichalsocountsasreserves.Morelikely,thecurrencywillbeshippedtotheReserveBanks.TheReserveBankscreditbankreserveaccountsandreduceFederalReservenoteliabilities.Seeillustration18.Sinceonly$10mustbeheldagainstthenew$100indeposits,$90isexcessreservesandcangiveriseto$900ofadditionaldeposits(7).

Toavoidmultiplecontractionorexpansionofdepositmoneymerelybecausethepublicwishestochangethecompositionofitsmoneyholdings,theeffectsofchangesinthepublic'scurrencyholdingsonbankreservesnormallyareoffsetbySystemopenmarketoperations.

6Thesamebalancesheetentriesapplywhethertheindividualphysicallycashesapapercheckorobtainscurrencybywithdrawingcashthroughanautomatictellermachine.back7Undercurrentreserveaccountingregulations,vaultcashreservesareusedtosatisfyreserverequirementsinafuturemaintenanceperiod

whilereservebalancessatisfyrequirementsinthecurrentperiod.Asaresult,theimpactonabank'scurrentreservepositionmaydifferfromthatshownunlessthebankrestoresitsvaultcashpositioninthecurrentperiodviachangesinitsreservebalance.

back15Whenadepositorcashesacheck,bothdepositsandvaultcashreservesdecline.

backBANKA

Assets

Vaultcashreserves..-100

(Required..-10)(Deficit....90)

LiabilitiesDeposits....-100

16Ifthebankreplenishesitsvaultcash,itsaccountattheReserveBankisdrawn

downinexchangefornotesissuedbytheFederalReserve.backFEDERALRESERVEBANKAssets

Liabilities

Reserveaccounts:BankA...-

100

F.R.notes...+100

BANKA

Assets

Vaultcash........+100ReserveswithF.R.Banks.-100

Liabilities

17Whencurrencycomesbacktothebanks,bothdepositsandvaultcashreservesrise.

backBANKA

Assets

Vaultcashreserves..+100

(Required...+10)(Excess....+90)

Liabilities

Deposits....+100

18IfthecurrencyisreturnedtotheFederalreserve,reserveaccountsarecreditedand

FederalReservenotesaretakenoutofcirculation.backFEDERALRESERVEBANKAssets

Liabilities

Reserveaccounts:BankA..

+100

F.R.notes.....-100

BANKA

Assets

Vaultcash.....-100

ReserveswithF.R.Banks...

+100

Liabilities

Page18

ChangesinU.S.TreasuryDepositsinFederalReserveBanks

ReserveaccountsofdepositoryinstitutionsconstitutethebulkofthedepositliabilitiesoftheFederalReserveSystem.Otherinstitutions,however,alsomaintainbalancesintheFederalReserveBanks-mainlytheU.S.Treasury,foreigncentralbanks,andinternationalfinancialinstitutions.In

general,whenthesebalancesrise,bankreservesfall,andviceversa.ThisoccursbecausethefundsusedbytheseagenciestobuilduptheirdepositsintheReserveBanksultimately

comefromdepositsinbanks.Conversely,recipientsofpaymentsfromtheseagenciesnormallydepositthefundsinbanks.Throughthecollectionprocessthesebanksreceivecredittotheirreserveaccounts.

ThemostimportantnonbankdepositoristheU.S.Treasury.PartoftheTreasury's

operatingcashbalanceiskeptintheFederalReserveBanks;therestisheldindepositoryinstitutionsalloverthecountry,inso-called\"Treasurytaxandloan\"(TT&L)noteaccounts.(Seechart.)DisbursementsbytheTreasury,however,aremadeagainstits

balancesattheFederalReserve.Thus,transfersfrombankstoFederalReserveBanksaremadethroughregularlyscheduled\"calls\"onTT&LbalancestoassurethatsufficientfundsareavailabletocoverTreasurychecksastheyarepresentedforpayment.(8)BankReservesDeclineastheTreasury'sDepositsattheReserveBanksIncrease

CallsonTT&LnoteaccountsdrainreservesfromthebanksbythefullamountofthetransferasfundsmovefromtheTT&Lbalances(viachargestobankreserveaccounts)toTreasurybalancesattheReserveBanks.BecausereservesarenotrequiredagainstTT&Lnoteaccounts,thesetransfersdonotreducerequiredreserves.(9)SupposeaTreasurycallpayablebyBankAamountsto$1,000.TheFederalReserveBanksareauthorizedtotransfertheamountoftheTreasurycallfromBankA'sreserveaccountattheFederalReservetotheaccountoftheU.S.TreasuryattheFederalReserve.Asaresultofthetransfer,bothreservesandTT&Lnotebalancesofthebankare

reduced.OnthebooksoftheReserveBank,bankreservesdeclineandTreasurydepositsrise.Seeillustration19.ThiswithdrawalofTreasuryfundswillcauseareserve

deficiencyof$1,000sincenoreservesarereleasedbythedeclineinTT&Lnoteaccountsatdepositoryinstitutions.

BankReservesRiseastheTreasury'sDepositsattheReserveBanksDecline

AstheTreasurymakesexpenditures,checksdrawnonitsbalancesintheReserveBanksarepaidtothepublic,andthesefundsfindtheirwaybacktobanksintheformofdeposits.Thebanksreceivereservecreditequaltothefullamountofthesedepositsalthoughthecorrespondingincreaseintheirrequiredreservesisonly10percentofthisamount.

Supposeagovernmentemployeedepositsa$1,000expensecheckinBankA.ThebanksendsthechecktoitsFederalReserveBankforcollection.TheReserveBankthencreditsBankA'sreserveaccountandchargestheTreasury'saccount.Asaresult,thebankgainsbothreservesanddeposits.WhilethereisnochangeintheassetsortotalliabilitiesoftheReserveBanks,thefundsdrawnawayfromtheTreasury'sbalanceshavebeenshiftedtobankreserveaccounts.Seeillustration20.

OneoftheobjectivesoftheTT&Lnoteprogram,whichrequiresdepositoryinstitutionsthatwanttoholdTreasuryfundsformorethanonedaytopayinterestonthem,istoallowtheTreasurytoholditsbalanceattheReserveBankstotheminimumconsistentwithcurrentpaymentneeds.Bymaintainingafairlyconstantbalance,largedrainsfromoradditionstobankreservesfromwideswingsintheTreasury'sbalancethatwouldrequireextensiveoffsettingopenmarketoperationscanbeavoided.Nevertheless,therearestillperiodswhenthesefluctuationshavelargereserveeffects.In1991,forexample,week-to-weekchangesinTreasurydepositsattheReserveBanksaveragedonly$56million,butrangedfrom-$4.15billionto+$8.57billion.

8WhentheTreasury'sbalanceattheFederalReserverisesaboveexpectedpaymentneeds,theTreasurymayplacetheexcessfundsinTT&L

noteaccountsthrougha\"directinvestment.\"Theaccountingentriesarethesame,butofoppositesigns,asthoseshownwhenfundsaretransferredfromTT&LnoteaccountstoTreasurydepositsattheFed.

back9TaxpaymentsreceivedbyinstitutionsdesignatedasFederaltaxdepositoriesinitiallyarecreditedtoreservabledemanddepositsduetothe

U.S.government.Becausesuchtaxpaymentstypicallycomefromreservabletransactionaccounts,requiredreservesarenotmateriallyaffectedonthisday.Onthenextbusinessday,however,whenthesefundsareplacedeitherinanonreservablenoteaccountorremittedtotheFederalReserveforcredittotheTreasury'sbalanceattheFed,requiredreservesdecline.

backEndpage18.forwardPage19.

19WhentheTreasurybuildsupitsdepositsattheFederalReservethrough\"calls\"on

TT&Lnotebalances,reserveaccountsarereduced.backFEDERALRESERVEBANKAssets

Liabilities

Reserveaccounts:BankA..-1,000

U.S.Treasurydeposits..+1,000BANKA

Assets

Liabilities

ReserveswithF.R.Banks..-1,000

(Required....0)(Deficit..1,000)

Treasurytaxandloannote

account..-1,000

20CheckswrittenontheTreasury'saccountattheFederalReserveBankaredeposited

inbanks.Asthesearecollected,banksreceivecredittotheirreserveaccountsattheFederalReserveBanks.backFEDERALRESERVEBANKAssets

Liabilities

Reserveaccounts:BankA..

+1,000

U.S.Treasurydeposits...-1,000BANKA

Assets

ReserveswithF.R.Banks..

+1,000

(Required...+100)(Excess.....+900)

Liabilities

Privatedeposits..+1,000

Endofpage19.forwardChangesinFederalReserveFloat

Alargeproportionofchecksdrawnonbanksanddepositedinotherbanksiscleared(collected)throughtheFederalReserveBanks.Someofthesechecksarecredited

immediatelytothereserveaccountsofthedepositingbanksandarecollectedthesamedaybydebitingthereserveaccountsofthebanksonwhichthechecksaredrawn.AllchecksarecreditedtotheaccountsofthedepositingbanksaccordingtoavailabilityschedulesrelatedtothetimeitnormallytakestheFederalReservetocollectthechecks,butrarelymorethantwobusinessdaysaftertheyarereceivedattheReserveBanks,eventhoughtheymaynotyethavebeencollectedduetoprocessing,transportation,orotherdelays.

ThereservecreditgivenforchecksnotyetcollectedisincludedinFederalReserve

\"float.\"(10)OnthebooksoftheFederalReserveBanks,balancesheetfloat,orstatement

floatasitissometimescalled,isthedifferencebetweentheassetaccount\"itemsinprocessofcollection,\"andtheliabilityaccount\"deferredcredititems.\"Statementfloatisusuallypositivesinceitismoreoftenthecasethatreservecreditisgivenbeforethechecksareactuallycollectedthantheotherwayaround.

PublisheddataonFederalReservefloatarebasedona\"reserves-factor\"frameworkratherthanabalancesheetaccountingframework.Aspublished,FederalReservefloatincludesstatementfloat,asdefinedabove,aswellasfloat-related\"as-of\"

adjustments.(11)Theseadjustmentsrepresentcorrectionsforerrorsthatarisein

processingtransactionsrelatedtoFederalReservepricedservices.As-ofadjustmentsdonotchangethebalancesheetsofeithertheFederalReserveBanksoranindividualbank.Rathertheyarecorrectionstothebank'sreserveposition,therebyaffectingthecalculationofwhetherornotthebankmeetsitsreserverequirements.

