Bank Reserves and the Money
Supply
Introduction
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Examine the relationship between bank
reserves and the money supply
Money supply (M1) is composed mostly of
demand deposits in commercial banks and
other financial institutions
Bank reserves play a crucial role in creating
demand deposits
By regulating bank reserves, Federal reserve
gets leverage to control amount of demand
deposits and thereby nation’s money supply
Check Clearing and Collection
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Many checks and electronic transfers
are “cleared” by local banks exchanging
them through local clearinghouse
associations.
Clearinghouses net out the value of
checks and transfers drawn on or
received by each depository institution
in the association.
The Fed’s Role in Check Clearing
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The Fed clears a check
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by subtracting the amount of the check from the reserve
account balance of the bank on which the check was written
and
by adding the amount to the reserve account balance of the
bank that presents the check to the Fed for clearing.
Reserve balances are transferred from one bank to
another when checks are cleared between them.
They do not disappear from the banking system.
Float
Inter-District Settlement Fund
Example: Barbara is on vacation in
Atlanta. While shopping at Saks Fifth
Avenue, she buys a coat for $500
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She writes a check for the purchase amount
on her bank in Minneapolis, Norwest Bank.
Saks receives the check in its processing
area.
It deposits the check at its bank, Wachovia
Bank, that evening - along with many others.
The bank first encodes the dollar amount in
magnetic ink on the bottom right-hand side of
the check, then batches this check with many
others it has received that were written on
banks outside the Atlanta area.
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It transports the checks to the Atlanta Federal
Reserve Bank.
The Atlanta Fed sorts this check and other unsorted
checks it has received, according to the check’s
destination (the drawee bank-Norwest Bank).
The Atlanta Fed settles accounts, crediting Wachovia
Bank’s reserve account according to a prearranged
“availability schedule”.
After settlement, checks drawn on banks in the 9th
District are grouped and sent to the Minneapolis Fed.
The Minneapolis Fed returns Barbara’s check to
Norwest and debits Norwest’s reserve account (called
presentment).
Norwest then debits Barbara’s checking account.
Sequence of events when a check, drawn
on Norwest, is deposited in Wachovia
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Demand deposits in Wachovia increase with a
corresponding increase in assets
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When the check clears through the Fed check
clearing system,
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Check in process of collection
The Fed increases Wachovia’s “deposits in Fed” by the
amount of the check
There is a corresponding decrease in the deposits of
Norwest which is made by the Fed
Demand deposits in Norwest decrease when the
check clears
The Federal Reserve neither gains or loses deposits,
only transfers ownership from one bank to another
Summary
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When a bank receives a check drawn on
another bank, it gains reserves equal to the
amount of the check
The bank on which the check was drawn
loses reserves of the same amount
Check Clearing and Collection
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The above sequence of events occur
whether the banks are members of the
Federal Reserve system or not
In this case the banks are in different
Federal Reserve regions, the two
regional banks have a clearing account
which permits the transfer of reserves
between regions
Money Supply
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Monetary Base = Currency + Reserves
M1= Currency + Travelers’ Checks +
Demand Deposits
M2 = M1 + Savings Deposits + Small
Time Deposits + MDA + MMMF
Required Reserves and Depository
Institution Balance Sheets
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Required reserve ratios:
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Fractions of transactions deposit balances that the
Federal Reserve mandates that depository
institutions maintain either as deposits with Federal
Reserve banks or as vault cash.
Required reserves:
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Legally mandated reserve holdings at depository
institutions, which are proportional to the dollar
amounts of transactions accounts.
Depository Institution Balance Sheets
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Excess reserves:
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Depository institutions’ cash balances at
Federal Reserve banks or in the institutions’
vaults that exceed the amount that they
must hold to meet legal requirements.
Total reserves:
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The total balances that depository
institutions hold on deposit with Federal
Reserve banks or as vault cash.
Bank Liquidity
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Why does a bank need liquidity?
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Required reserves
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Not really there to provide liquidity.
Excess reserves
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Deposits are convertible on demand into cash.
Accommodate customers when they come for loans.
Provide liquidity
Expensive
Federal funds market – banks short of required
reserves can borrow from those that have excess
reserves.
Discount Window – banks short of required reserves
can borrow from the Fed at its discount window.
Required Reserves
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Federal funds market – banks short of
required reserves can borrow from
those that have excess reserves.