AnIncreaseinFederalReserveFloatIncreasesBankReserves

Asfloatrises,totalbankreservesrisebythesameamount.Forexample,supposeBankAreceivescheckstotaling$100drawnonBanksB,C,andD,allindistantcities.BankAincreasestheaccountsofitsdepositors$100,andsendstheitemstoaFederalReserveBankforcollection.Uponreceiptofthechecks,theReserveBankincreasesitsownassetaccount\"itemsinprocessofcollection,\"andincreasesitsliabilityaccount\"deferredcredititems\"(checksandotheritemsnotyetcreditedtothesendingbank'sreserve

accounts).Aslongasthesetwoaccountsmovetogether,thereisnochangeinfloatorintotalreservesfromthissource.Seeillustration21.

Onthenextbusinessday(assumingBanksB,C,andDareone-daydeferredavailabilitypoints),theReserveBankpaysBankA.TheReserveBank's\"deferredcredititems\"accountisreduced,andBankA'sreserveaccountisincreased$100.Iftheseitemsactuallytakemorethanonebusinessdaytocollectsothat\"itemsinprocessof

collection\"arenotreducedthatday,thecredittoBankArepresentsanadditiontototalbankreservessincethereserveaccountsofBanksB,C,andDwillnothavebeencommensuratelyreduced.(12)Seeillustration22.

ADeclineinFederalReserveFloatReducesBankReserves

OnlywhenthechecksareactuallycollectedfromBanksB,C,andDdoesthefloat

involvedintheaboveexampledisappear-\"itemsinprocessofcollection\"oftheReserveBankdeclineasthereserveaccountsofBanksB,C,andDarereduced.Seeillustration23.

Onanannualaveragebasis,FederalReservefloatdeclineddramaticallyfrom1979through1984,inpartreflectingactionstakentoimplementprovisionsoftheMonetaryControlActthatdirectedtheFederalReservetoreduceandpricefloat.(Seechart.)Since1984,FederalReservefloathasbeenfairlystableonanannualaveragebasis,butoften

fluctuatessharplyovershortperiods.Fromthestandpointoftheeffectonbankreserves,thesignificantaspectoffloatisnotthatitexistsbutthatitsvolumechangesinadifficult-to-predictway.Floatcanincreaseunexpectedly,forexample,ifweatherconditions

groundplanestransportingcheckstopayingbanksforcollection.However,suchperiodstypicallyarefollowedbyoneswhereactualcollectionsexceednewitemsbeingreceivedforcollection.Thus,reservesgainedfromfloatexpansionusuallyarequitetemporary.

10FederalReservefloatalsoarisesfromotherfundstransferservicesprovidedbytheFed,andautomaticclearinghousetransfers.back11As-ofadjustmentsalsoareusedasonemeansofpricingfloat,asdiscussedonpage22,andfornonfloatrelatedcorrections,asdiscussedonpage35.back12IfthechecksreceivedfromBankAhadbeenerroneouslyassignedatwo-daydeferredavailability,thenneitherstatementfloatnorreserves

wouldincrease,althoughbothshould.BankA'sreservepositionandpublishedFederalReservefloatdataarecorrectedforthisandsimilarerrorsthroughas-ofadjustments.

back21Whenabankreceivesdepositsintheformofchecksdrawnonotherbanks,itcan

sendthemtotheFederalReserveBankforcollection.(Requiredreservesarenotaffectedimmediatelybecauserequirementsapplytonettransactionaccounts,i.e.,totaltransactionaccountsminusbothcashitemsinprocessofcollectionanddepositsduefromdomesticdepositoryinstitutions.)backFEDERALRESERVEBANK

Assets

Itemsinprocessofcollection..

+100

Liabilities

Deferredcredititems..+100

BANKA

AssetsLiabilities

Cashitemsinprocessofcollection..+100Deposits.......+100

22Ifthereserveaccountofthepayeebankiscreditedbeforethereserveaccountsof

thepayingbanksaredebited,totalreservesincrease.backFEDERALRESERVEBANKAssets

Liabilities

Deferredcredititems..-100

Reserveaccount:BankA..+100BANKA

Assets

Cashitemsinprocessofcollection..-100

ReserveswithF.R.Banks...+100

(Required....+10)(Excess......+90)

Liabilities

23Butuponactualcollectionoftheitems,accountsofthepayingbanksarecharged,

andtotalreservesdecline.backFEDERALRESERVEBANK

Assets

Itemsinprocess

ofcollection......-100Assets

ReserveswithF.R.Banks..-100

(Required...-10)(Deficit.....90)

Liabilities

Reserveaccounts:

BanksB,C,andD.....-100

Liabilities

Deposits......-100

BANKB,C,andD

Page22.

ChangesinService-RelatedBalancesandAdjustments

Inordertofosterasafeandefficientpaymentssystem,theFederalReserveoffersbanksavarietyofpaymentsservices.PriortopassageoftheMonetaryControlActin1980,theFederalReserveoffereditsservicesfree,butonlytobanksthatweremembersoftheFederalReserveSystem.TheMonetaryControlActdirectedtheFederalReservetoofferitsservicestoalldepositoryinstitutions,tochargefortheseservices,andtoreduceandpriceFederalReservefloat.(13)Exceptforfloat,allservicescoveredbytheActwerepricedbytheendof1982.Implementationoffloatpricingessentiallywascompletedin1983.

TheadventofFederalreservepricedservicesledtoseveralchangesthataffecttheuseoffundsinbanks'reserveaccounts.Asaresult,onlypartofthetotalbalancesinbankreserveaccountsisidentifiedas\"reservebalances\"availabletomeetreserve

requirements.Otherbalancesheldinreserveaccountsrepresent\"service-relatedbalances

andadjustments(tocompensateforfloat).\"Service-relatedbalancesare\"required

clearingbalances\"heldbybanksthatuseFederalReserveserviceswhile\"adjustments\"representbalancesheldbybanksthatpayforfloatwithas-ofadjustments.

AnIncreaseinRequiredClearingBalancesReducesReserveBalances

ProceduresforestablishingandmaintainingclearingbalanceswereapprovedbytheBoardofGovernorsoftheFederalReserveSysteminFebruaryof1981.Abankmayberequiredtoholdaclearingbalanceifithasnorequiredreservebalanceorifitsrequiredreservebalance(heldtosatisfyreserverequirements)isnotlargeenoughtohandleitsvolumeofclearings.Typicallyabankholdsbothreservebalancesandrequiredclearingbalancesinthesamereserveaccount.Thus,asrequiredclearingbalancesareestablishedorincreased,theamountoffundsinreserveaccountsidentifiedasreservebalancesdeclines.

SupposeBankAwantstouseFederalReserveservicesbuthasareservebalancerequirementthatislessthanitsexpectedoperatingneeds.WithitsReserveBank,itisdeterminedthatBankAmustmaintainarequiredclearingbalanceof$1,000.IfBankAhasnoexcessreservebalance,itwillhavetoobtainfundsfromsomeothersource.BankAcouldsell$1,000ofsecurities,butthiswillreducetheamountoftotalbankreservebalancesanddeposits.Seeillustration24.

BanksarebilledeachmonthfortheFederalReserveservicestheyhaveusedwith

paymentcollectedonaspecifieddaythefollowingmonth.Allrequiredclearingbalancesheldgenerate\"earningscredits\"whichcanbeusedonlytooffsetchargesforFederalReserveservices.(14)Alternatively,bankscanpayforservicesthroughadirectchargetotheirreserveaccounts.Ifaccruedearningscreditsareusedtopayforservices,then

reservebalancesareunaffected.Ontheotherhand,ifpaymentforservicestakestheformofadirectchargetothebank'sreserveaccount,thenreservebalancesdecline.Seeillustration25.

FloatPricingAs-OfAdjustmentsReduceReserveBalances

In1983,theFederalReservebeganpricingexplicitlyforfloat,(15)specifically

\"interterritory\"checkfloat,i.e.,floatgeneratedbychecksdepositedbyabankservedbyoneReserveBankbutdrawnonabankservedbyanotherReserveBank.Thedepositingbankhasthreeoptionsinpayingforinterterritorycheckfloatitgenerates.Itcanuseitsearningscredits,authorizeadirectchargetoitsreserveaccount,orpayforthefloatwithanas-ofadjustment.Ifeitherofthefirsttwooptionsischosen,theaccountingentriesarethesameaspayingforotherpricedservices.Iftheas-ofadjustmentoptionischosen,however,thebalancesheetsoftheReserveBanksandthebankarenotdirectlyaffected.Ineffectwhathappensisthatpartofthetotalbalancesheldinthebank'sreserveaccountisidentifiedasbeingheldtocompensatetheFederalreserveforfloat.Thispart,then,cannotbeusedtosatisfyeitherreserverequirementsorclearingbalancerequirements.Floatpricingas-ofadjustmentsareappliedtwoweeksaftertherelatedfloatisgenerated.Thus,anindividualbankhassufficienttimetoobtainfundsfromothersourcesinorderto

avoidanyreservedeficienciesthatmightresultfromfloatpricingas-ofadjustments.Ifallbankstogetherhaveno

excessreserves,however,thefloatpricingas-ofadjustmentsleadtoadeclineintotalbankreservebalances.

Week-to-weekchangesinservice-relatedbalancesand

adjustmentscanbevolatile,primarilyreflectingadjustmentstocompensateforfloat.(Seechart.)Sincethesechangesare

knowninadvance,anyundesiredimpactonreservebalancescanbeoffseteasilythroughopenmarketoperations.

13TheActspecifiedthatfeeschedulescoverservicessuchascheckclearingandcollection,wiretransfer,automatedclearinghouse,settlement,securitiessafekeeping,noncashcollection,FederalReservefloat,andanynewservicesoffered.back14\"Earningscredits\"arecalculatedbymultiplyingtheactualaverageclearingbalanceheldoveramaintenanceperiod,uptothatrequired

plustheclearingbalanceband,timesaratebasedontheaveragefederalfundsrate.Theclearingbalancebandis2percentoftherequiredclearingbalanceor$25,000,whicheveramountislarger.back15Whilesometypesoffloatarepriceddirectly,theFederalReservepricesothertypesoffloatindirectly,forexample,byincludingthecostoffloatintheper-itemfeesforthepricedservice.backEndofpage22.back24WhenBankAestablishesarequiredclearingbalanceataFederalReserveBankby

sellingsecurities,thereservebalancesanddepositsofotherbanksdecline.backBANKA

Assets

U.S.governmentsecurities..-1,000

ReserveaccountwithF.R.

Banks:

Requiredclearingbalance..

+1000

Assets

Liabilities

FEDERALRESERVEBANK

Liabilities

Reserveaccounts:Requiredclearing

balancesBankA....+1000Reservebalances:

Otherbanks........-1000

OTHERBANKS

Assets

ReserveaccountswithF.R.

Banks:

Reservebalances....-1,000

(Required...-100)(Deficit.....900)

Liabilities

Deposits.......-1,000

25WhenBankAisbilledmonthlyforFederalReserveservicesused,itcanpayfor

theseservicesbyhavingearningscreditsappliedand/orbyauthorizingadirectchargetoitsreserveaccount.SupposeBankAhasaccruedearningscreditsof$100butincursfeesof$125.Thenbothmethodswouldbeused.OntheFederalReserveBank'sbooks,theliabilityaccount\"earningscreditsduetodepositoryinstitutions\"declinesby$100andBankA'sreserveaccountisreducedby$25.OffsettingtheseentriesisareductionintheFed's(other)assetaccount\"accruedserviceincome.\"OnBankA'sbooks,theaccountingentriesmightbea$100reductiontoitsassetaccount\"earningscreditduefromFederalReserveBanks\"anda$25reductioninitsreserveaccount,whichareoffsetbya$125declineinitsliability\"accountspayable.\"Whileanindividualbankmayusedifferentaccountingentries,theneteffectonreservesisareductionof$25,theamountofbilledfeesthatwerepaidthroughadirectchargetoBankA'sreserveaccount.backFEDERALRESERVEBANK

Liabilities

Earningscreditsdueto

Accruedserviceincome.....-depository

125

institutions........-100Reserveaccounts:BankA..-25

BANKA

Assets

EarningscreditsduefromF.R.

Banks..-100

ReserveswithF.R.Banks.....-25

Liabilities

Accountspayable.....-125

Assets

ChangesinLoanstoDepositoryInstitutions

PriortopassageoftheMonetaryControlActof1980,onlybanksthatweremembersoftheFederalReserveSystemhadregularaccesstotheFed's\"discountwindow.\"Sincethen,allinstitutionshavingdepositsreservableundertheActalsohavebeenabletoborrowfromtheFed.UnderconditionssetbytheFederalReserve,loansareavailableunderthreecreditprograms:adjustment,seasonal,andextendedcredit.(16)The

averageamountofeachtypeofdiscountwindowcreditprovidedvariesovertime.(Seechart.)

WhenabankborrowsfromaFederalReserveBank,itborrowsreserves.Theacquisitionofreservesinthismannerdiffersinanimportantwayfromthecasesalreadyillustrated.Banksnormallyborrowadjustmentcreditonlytoavoidreservedeficienciesoroverdrafts,nottoobtainexcessreserves.Adjustmentcreditborrowings,therefore,arereservesonwhichexpansionhasalreadytakenplace.Howcanthishappen?

Intheireffortstoaccommodatecustomersaswellastokeepfullyinvested,banksfrequentlymakeloansinanticipationofinflowsofloanablefundsfromdepositsormoneymarketsources.Loansaddtobankdepositsbutnottobankreserves.Unlessexcessreservescanbetapped,bankswillnothaveenoughreservestomeetthereserverequirementsagainstthenewdeposits.Likewise,individualbanksmayincurdeficienciesthroughunexpecteddepositoutflowsandcorrespondinglossesofreservesthrough

clearings.Otherbanksreceivethesedepositsandcanincreasetheirloansaccordingly,butthebanksthatlostthemmaynotbeabletoreduceoutstandingloansorinvestmentsinordertorestoretheirreservestorequiredlevelswithintherequiredtimeperiod.Ineithercase,abankmayborrowreservestemporarilyfromitsReserveBank.

SupposeacustomerofBankAwantstoborrow$100.Onthebasisofthemanagements'sjudgmentthatthebank'sreserveswillbesufficienttoprovidethenecessaryfunds,thecustomerisaccommodated.Theloanismadebyincreasing\"loans\"andcreditingthecustomer'sdepositaccount.NowBankA'sdepositshaveincreasedby$100.However,ifreservesareinsufficienttosupportthehigherdeposits,BankAwillhavea$10reservedeficiency,assumingrequirementsof10percent.Seeillustration26.BankAmaytemporarilyborrowthe$10fromitsFederalReserveBank,whichmakesaloanby

increasingitsassetitem\"loanstodepositoryinstitutions\"andcreditingBankA'sreserveaccount.BankAgainsreservesandacorrespondingliability\"borrowingsfromFederalReserveBanks.\"Seeillustration27.

Torepayborrowing,abankmustgainreservesthrougheitherdepositgrowthorassetliquidation.Seeillustration28.Abankmakespaymentbyauthorizingadebittoits

reserveaccountattheFederalReserveBank.Repaymentofborrowing,therefore,reducesbothreservesand\"borrowingsfromFederalReserveBanks.\"Seeillustration29.Unlikeloansmadeundertheseasonalandextendedcreditprograms,adjustmentcreditloanstobanksgenerallymustberepaidwithinashorttimesincesuchloansaremadeprimarilytocoverneedscreatedbytemporaryfluctuationsindepositsandloansrelative

tousualpatterns.Adjustments,suchassalesofsecurities,madebysomebanksto\"getoutofthewindow\"tendtotransferreserveshortagestootherbanksandmayforcetheseotherbankstoborrow,especiallyinperiodsofheavycreditdemands.Evenattimeswhenthetotalvolumeofadjustmentcreditborrowingisrising,someindividualbanksare

repayingloanswhileothersareborrowing.Intheaggregate,adjustmentcreditborrowingusuallyincreasesinperiodsofrisingbusinessactivitywhenthepublic'sdemandsforcreditarerisingmorerapidlythannonborrowedreservesarebeingprovidedbySystemopenmarketoperations.

DiscountWindowasaToolofMonetaryPolicy

Althoughreserveexpansionthroughborrowingisinitiatedbybanks,theamountofreservesthatbankscanacquireinthiswayordinarilyislimitedbytheFederalReserve'sadministrationofthediscountwindowandbyitscontroloftheratechargedbanksforadjustmentcreditloans-thediscountrate.(17)Loansaremadeonlyforapprovedpurposes,andotherreasonablyavailablesourcesoffundsmusthavebeenfullyused.Moreover,banksarediscouragedfromborrowingadjustmentcredittoofrequentlyorforextendedtimeperiods.Raisingthediscountratetendstorestrainborrowingbyincreasingitscostrelativetothecostofalternativesourcesofreserves.

DiscountwindowadministrationisanimportantadjuncttotheotherFederalReservetoolsofmonetarypolicy.Whiletheprivilegeofborrowingoffersa\"safetyvalve\"totemporarilyrelieveseverestrainsonthereservepositionsofindividualbanks,thereisgenerallyastrongincentiveforabanktorepayborrowingbeforeaddingfurthertoitsloansandinvestments.

16Adjustmentcreditisshort-termcreditavailabletomeettemporaryneedsforfunds.Seasonalcreditisavailableforlongerperiodstosmaller

institutionshavingregularseasonalneedsforfunds.Extendedcreditmaybemadeavailabletoaninstitutionorgroupofinstitutionsexperiencingsustainedliquiditypressures.Thereservesprovidedthroughextendedcreditborrowingtypicallyareoffsetbyopenmarketoperations.

back17Flexiblediscountratesrelatedtoratesonmoneymarketsourcesoffundscurrentlyarechargedforseasonalcreditandforextendedcreditoutstandingmorethan30days.back26Abankmayincurareservedeficiencyifitmakesloanswhenithasnoexcess

reserves.backBANKA

Assets

Loans.........+100

ReserveswithF.R.Banks..no

change

(Required....+10)

Liabilities

Deposits........+100

(Deficit.......10)

27BorrowingfromaFederalReserveBanktocoversuchadeficitisaccompaniedby

adirectcredittothebank'sreserveaccount.backFEDERALRESERVEBANK

AssetsLiabilitiesLoanstodepository

institution:Reserveaccounts:BankA..+10

BankA........+10

BANKA

Assets

ReserveswithF.R.Banks..+10

Liabilities

BorrowingsfromF.R.Banks..

+10

Nofurtherexpansioncantakeplaceonthenewreservesbecausetheyareallneeded

againstthedepositscreatedin(26).

28Beforeabankcanrepayborrowings,itmustgainreservesfromsomeothersource.

backBANKA

Assets

Securities.......-10ReserveswithF.R.Banks...

+10

Liabilities

29RepaymentofborrowingsfromtheFederalReserveBankreducesreserves.backFEDERALRESERVEBANK

Assets

Loanstodepository

institutions:

BankA.........-10

Liabilities

Reserveaccounts:BankA...-10

BANKA

Liabilities

BorrowingsfromF.R.Bank..-ReserveswithF.R.Bank..-10

10

Assets

ChangesinReserveRequirements

Thusfarwehavedescribedtransactionsthataffectthevolumeofbankreservesandtheimpactthesetransactionshaveuponthecapacityofthebankstoexpandtheirassetsanddeposits.Itisalsopossibletoinfluencedepositexpansionorcontractionbychangingtherequiredminimumratioofreservestodeposits.

TheauthoritytovaryrequiredreservepercentagesforbanksthatweremembersoftheFederalReserveSystem(memberbanks)wasfirstgrantedbyCongresstotheFederalReserveBoardofGovernorsin1933.Therangeswithinwhichthisauthoritycanbe

exercisedhavebeenchangedseveraltimes,mostrecentlyintheMonetaryControlActof1980,whichprovidedfortheestablishmentofreserverequirementsthatapplyuniformlytoalldepositoryinstitutions.The1980statuteestablishedthefollowinglimits:

Ontransactionaccounts

first$25million.........3%above$25million.....8%to14%Onnonpersonaltimedeposits....0%to9%

The1980lawinitiallysettherequirementagainsttransactionaccountsover$25millionat12percentandthatagainstnonpersonaltimedepositsat3percent.Theinitial$25million\"lowreservetranche\"wasindexedtochangeeachyearinlinewith80percentofthegrowthintransactionaccountsatalldepositoryinstitutions.(Forexample,thelowreservetranchewasincreasedfrom$41.1millionfor1991to$42.2millionfor1992.)Inaddition,reserverequirementscanbeimposedoncertainnondepositsourcesoffunds,suchasEurocurrencyliabilities.(18)(InitiallytheBoardseta3percentrequirementonEurocurrencyliabilities.)

TheGarn-St.GermainActof1982modifiedtheseprovisionssomewhatbyexemptingfromreserverequirementsthefirst$2millionoftotalreservableliabilitiesateachdepositoryinstitution.Similartothelowreservetrancheadjustmentfortransactionaccounts,the$2million\"reservableliabilitiesexemptionamount\"wasindexedto80percentofannualincreasesintotalreservableliabilities.(Forexample,theexemptionamountwasincreasedfrom$3.4millionfor1991to$3.6millionfor1992.)

TheFederalReserveBoardisauthorizedtochange,atitsdiscretion,thepercentagerequirementsontransactionaccountsabovethelowreservetrancheandonnonpersonaltimedepositswithintherangesindicatedabove.Inaddition,theBoardmayimpose

differingreserverequirementsonnonpersonaltimedepositsbasedonthematurityofthedeposit.(TheBoardinitiallyimposedthe3percentnonpersonaltimedepositrequirementonlyonsuchdepositswithoriginalmaturitiesofunderfouryears.)

Duringthephase-inperiod,whichendedin1984formostmemberbanksandin1987formostnonmemberinstitutions,requirementschangedaccordingtoapredeterminedschedule,withoutanyactionbytheFederalReserveBoard.Apartfromtheselegallyprescribedchanges,oncetheMonetaryControlActprovisionswereimplementedinlate1980,theBoarddidnotchangeanyreserverequirementratiosuntillate1990.(Theoriginalmaturitybreakforrequirementsonnonpersonaltimedepositswasshortenedseveraltimes,oncein1982,andtwicein1983,inconnectionwithactionstakentoderegulateratespaidondeposits.)InDecember1990,theBoardreducedreserverequirementsagainstnonpersonaltimedepositsandEurocurrencyliabilitiesfrom3

percenttozero.EffectiveinApril1992,thereserverequirementontransactionaccountsabovethelowreservetranchewasloweredfrom12percentto10percent.

Whenreserverequirementsarelowered,aportionofbanks'existingholdingsofrequiredreservesbecomesexcessreservesandmaybeloanedorinvested.Forexample,witharequirementof10percent,$10ofreserveswouldberequiredtosupport$100ofdeposits.Seeillustration30.Butareductioninthelegalrequirementto8percentwouldtieuponly$8,freeing$2outofeach$10ofreservesforuseincreatingadditionalbankcreditanddeposits.Seeillustration31.

Anincreaseinreserverequirements,ontheotherhand,absorbsadditionalreservefunds,andbankswhichhavenoexcessreservesmustacquirereservesorreduceloansorinvestmentstoavoidareservedeficiency.Thusanincreaseintherequirementfrom10percentto12percentwouldboostrequiredreservesto$12foreach$100ofdeposits.Assumingbankshavenoexcessreserves,thiswouldforcethemtoliquidateassetsuntilthereservedeficiencywaseliminated,atwhichpointdepositswouldbeone-sixthlessthanbefore.Seeillustration32.

ReserveRequirementsandMonetaryPolicy

Thepowertochangereserverequirements,likepurchasesandsalesofsecuritiesbytheFederalReserve,isaninstrumentofmonetarypolicy.Evenasmallchangein

requirements-say,one-halfofonepercentagepoint-canhavealargeandwidespreadimpact.Otherinstrumentsofmonetarypolicyhavesometimesbeenusedtocushiontheinitialimpactofareserverequirementchange.Thus,theSystemmaysellsecurities(orpurchaselessthanotherwisewouldbeappropriate)toabsorbpartofthereservesreleasedbyacutinrequirements.

Itshouldbenotedthatinadditiontotheirinitialimpactonexcessreserves,changesinrequirementsaltertheexpansionpowerofeveryreservedollar.Thus,suchchangesaffecttheleverageofallsubsequentincreasesordecreasesinreservesfromanysource.Forthisreason,changesinthetotalvolumeofbankreservesactuallyheldbetweenpointsintime

whenrequirementsdifferdonotprovideanaccurateindicationoftheFederalReserve'spolicyactions.

Bothreservebalancesandvaultcashareeligibletosatisfyreserverequirements.Totheextentsomeinstitutionsnormallyholdvaultcashtomeetoperatingneedsinamountsexceedingtheirrequiredreserves,theyareunlikelytobeaffectedbyanychangeinrequirements.

18The1980statutealsoprovidesthat\"underextraordinarycircumstances\"reserverequirementscanbeimposedatanylevelonanyliability

ofdepositoryinstitutionsforaslongassixmonths;and,ifessentialfortheconductofmonetarypolicy,supplementalrequirementsupto4percentoftransactionaccountscanbeimposed.back30Undera10percentreserverequirement,$10ofreservesareneededtosupporteach

$100ofdeposits.backBANKA

Assets

Loansandinvestments...90

Reserves........10(Required....10)(Excess.......0)

Liabilities

Deposits.......100

31Withareductioninrequirementsfrom10percentto8percent,fewerreservesare

requiredagainstthesamevolumeofdepositssothatexcessreservesarecreated.Thesecanbeloanedorinvested.backBANKA

Assets

Loansandinvestments.....90

Reserves........10(Required.....8)(Excess......2)

AssetsNochange

Liabilities

Deposits.......100

FEDERALRESERVEBANK

LiabilitiesNochange

Thereisnochangeinthetotalamountofreserves.

32Withanincreaseinrequirementsfrom10percentto12percent,morereservesare

requiredagainstthesamevolumeofdeposits.Theresultingdeficienciesmustbecoveredbyliquidationofloansorinvestments...backBANKA

Assets

Loansandinvestments.....90

Reserves.........10

(Required.....12)(Deficit.......2)

AssetsNochange

Liabilities

Deposits.........100

FEDERALRESERVEBANK

LiabilitiesNochange

...becausethetotalamountofbankreservesremainsunchanged.

ChangesinForeign-RelatedFactors

TheFederalReservehasengagedinforeigncurrencyoperationsforitsownaccountsince1962.Inaddition,itactsastheagentforforeigncurrencytransactionsoftheU.S.Treasury,andsincethe1950shasexecutedtransactionsforcustomerssuchasforeigncentralbanks.PerhapsthemostpublicizedtypeofforeigncurrencytransactionundertakenbytheFederalReserveisinterventioninforeignexchangemarkets.

Intervention,however,isonlyoneofseveralforeign-relatedtransactionsthathavethepotentialforincreasingordecreasingreservesofbanks,therebyaffectingmoneyandcreditgrowth.

Severalforeign-relatedtransactionsandtheireffectsonU.S.bankreservesaredescribedinthenextfewpages.Includedaresomebutnotallofthetypesoftransactionsused.Thekeypointtoremember,however,isthattheFederalReserveroutinelyoffsetsany

undesiredchangeinU.S.bankreservesresultingfromforeign-relatedtransactions.Asaresult,suchtransactionsdonotaffectmoneyandcreditgrowthintheUnitedStates.

ForeignExchangeInterventionfortheFederalReserve'sOwnAccount

WhentheFederalReserveintervenesinforeignexchangemarketstoselldollarsforitsownaccount,(19)itacquiresforeigncurrencyassetsandreservesofU.S.banksinitiallyrise.Incontrast,whentheFedintervenestobuydollarsforitsownaccount,itusesforeigncurrencyassetstopayforthedollarspurchasedandreservesofU.S.banksinitiallyfall.

ConsidertheexamplewheretheFederalReserveintervenesintheforeignexchangemarketstosell$100ofU.S.dollarsforitsownaccount.Inthistransaction,theFederalReservebuysaforeign-currency-denominateddepositofaU.S.bankheldataforeigncommercialbank,(20)andpaysforthisforeigncurrencydepositbycrediting$100totheU.S.bank'sreserveaccountattheFed.TheFederalReservedepositstheforeigncurrencyproceedsinitsaccountataForeignCentral

Bank,andasthistransactionclears,theforeignbank'sreservesattheForeignCentralBankdecline.Seeillustration33.Initially,then,theFed'sinterventionsaleofdollarsinthisexampleleadstoanincreaseinFederalReserveBankassetsdenominatedinforeigncurrenciesandanincreaseinreservesofU.S.banks.

SupposeinsteadthattheFederalReserveintervenesintheforeignexchangemarketstobuy$100ofU.S.dollars,againforitsownaccount.TheFederalReservepurchasesadollar-denominateddepositofaforeignbankheldataU.S.bank,andpaysforthisdollardepositbydrawingonitsforeigncurrencydepositataForeignCentralBank.(TheFederalReservemighthavetosellsomeofitsforeigncurrencyinvestmentstobuildupitsdepositsattheForeignCentralBank,butthiswouldnotaffectU.S.bankreserves.)AstheFederalReserve'saccountattheForeignCentralBankischarged,theforeignbank'sreservesattheForeignCentralBankincrease.Inturn,thedollardepositoftheforeignbankattheU.S.bankdeclinesastheU.SbanktransfersownershipofthosedollarstotheFederalReserveviaa$100chargetoitsreserveaccountattheFederalReserve.Seeillustration34.Initially,then,theFed'sinterventionpurchaseofdollarsinthisexampleleadstoadecreaseinFederalReserveBankassetsdenominatedinforeigncurrenciesandadecreaseinreservesofU.S.banks.

Asnotedearlier,theFederalReserveoffsetsor\"sterilizes\"anyundesiredchangeinU.S.bankreservesstemmingfromforeignexchangeinterventionsalesorpurchasesofdollars.Forexample,FederalReserveBankassetsdenominatedinforeigncurrenciesrosedramaticallyin19,inpartduetosignificantU.S.interventionsalesofdollars.(Seechart.)TotalreservesofU.S.banks,however,declinedslightlyin19asopenmarketoperationswereusedto\"sterilize\"theinitialintervention-inducedincreaseinreserves.

MonthlyRevaluationofForeignCurrencyAssets

AnothersetofaccountingtransactionsthataffectsFederalReserveBankassetsdenominatedinforeigncurrenciesisthemonthlyrevaluationofsuchassets.Twobusinessdayspriortotheendofthemonth,theFed'sforeigncurrencyassetsare

increasediftheirmarketvaluehasappreciatedordecreasediftheirvaluehasdepreciated.TheoffsettingaccountingentryontheFed'sbalancesheetistothe\"exchange-translationaccount\"includedin\"otherF.R.liabilities.\"ThesechangesintheFed'sbalancesheetdonotalterbankreservesdirectly.However,sincetheFederalReserveturnsoveritsnetearningstotheTreasuryeachweek,therevaluationaffectstheamountoftheFed'spaymenttotheTreasury,whichinturninfluencesthesizeofTT&Lcallsandbankreserves.(Seeexplanationonpages18and19.

Foreign-RelatedTransactionsfortheTreasury

U.S.interventioninforeignexchangemarketsbytheFederalReserveusuallyisdividedbetweenitsownaccountandtheTreasury'sExchangeStabilizationFund(ESF)account.TheimpactonU.S.bankreservesfromtheinterventiontransactionisthesameforboth-salesofdollarsaddtoreserveswhilepurchasesofdollarsdrainreserves.Seeillustration35.DependinguponhowtheTreasurypaysfor,orfinances,itspartoftheintervention,however,theFederalReservemaynotneedtoconductoffsettingopenmarketoperations.TheTreasurytypicallykeepsonlyminimalbalancesintheESF'saccountattheFederalReserve.Therefore,theTreasurygenerallyhastoconvertsomeESFassetsintodollarorforeigncurrencydepositsinordertopayforitspartofaninterventiontransaction.

Likewise,thedollarorforeigncurrencydepositsacquiredbytheESFintheinterventiontypicallyaredrawndownwhentheESFinveststheproceedsinearningassets.

Forexample,tofinanceaninterventionsaleofdollars(suchasthatshowninillustration35),theTreasurymightredeemsomeoftheU.S.governmentsecuritiesissuedtotheESF,resultinginatransferoffundsfromtheTreasury's(generalaccount)balancesattheFederalReservetotheESF'saccountattheFed.(OntheFederalReserve'sbalancesheet,theESF'saccountisincludedintheliabilitycategory\"otherdeposits.\")TheTreasury,however,wouldneedtoreplenishitsFedbalancestodesiredlevels,perhapsbyincreasingthesizeofTT&Lcalls-atransactionthatdrainsU.S.bankreserves.The

interventionandfinancingtransactionsessentiallyoccursimultaneously.Asaresult,U.S.bankreservesaddedintheinterventionsaleofdollarsareoffsetbythedraininU.S.bankreservesfromtheTT&Lcall.Seeillustrations35and36.Thus,noFederalReserveoffsettingactionswouldbeneedediftheTreasuryfinancedtheinterventionsaleofdollarsthroughaTT&Lcallonbanks.

OffsettingactionsbytheFederalReservewouldbeneeded,however,iftheTreasuryrestoreddepositsaffectedbyforeign-relatedtransactionsthroughanumberof

transactionsinvolvingtheFederalReserve.TheseincludetheTreasury'sissuanceofSDRorgoldcertificatestotheFederalReserveandthe\"warehousing\"offoreigncurrenciesbytheFederalReserve.

SDRcertificates.OccasionallytheTreasuryacquiresdollardepositsfortheESF'saccountbyissuingcertificatestotheFederalReserveagainstallocationsofSpecialDrawingRights(SDRs)receivedfromtheInternationalMonetaryFund.(21)For

example,$3.5billionofSDRcertificateswereissuedin19,andanother$1.5billionin1990.This\"monetization\"ofSDRsisreflectedontheFederalReserve'sbalancesheetasanincreaseinitsasset\"SDRcertificateaccount\"andanincreaseinitsliability\"otherdeposits(ESFaccount).\"

IftheESFusesthesedollardepositsdirectlyinaninterventionsaleofdollars,thentheintervention-inducedincreaseinU.S.bankreservesisnotaltered.Seeillustrations35and37.Ifnotneededimmediatelyforaninterventiontransaction,theESFmightusethedollardepositsfromissuanceofSDRcertificatestobuysecuritiesfromtheTreasury,

resultinginatransferoffundsfromtheESF'saccountattheFederalReservetotheTreasury'saccountattheFed.U.S.bankreserveswouldthenincreaseastheTreasuryspentthefundsortransferredthemtobanksthroughadirectinvestmenttoTT&Lnoteaccounts.

Goldstockandgoldcertificates.ChangesintheU.S.

monetarygoldstockusedtobeanimportantfactoraffectingbankreserves.However,thegoldstockandgoldcertificatesissuedtotheFederalReservein\"monetizing\"gold,havenotchangedsignificantlysincetheearly1970s.(Seechart.)

PriortoAugust1971,theTreasuryboughtandsoldgoldforafixedpriceintermsofU.S.dollars,mainlyattheinitiativeofforeigncentralbanksandgovernments.GoldpurchasesbytheTreasurywereaddedtotheU.S.monetarygoldstock,andpaidforfromits

accountattheFederalReserve.AsthesellersdepositedtheTreasury'schecksinbanks,reservesincreased.ToreplenishitsbalanceattheFed,theTreasuryissuedgoldcertificatestotheFederalReserveandreceivedacredittoitsdepositbalance.

Treasurysalesofgoldhavetheoppositeeffect.Buyers'checksarecreditedtothe

Treasury'saccountandreservesdecline.BecausetheofficialU.S.goldstockisnowfully\"monetized,\"theTreasurycurrentlyhastouseitsdepositstoretiregoldcertificatesissuedtotheFederalReservewhenevergoldissold.However,thevalueofgold

certificatesretired,aswellasthenetcontractioninbankreserves,isbasedontheofficialgoldprice.Proceedsfromagoldsaleatthemarketpricetomeetdemandsofdomesticbuyerslikelywouldbegreater.ThedifferencerepresentstheTreasury'sprofit,which,whenspent,restoresdepositsandbankreservesbyalikeamount.

WhiletheTreasurynolongerpurchasesgoldandsalesofgoldhavebeenlimited,increasesintheofficialpriceofgoldhaveaddedtothevalueofthegoldstock.(Theofficialgoldpricewaslastraisedfrom$38.00to$42.22pertroyounce,in1973.)Warehousing.TheTreasurysometimesacquiresdollardepositsattheFederalReserveby\"warehousing\"foreigncurrencieswiththeFed.(Forexample,$7billionofforeigncurrencieswerewarehousedin19.)TheTreasuryorESFacquiresforeigncurrencyassetsasaresultoftransactionssuchasinterventionsalesofdollarsorsalesofU.Sgovernmentsecuritiesdenominatedinforeigncurrencies.WhentheFederalReservewarehousesforeigncurrenciesfortheTreasury,(22)\"FederalReserveBanksassets

denominatedinforeigncurrencies\"increaseasdoTreasurydepositsattheFed.Asthesedepositsarespent,reservesofU.S.banksrise.Incontrast,theTreasurylikelywillhavetoincreasethesizeofTT&Lcalls-atransactionthatdrainsreserves-whenit

repurchaseswarehousedforeigncurrenciesfromtheFederalReserve.(In1991,$2.5billionofwarehousedforeigncurrencieswererepurchased.)TherepurchasetransactionisreflectedontheFed'sbalancesheetasdeclinesinbothTreasurydepositsattheFederalReserveandFederalReserveBankassetsdenominatedinforeigncurrencies.

TransactionsforForeignCustomers

ManyforeigncentralbanksandgovernmentsmaintaindepositsattheFederalReservetofacilitatedollar-denominatedtransactions.These\"foreigndeposits\"ontheliabilitysideoftheFed'sbalancesheettypicallyareheldatminimallevelsthatvarylittlefromweektoweek.Forexample,foreigndepositsattheFederalReserveaveragedonly$237millionin1991,rangingfrom$178millionto$319milliononaweeklyaveragebasis.Changesinforeign

depositsaresmallbecauseforeigncustomers\"manage\"theirFederalReservebalancestodesiredlevelsdailybybuyingandsellingU.S.governmentsecurities.Theextentoftheseforeigncustomer\"cashmanagement\"transactionsisreflected,inpart,bylargeand

frequentchangesinmarketableU.S.governmentsecuritiesheldincustodybytheFederalReserveforforeigncustomers.(Seechart.)Theneteffectofforeigncustomers'cashmanagementtransactionsusuallyistoleaveU.S.bankreservesunchanged.

Managingforeigndepositsthroughsalesofsecurities.ForeigncustomersoftheFederalReservemakedollar-denominatedpayments,includingthoseforinterventionsalesofdollarsbyforeigncentralbanks,bydrawingdowntheirdepositsattheFederalReserve.AsthesefundsaredepositedinU.S.banksandcleared,reservesofU.S.banksrise.Seeillustration38.However,ifpaymentsfromtheiraccountsattheFederalReservelowerbalancestobelowdesiredlevels,foreigncustomerswillreplenishtheirFederalReservedepositsbysellingU.S.governmentsecurities.Actingastheiragent,theFederalReserveusuallyexecutesforeigncustomers'sellordersinthemarket.Asbuyerspayforthe

securitiesbydrawingdowndepositsatU.S.banks,reservesofU.S.banksfallandoffsettheincreaseinreservesfromthedisbursementtransactions.TheneteffectistoleaveU.S.bankreservesunchangedwhenU.S.governmentsecuritiesofcustomersaresoldinthemarket.Seeillustrations38and39.Occasionally,however,theFederalReserveexecutesforeigncustomers'sellorderswiththeSystem'saccount.Whenthisisdone,theriseinreservesfromtheforeigncustomers'disbursementoffundsremainsinplace.See

illustration38and40.TheFederalreservemightchoosetoexecutesellorderswiththeSystem'saccountifanincreaseinreservesisdesiredfordomesticpolicyreasons.Managingforeigndepositsthroughpurchasesofsecuritites.ForeigncustomersoftheFederalReservealsoreceiveavarietyofdollardenominatedpayments,including

proceedsfrominterventionpurchasesofdollarsbyforeigncentralbanks,thataredrawnonU.S.banks.AsthesefundsarecreditedtoforeigndepositsattheFederalReserve,reservesofU.S.banksdecline.Butifreceiptsofdollar-denominatedpaymentsraisetheirdepositsattheFederalReservetolevelshigherthandesired,foreigncustomerswillbuyU.S.governmentsecurities.TheneteffectgenerallyistoleaveU.S.bankreservesunchangedwhentheU.S.governmentsecuritiesarepurchasedinthemarket.

Usingtheswapnetwork.Occasionally,foreigncentralbanksacquiredollardepositsbyactivatingthe\"swap\"network,whichconsistsofreciprocalshort-termcredit

arrangementsbetweentheFederalReserveandcertainforeigncentralbanks.WhenaforeigncentralbankdrawsonitsswaplineattheFederalReserve,itimmediatelyobtainsadollardepositattheFedinexchangeforforeigncurrencies,andagreestoreversethe

exchangesometimeinthefuture.OntheFederalReserve'sbalancesheet,activationoftheswapnetworkisreflectedasanincreaseinFederalReserveBankassetsdenominatedinforeigncurrenciesandanincreaseintheliabilitycategory\"foreigndeposits.\"Whentheswaplineisrepaid,bothoftheseaccountsdecline.ReservesofU.S.bankswillrisewhentheforeigncentralbankspendsitsdollarproceedsfromtheswapdrawing.Seeillustration41.Incontrast,reservesofU.S.bankswillfallastheforeigncentralbankrebuildsitsdepositsattheFederalReserveinordertorepayaswapdrawing.TheaccountingentriesandimpactofU.S.bankreservesarethesameiftheFederalReserveusestheswapnetworktoborrowandrepayforeigncurrencies.However,theFederalReservehasnotactivatedtheswapnetworkinrecentyears.

19OverallresponsibilityforU.S.interventioninforeignexchangemarketsrestswiththeU.STreasury.Foreignexchangetransactionsforthe

FederalReserve'saccountarecarriedoutunderdirectivesissuedbytheFederalReserve'sOpenMarketCommitteewithinthegeneral

frameworkofexchangeratepolicyestablishedbytheU.S.TreasuryinconsultationwiththeFed.TheyareimplementedattheFederalReserveBankofNewYork,typicallyatthesametimethatsimilartransactionsareexecutedfortheTreasury'sExchangeStabilizationFund.back20Americanstravelingtoforeigncountriesengagein\"foreignexchange\"transactionswhenevertheyobtainforeigncoinsandpapercurrency

inexchangeforU.S.coinsandcurrency.However,mostforeignexchangetransactionsdonotinvolvethephysicalexchangeofcoinsandcurrency.Rather,mostofthesetransactionsrepresentthebuyingandsellingofforeigncurrenciesbyexchangingonebankdeposit

denominatedinonecurrencyforanotherbankdepositdenominatedinanothercurrency.Foreaseofexposition,theexamplesassumethatU.S.banksandforeignbanksarethemarketparticipantsintheinterventiontransactions,buttheimpactonreserveswouldbethesameiftheU.S.orforeignpublicwereinvolved.back21SDRswerecreatedin1970forusebygovernmentsinofficialbalanceofpaymentstransactions.back22Technically,warehousingconsistsoftwoparts:theFederalReserve'sagreementtopurchaseforeigncurrencyassetsfromtheTreasuryorESFfordollardepositsnow,andtheTreasury'sagreementtorepurchasetheforeigncurrenciessometimeinthefuture.back33WhentheFederalReserveintervenestoselldollarsforitsownaccount,itpaysfor

aforeign-currency-denominateddepositofaU.S.bankataforeigncommercialbankbycreditingthereserveaccountoftheU.S.bank,andacquiresaforeigncurrencyassetintheformofadepositataForeignCentralBank.TheFederalReserve,however,willoffsettheincreaseinU.S.bankreservesifitisinconsistentwithdomesticpolicyobjectives.backFEDERALRESERVEBANKAssets

DepositsatForeignCentralBank..+100

U.S.BANK

Assets

Liabilities

Liabilities

Reserves:U.S.bank..

+100

ReserveswithF.R.Bank..+100Depositsatforeignbank..-100

FOREIGNBANK

Assets

Reserveswith

ForeignCentralBank..-100

Assets

Liabilities

DepositsofU.S.bank..-100Liabilities

DepositsofF.R.Banks...+100Reservesofforeignbank...-100

FOREIGNCENTRALBANK

34WhentheFederalReserveintervenestobuydollarsforitsownaccount,itdraws

downitsforeigncurrencydepositsataforeignCentralBanktopayforadollar-denominateddepositofaforeignbankataU.S.bank,whichleadstoacontractioninreservesoftheU.S.bank.ThisreductioninreserveswillbeoffsetbytheFederalReserveifitisinconsistentwithdomesticpolicyobjectives.backFEDERALRESERVEBANK

AssetsLiabilities

DepositsatForeignCentralBank.-Reserves:U.S.bank..-100100

U.S.BANK

AssetsLiabilities

ReserveswithF.R.Bank..-100Depositsofforeignbank..-100

FOREIGNBANK

Assets

depositsatU.S.bank...-100

ReserveswithForeignCentralBank.+100

FOREIGNCENTRALBANKAssets

Liabilities

DepositsofF.R.Banks..-100Reservesofforeignbank..+100

Liabilities

35InaninterventionsaleofdollarsfortheU.S.Treasury,depositsoftheESFatthe

FederalReserveareusedtopayforaforeigncurrencydepositofaU.S.bankataforeignbank,andtheforeigncurrencyproceedsaredepositedinanaccountataForeignCentralBank.U.S.bankreservesincreaseasaresultofthisinterventiontransaction.backESF

Assets

DepositsatF.R.Bank....-100DepositsatForeignCentralBank..

+100

U.S.Treasury

AssetsNochangeAssets

LiabilitiesNochange

Liabilities

Reserves:U.S.bank...+100Otherdeposits:ESF...-100

U.S.BANK

Assets

ReserveswithF.R.Bank...

+100

Depositsatforeignbank...-100

FOREIGNBANK

Liabilities

DepositsofU.S.bank.

ReserveswithForeignCentralBank.-100

-100

FOREIGNCENTRALBANKAssets

Liabilities

DepositsofESF...+100Reservesofforeignbank..-100

Assets

LiabilitiesLiabilities

FEDERALRESERVEBANK

36Concurrently,theTreasurymustfinancetheinterventiontransactionin(35).The

TreasurymightbuildupdepositsintheESF'saccountattheFederalReserveby

redeemingsecuritiesissuedtotheESF,andreplenishitsown(generalaccount)depositsattheFederalReservetodesiredlevelsbyissuingacallonTT&Lnoteaccounts.Thisset

oftransactionsdrainsreservesofU.S.banksbythesameamountastheinterventionin(35)addedtoU.S.bankreserves.backESF

Assets

U.Sgovt.securities...-100DepositsatF.R.Banks..+100

U.S.Treasury

Assets

TT&Laccts.........-100DepositsatF.R.Banks...net0

(fromU.Sbank..+100)(toESF........-100)

Assets

Liabilities

SecuritiesissuedESF...-100

Liabilities

FEDERALRESERVEBANK

Liabilities

Reserves:U.S.bank...-100

Treas.deps:....net0(fromU.S.bank.+100)(toESF.........-100)Otherdeposits:ESF....+100

U.S.BANK

Assets

ReserveswithF.R.Bank..-100

Liabilities

TT&Laccts.....-100

37Alternatively,theTreasurymightfinancetheinterventionin(35)byissuingSDR

certificatestotheFederalReserve,atransactionthatwouldnotdisturbtheadditionofU.S.bankreservesinintervention(35).TheFederalReserve,however,wouldoffsetanyundesiredchangeinU.S.bankreserves.backESF

Assets

DepositsatF.R.Banks..+100

Liabilities

SDRcertificatesissuedto

F.R.Banks......+100

LiabilitiesNochange

U.S.Treasury

AssetsNochange

FEDERALRESERVEBANK

Assets

SDRcertificateaccount..+100

AssetsNochange

Liabilities

Otherdeposits:ESF...+100

LiabilitiesNochange

U.S.BANK

38WhenaForeignCentralBankmakesadollar-denominatedpaymentfromits

accountattheFederalReserve,therecipientdepositsthefundsinaU.S.bank.Asthepaymentorderclears,U.S.bankreservesrise.backFEDERALRESERVEBANKAssets

Liabilities

Reserves:U.S.bank...+100Foreigndeposits....-100

U.S.BANK

Assets

ReserveswithF.R.Banks..

+100Assets

DepositsatF.R.Banks....-100

Liabilities

Deposits........+100

FOREIGNCENTRALBANK

Liabilities

Accountspayable.....-100

39IfadeclineinitsdepositsattheFederalReservelowersthebalancebelowdesired

levels,theForeignCentralBankwillrequestthattheFederalReservesellU.S.

governmentsecuritiesforit.Ifthesellorderisexecutedinthemarket,reservesofU.S.bankswillfallbythesamesmountasreserveswereincreasedin(38).backFEDERALRESERVEBANKAssets

Liabilities

Reserves:U.S.bank....-100Foreigndeposits.....+100

U.S.BANK

Assets

Liabilities

ReserveswithF.R.Banks...-100

Assets

DepositsatF.R.Banks..+100U.S.govt.securities..-100

Depositsofsecuritiesbuyer..-100

Liabilities

FOREIGNCENTRALBANK

40IfthesellorderisexecutedwiththeFederalReserve'saccount,however,the

increaseinreservesfrom(38)willremaininplace.TheFederalReservemightchoosetoexecutetheforeigncustomer'ssellorderwiththeSystem'saccountifanincreaseinreservesisdesiredfordomesticpolicyreasons.

FEDERALRESERVEBANK

Assets

U.S.govt.securities....+100

U.S.Bank

AssetsNochange

Assets

DepositsatF.R.Banks...+100U.S.govt.securities.....-100

LiabilitiesNochangeLiabilities

Liabilities

Foreigndeposits....+100

FOREIGNCENTRALBANK

41WhenaForeignCentralBankdrawsona\"swap\"line,itreceivesacredittoits

dollardepositsattheFederalReserveinexchangeforaforeigncurrencydepositcreditedtotheFederalReserve'saccount.ReservesofU.S.banksarenotaffectedbytheswapdrawingtransaction,butwillincreaseastheForeignCentralBankusesthefundsasin(38).backFEDERALRESERVEBANK

AssetsLiabilities

depositsatForeignCentralBank..

Foreigndeposits....+100+100

U.S.Bank

Assets

Liabilities

NochangeNochange

FOREIGNCENTRALBANK

AssetsLiabilities

DepositsatF.R.Banks...+100DepositsofF.R.Banks...+100

FederalReserveActionsAffectingItsHoldingsofU.S.GovernmentSecurities

Indiscussingvariousfactorsthataffectreserves,itwasoftenindicatedthattheFederalReserveoffsetsundesiredchangesinreservesthroughopenmarketoperations,thatis,bybuyingandsellingU.S.governmentsecuritiesinthemarket.However,outright

purchasesandsalesofsecuritiesbytheFederalReserveinthemarketoccurinfrequently,andtypicallyareconductedwhenanincreaseordecreaseinanotherfactorisexpectedtopersistforsometime.Mostmarketactionstakentoimplementchangesinmonetarypolicyortooffsetchangesinotherfactorsareaccomplishedthroughtheuseoftransactionsthatchangereservestemporarily.Inaddition,thereareoff-markettransactionstheFederalReservesometimesusestochangeitsholdingsofU.S.

governmentsecuritiesandaffectreserves.(Recalltheexampleinillustrations38and40.)TheimpactonreservesofvariousFederalReservetransactionsinU.S.governmentandfederalagencysecuritiesisexplainedbelow.(Seetableforasummary.)

Outrighttransactions.Ownershipofsecuritiesistransferredpermanentlytothebuyerinanoutrighttransaction,andthefundsusedinthetransactionaretransferredpermanentlytotheseller.Asaresult,anoutrightpurchaseofsecuritiesbytheFederalReservefromadealerinthemarketaddsreservespermanentlywhileanoutrightsaleofsecuritiestoadealerdrainsreservespermanently.TheFederalReservecanachievethesameneteffectonreservesthroughoff-markettransactionswhereitexecutesoutrightsellandpurchaseordersfromcustomersinternallywiththeSystemaccount.Incontrast,thereisnoimpactonreservesiftheFederalReservefillscustomers'outrightsellandpurchaseordersinthemarket.

Temporarytransactions.Repurchaseagreements(RPs),andassociatedmatchedsale-purchaseagreements(MSPs),transferownershipofsecuritiesanduseoffunds

temporarily.InanRPtransaction,onepartysellssecuritiestoanotherandagreestobuythembackonaspecifiedfuturedate.InanMSPtransaction,onepartybuyssecuritiesfromanotherandagreestosellthembackonaspecifiedfuturedate.Inessence,then,andRPforonepartyinthetransactionworkslikeanMSPfortheotherparty.

WhentheFederalReserveexecuteswhatisreferredtoasa\"SystemRP,\"itacquiressecuritiesinthemarketfromdealerswhoagreetobuythembackonaspecifiedfuturedate1to15dayslater.BoththeSystem'sportfolioofsecuritiesandbankreservesareincreasedduringthetermoftheRP,butdeclineagainwhenthedealersrepurchasethesecurities.ThusSystemRPsincreasereservesonlytemporarily.Reservesaredrained

temorarilywhentheFedexecuteswhatisknownasa\"SystemMSP.\"ASystemMSPworkslikeaSystemRP,onlyintheoppositedirections.InasystemMSP,theFedsellssecuritiestodealersinthemarketandagreestobuythembackonaspecifiedday.TheSystem'sholdingsofsecuritiesandbankreservesarereducedduringthetermoftheMSP,butbothincreasewhentheFederalReservebuysbackthesecurities.

ImpactonreservesofFederalReservetransactionsinU.S.governmentandfederalagencysecurities

FederalReserveTransactionsReserveImpact

OutrightpurchaseofSecurities-FromdealerinmarketPermanentincrease-TofillcustomersellordersPermanentincrease(Ifcustomerbuyordersfilledinmarket)(Noimpact)OutrightSalesofSecurites-TodealerinmarketPermanentdecrease-TofillcustomerbuyordersinternallyPermanentdecrease(Ifcustomerbuyordersfilledinmarket)(Noimpact)RepurchaseAgreements(RPs)

-WithdealerinmarketinSystemRPMatchedSale-PurchaseAgreements(MSPs)-WithdealerinmarketinasystemMSP-TofillcustomerRPordersinternally(IfcustomerRPorderspassedtomarketascustomerrelatedRPs)

TemporaryincreaseTemporarydecreaseNoimpact*

(Temporaryincrease*)

RedemptionofMaturingSecurities-ReplacetotalamountmaturingNoimpact-RedeempartofamountmaturingPermanentdecrease-Buymorethanamountmaturing**Permanentincrease**

___________________________________________________________________________

*ImpactbasedonassumptionthattheamountofRPordersdoneinternallyisthesameasonthepriorday.

**TheFederalReservecurrentlyisprohibitedbylawfrombuyingsecuritiesdirectlyfromtheTreasury,excepttoreplacematuringissues.

TheFederalReservealsousesMSPstofillforeigncustomers'RPordersinternallywiththeSystemaccount.Consideredinisolation,aFederalReserveMSPtransactionwithcustomerswoulddrainreservestemporarily.However,thesetransactionsoccureveryday,withthetotalamountofRPordersbeingfairlystablefromdaytoday.Thus,onany

givenday,theFedbothbuysbacksecuritiesfromcustomerstofulfillthepriorday'sMSP,andsellsthemaboutthesameamountofsecuritiestosatisfythatday'sagreement.Asaresult,theregenerallyislittleornoimpactonreserveswhentheFedusesMSPstofillcustomerRPordersinternallywiththeSystemaccount.Sometimes,however,theFederalReservefillssomeoftheRPordersinternallyandtherestinthemarket.Thepartthatispassedontothemarketisknownasa\"customer-relatedRP.\"TheFedendsuprepurchasingmoresecuritiesfromcustomerstocompletethepriorday'sMSPthanitsellstotheminthatday'sMSP.Asaresult,customer-relatedRPsaddreservestemporarily.Maturingsecurities.AssecuritiesheldbytheFederalReservemature,theyare

exchangedfornewsecurities.UsuallythetotalamountmaturingisreplacedsothatthereisnoimpactonreservessincetheFed'stotalholdingsremainthesame.Occasionally,however,theFederalReservewillexchangeonlypartoftheamountmaturing.Treasurydepositsdeclineaspaymentfortheredeemedsecuritiesismade,andreservesfallastheTreasuryreplenishesitsdepositsattheFedthroughTT&Lcalls.Thereservedrainispermanent.IftheFedweretobuymorethantheamountofsecuritiesmaturingdirectlyfromtheTreasury,thenreserveswouldincreasepermanently.However,theFederalReservecurrentlyisprohibitedbylawfrombuyingsecuritiesdirectlyfromtheTreasury,excepttoreplacematuringissues.

Page35.

MiscellaneousFactorsAffectingBankReserves

Thefactorsdescribedbelownormallyhavenegligibleeffectsonbankreservesbecausechangesinthemeitheroccurveryslowlyortendtobebalancedbyconcurrentchangesinotherfactors.Butattimestheymayrequireoffsettingaction.

TreasuryCurrencyOutstanding

Treasurycurrencyoutstandingconsistsofcoins,silvercertificatesandU.S.notesoriginallyissuedbytheTreasury,andothercurrencyoriginallyissuedbycommercialbanksandbyFederalReserveBanksbeforeJuly1929butforwhichtheTreasuryhasredemptionresponsibility.Short-runchangesaresmall,andtheireffectsonbankreservesareindirect.

TheamountofTreasurycurrencyoutstandingcurrentlyincreasesonlythroughissuanceofnewcoin.TheTreasuryshipsnewcointotheFederalReserveBanksforcredittoTreasurydepositsthere.Thesedepositswillbedrawndownagain,however,astheTreasurymakesexpenditures.Checksissuedagainstthesedepositsarepaidouttothepublic.Asindividualsdepositthesechecksinbanks,reservesincrease.(Seeexplanationonpages18and19.)

WhenanytypeofTreasurycurrencyisretired,bankreservesdecline.AsbanksturninTreasurycurrencyforredemption,theyreceiveFederalReservenotesorcoininexchangeoracredittotheirreserveaccounts,leavingtheirtotalreserves(reservebalancesandvaultcash)initiallyunchanged.However,theTreasury'sdepositsintheReserveBanksarechargedwhenTreasurycurrencyisretired.TransfersfromTT&LbalancesinbankstotheReserveBanksreplenishthesedeposits.Suchtransfersabsorbreserves.

TreasuryCashHoldings

InadditiontoaccountsindepositoryinstitutionsandFederalReserveBanks,the

Treasuryholdssomecurrencyinitsownvaults.ChangesintheseholdingsaffectbankreservesjustlikechangesintheTreasury'sdepositaccountattheReserveBanks.WhenTreasuryholdingsofcurrencyincrease,theydosoattheexpenseofdepositsinbanks.AscashholdingsoftheTreasurydecline,ontheotherhand,thesefundsmoveintobankdepositsandincreasebankreserves.

OtherDepositsinReserveBanks

BesidesU.S.banks,theU.S.Treasury,andforeigncentralbanksandgovernments,therearesomeinternationalorganizationsandcertainU.S.governmentagenciesthatkeepfundsondepositintheFederalReserveBanks.Ingeneral,balancesarebuiltupthroughtransfersofdepositsheldatU.S.banks.Suchtransfersmaytakeplaceeitherdirectly,wherethesecustomersalsohavedepositsinU.S.banks,orindirectlybythedepositoffundsacquiredfromotherswhodohaveaccountsatU.S.banks.Suchtransfersinto\"otherdeposits\"drainreserves.

WhenthesecustomersdrawontheirFederalReservebalances(say,topurchase

securities),thesefundsarepaidtothepublicanddepositedinU.S.banks,thusincreasingbankreserves.Justlikeforeigncustomers,these\"other\"customersmanagetheirbalancesattheFederalReservecloselysothatchangesintheirdepositstendtobesmallandhaveminimalnetimpactonreserves.

Nonfloat-RelatedAdjustments

Certainadjustmentsareincorporatedintopublisheddataonreservebalancestoreflectnonfloat-relatedcorrections.Suchacorrectionmightbemade,forexample,ifan

individualbankhadmistakenlyreportedfewerreservabledepositsthanactuallyexistedandhadheldsmallerreservebalancesthannecessaryinsomepastperiod.Tocorrectforthiserror,anonfloat-relatedas-ofadjustmentwillbeappliedtothebank'sreserve

position.Thisessentiallyresultsinthebankhavingtoholdhigherbalancesinitsreserveaccountinthecurrentand/orfutureperiodsthanwouldbeneededtosatisfyreserve

requirementsinthoseperiods.Nonfloat-relatedas-ofadjustmentsaffecttheallocationoffundsinbankreserveaccountsbutnotthetotalamountintheseaccountsasreflectedonFederalReserveBankandindividualbankbalancesheets.Publisheddataonreserve

balances,however,areadjustedtoshowonlythosereservebalancesheldtomeetthecurrentand/orfutureperiodreserverequirements.

OtherFederalReserveAccounts

EarliersectionsofthisbookletdescribedthewayinwhichbankreservesincreasewhentheFederalReservepurchasessecuritiesanddeclinewhentheFedsellssecurities.ThesameresultsfollowfromanyFederalReserveexpenditureorreceipt.EverypaymentmadebytheReserveBanks,inmeetingexpensesoracquiringanyassets,affectsdepositsandbankreservesinthesamewayasdoespaymenttoadealerforgovernmentsecurities.Similarly,ReserveBankreceiptsofinterestonloansandsecuritiesandincreasesinpaid-incapitalabsorbreserves.

Endofpage35.backTheReserveMultiplier-WhyItVaries

Thedepositexpansionandcontractionassociatedwithagivenchangeinbankreserves,asillustratedearlierinthisbooklet,assumedafixedreserve-to-depositmultiplier.Thatmultiplierwasdeterminedbyauniformpercentagereserverequirementspecifiedfortransactionaccounts.Suchanassumptionisanoversimplificationoftheactual

relationshipbetweenchangesinreservesandchangesinmoney,especiallyintheshort-run.Foranumberofreasons,asdiscussedinthissection,thequantityofreservesassociatedwithagivenquantityoftransactiondepositsisconstantlychanging.Oneslippageaffectingthereservemultiplierisvariationintheamountofexcess

reserves.Intherealworld,reservesarenotalwaysfullyutilized.Therearealwayssomeexcessreservesinthebankingsystem,reflectingfrictionsandlagsasfundsflowamongthousandsofindividualbanks.

Excessreservespresentaproblemformonetarypolicyimplementationonlybecausetheamountchanges.Totheextentthatnewreservessuppliedareoffsetbyrisingexcessreserves,actualmoneygrowthfallsshortofthetheoreticalmaximum.Conversely,areductioninexcessreservesbythebankingsystemhasthesameeffectonmonetaryexpansionastheinjectionofanequalamountofnewreserves.

Slippagesalsoarisefromreserverequirementsbeingimposedonliabilitiesnotincludedinmoneyaswellasdifferingreserveratiosbeingappliedtotransactiondeposits

accordingtothesizeofthebank.From1980through1990,reserverequirementswereimposedoncertainnontransactionliabilitiesofalldepositoryinstitutions,andbeforethenonalldepositsofmemberbanks.Thereservemultiplierwasaffectedbyflowsoffundsbetweeninstitutionssubjecttodifferingreserverequirementsaswellasbyshiftsoffundsbetweentransactiondepositsandotherliabilitiessubjecttoreserverequirements.The

extensionofreserverequirementstoalldepositoryinstitutionsin1980andthe

eliminationofreserverequirementsagainstnonpersonaltimedepositsandEurocurrencyliabilitiesinlate1990reduced,butdidnoteliminate,thissourceofinstabilityinthereservemultiplier.Thedepositexpansionpotentialofagivenvolumeofreservesstillisaffectedbyshiftsoftransactiondepositsbetweenlargerinstitutionsandthoseeitherexemptfromreserverequirementsorwhosetransactiondepositsarewithinthetranchesubjecttoa3percentreserverequirement.

Inaddition,thereservemultiplierisaffectedbyconversionsofdepositsintocurrencyorviceversa.Thisfactorwasimportantinthe1980sasthepublic'sdesiredcurrency

holdingsrelativetotransactiondepositsinmoneyshiftedconsiderably.Alsoaffectingthemultiplierareshiftsbetweentransactiondepositsincludedinmoneyandothertransactionaccountsthatalsoarereservablebutnotincludedinmoney,suchasdemanddepositsduetodepositoryinstitutions,theU.S.government,andforeignbanksandofficial

institutions.Intheaggregate,thesenon-moneytransactiondepositsarerelativelysmallincomparisontototaltransactionaccounts,butcanvarysignificantlyfromweektoweek.Anetinjectionofreserveshaswidelydifferenteffectsdependingonhowitisabsorbed.

Onlyadollar-for-dollarincreaseinthemoneysupplywouldresultifthenewreserveswerepaidoutincurrencytothepublic.Withauniform10percentreserverequirement,a$1increaseinreserveswouldsupport$10ofadditionaltransactionaccounts.Anevenlargeramountwouldbesupportedunderthegraduatedsystemwheresmallerinstitutionsaresubjecttoreserverequirementsbelow10percent.But,$1ofnewreservesalsowouldsupportan

additional$10ofcertainreservabletransactionaccountsthatarenotcountedasmoney.(Seechartbelow.)Normally,anincreaseinreserveswouldbeabsorbedbysomecombinationofthesecurrencyandtransactiondepositchanges.

Allofthesefactorsaretosomeextentpredictableandaretakenintoaccountindecisionsastotheamountofreservesthatneedtobesuppliedtoachievethedesiredrateofmonetaryexpansion.Theyhelpexplainwhyshort-runfluctuationsinbankreservesoftenaredisproportionateto,andsometimesintheoppositedirectionfrom,changesinthedepositcomponentofmoney.

MoneyCreationandReserveManagement

Anotherreasonforshort-runvariationintheamountofreservessuppliedisthatcreditexpansion-andthusdepositcreation-isvariable,reflectinguneventimingofcreditdemands.Althoughbankloanpoliciesnormallytakeaccountofthegeneralavailabilityoffunds,thesizeandtimingofloansandinvestmentsmadeunderthosepoliciesdependlargelyoncustomers'creditneeds.

Intherealworld,abank'slendingisnotnormally

constrainedbytheamountofexcessreservesithasatanygivenmoment.Rather,loansaremade,ornotmade,

dependingonthebank'screditpoliciesanditsexpectationsaboutitsabilitytoobtainthefundsnecessarytopayits

customers'checksandmaintainrequiredreservesinatimelyfashion.Infact,becauseFederalReserveregulationsineffectfrom1968throughearly1984specifiedthataveragerequiredreservesforagivenweekshouldbebasedonaveragedepositlevelstwoweeksearlier(\"lagged\"reserveaccounting),

depositcreationactuallyprecededtheprovisionofsupportingreserves.Inearly1984,amore\"contemporaneous\"reserveaccountingsystemwasimplementedinordertoimprovemonetarycontrol.

InFebruary1984,banksshiftedtomaintainingaverage

reservesoveratwo-weekreservemaintenanceperiodendingWednesdayagainstaveragetransactiondepositsheldoverthetwo-weekcomputationperiodendingonlytwodaysearlier.Underthisrule,actualtransactiondepositexpansionwasexpectedtomorecloselyapproximatetheprocessexplainedatthebeginningofthisbooklet.However,someslippagesstillexistbecauseofshort-rununcertaintiesaboutthelevelofbothreservesandtransactiondepositsnearthecloseofreservemaintenanceperiods.Moreover,notallbanksmustmaintainreservesaccordingtothecontemporaneousaccountingsystem.Smallerinstitutionsareeitherexemptcompletelyoronlyhavetomaintainreservesquarterlyagainstaveragedepositsinoneweekofthepriorquarterlyperiod.

Onbalance,however,variabilityinthereservemultiplierhasbeenreducedbytheextensionofreserverequirementstoallinstitutionsin1980,bytheadoptionofcontemporaneousreserveaccountingin1984,andbytheremovalofreserverequirementsagainstnontransactiondepositsandliabilitiesinlate1990.Asaresult,short-termchangesintotalreservesandtransactiondepositsinmoneyaremorecloselyrelatednowthantheywerebefore.(Seechartsonthispage.)Theloweringofthereserverequirementagainsttransaction

accountsabovethe3percenttrancheinApril1992alsoshouldcontributetostabilizingthemultiplier,atleastintheory.

Ironically,thesemodificationscontributingtoalessvariablerelationshipbetweenchangesinreservesandchangesintransactiondepositsoccurredastherelationshipbetweentransactionsmoney(M1)andtheeconomydeteriorated.BecausetheM1

measureofmoneyhasbecomelessusefulasaguideforpolicy,somewhatgreaterattentionhasshiftedtothebroadermeasuresM2andM3.However,reservemultiplierrelationshipsforthebroadermonetarymeasuresarefarmorevariablethanthatforM1.AlthougheverybankmustoperatewithinthesystemwherethetotalamountofreservesiscontrolledbytheFederalReserve,itsresponsetopolicyactionisindirect.Theindividualbankdoesnotknowtodaypreciselywhatitsreservepositionwillbeatthetimetheproceedsoftoday'sloansarepaidout.Nordoesitknowwhennewreservesarebeingsuppliedtothebankingsystem.Reservesaredistributedamongthousandsofbanks,andtheindividualbankercannotdistinguishbetweeninflowsoriginatingfromadditonstoreservesthroughFederalreserveactionandshiftsoffundsfromotherbanksthatoccurinthenormalcourseofbusiness.

Toequateshort-runreserveneedswithavailablefunds,therefore,manybanksturntothemoneymarket-borrowingfundstocoverdeficitsorlendingtemporarysurpluses.Whenthedemandforreservesisstrongrelativetothesupply,fundsobtainedfrommoneymarketsourcestocoverdeficitstendtobecomemoreexpensiveandhardertoobtain,which,inturn,mayinducebankstoadoptmorerestrictiveloanpoliciesandthusslowtherateofdepositgrowth.

FederalReserveopenmarketoperationsexertcontroloverthecreationofdepositsmainlythroughtheirimpactontheavailabilityandcostoffundsinthemoneymarket.Whenthetotalamountofreservessuppliedtothebankingsystemthroughopenmarketoperationsfallsshortoftheamountrequired,somebanksareforcedtoborrowattheFederalReservediscountwindow.Becausesuchborrowingisrestrictedtoshortperiods,theneedtorepayittendstoinducerestraintonfurtherdepositexpansionbytheborrowingbank.Conversely,whenthereareexcessreservesinthebankingsystem,individualbanksfinditeasyandrelativelyinexpensivetoacquirereserves,andexpansioninloans,investments,anddepositsisencouraged.