Discount Window – banks short of
required reserves can borrow from the
Fed at its discount window.
Deposit Expansion: The Single Bank
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How much a bank safely can loan depends on
the amount its excess reserves.
When a bank lends, the borrower receives a
checking account (demand deposit)
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Both sides of balance rise, increase in “demand
deposits” (liability) and increase in “loans” (asset)
Since demand deposits are part of the money
supply, when banks create demand deposits
through lending, there is an increase in the
money supply
Deposit Expansion: The Single Bank
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A bank can safely lend up to the amount of its excess
reserves
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When proceeds of the loan are withdrawn and the reserves
are reduced by the amount of the check, all the excess
reserves will be used up.
If the bank tries to lend more, there will be insufficient
reserves as soon as the borrower withdraws the proceeds
from the loan.
An individual bank can create money (demand
deposits) only if it has excess reserves.
As soon as it creates this money, it loses it to another
bank when the money is spent
Deposit Expansion: The
Banking System
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Although the initial bank lost its excess reserves,
another bank gained these excess reserves which
permits them to expand their lending and
increase the money supply
However, ability of the next bank to extend loans is
reduced by 10% since some of gain in reserves must
be held on deposit with Fed.
Process will continue with each successive bank
being able to lend only 90% of gained excess
reserves and 10% placed on deposit with Fed
How the Banking System
Creates Money
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The banking system will have demand
deposits that are a multiple of the initial
injection of excess reserves into the system.
The Fed will have additional required reserves
on deposit equal to the initial injection of
excess reserves into the system
The final state is reached not by shrinking
reserves, as in the case of a single bank, but
by expanding deposits
Deposit Expansion: The
Banking System
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When one bank loses reserves, another bank gains
the excess and lends out 90%
As banks lend more and more, demand deposit
liabilities grow, thereby reducing excess reserves
Whereas a single bank can lend the amount of
excess reserves, the banking system can create
demand deposits up to a multiple of original change
in reserves
The process of deposit expansion can continue until
all excess reserves become required reserves
because of growth of demand deposits
Demand Deposit Expansion
Multiplier
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The demand deposit expansion simple
multiplier is always the reciprocal of the
reserve requirement ratio
1
 Demand Deposits   Re serves x
Re serve Ratio
Where:
1
Re serve Ratio
is the simple multiplier
The Money Multiplier
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This money multiplier formula calculates the
maximum possible expansion of M1 because it
assumes:
1.
2.
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everyone deposits their new loans into a checking account at a
bank.
banks hold no excess reserves.
If either of these assumptions are violated, the
amount of money actually created in the economy will
be smaller than the formula predicts.
The money creation process works exactly the same
in reverse. For example, if someone withdraws
money from a bank, a bank will be short of its
required reserves and must reduce loans. M1 will
decrease by $900,000 in the example above.
Deposit Contraction
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If a bank starts with deficient
reserves, potential change in demand
deposits is negative rather than positive
Money is destroyed as bank loans are
repaid or securities sold
The potential multiple contraction in
demand deposits (money supply)
follows the same principles as
expansion of demand deposits
Depository Institution Reserves,
the Monetary Base, and Money
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The monetary base (MB):
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The amount of currency, C, plus the total
quantity of reserves (TR) in the banking
system, or money produced directly by the
government,
Multiple Expansion Process
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The stages of expansion occur neither simultaneously
nor in the sequence described above.
Some banks use their reserves incompletely or only
after a considerable time lag, while others expand
assets on the basis of expected reserve growth.
The process is continuous and may never reach its
theoretical limits.
What happens to the quantity of money will vary,
depending upon the reactions of the banks and the
public.
A number of slippages may occur:
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What amount of reserves will be drained into
the public’s currency holdings?
To what extent will the increase in the
reserve base remain unused as excess
reserves?
How much will be absorbed by time deposits
or other liabilities not defined as money but
against which banks must also hold reserves?
Appendix—The Complete
Money Supply Process
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Actual change in demand deposits will reach
the maximum amount indicated by the
simple multiplier if banks lend all excess
reserves.
Any leakages of cash out of the multiple
expansion cycle will result in a smaller
expansion of the money supply
Federal Reserve can control additional excess
reserves but leakages are outside their
control and may adversely affect their
attempt to expand the money supply
Shifts between Currency and
Checking Deposits
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Monetary base (B)—total reserves held by
banks plus currency held by nonbanking
public
When the Federal Reserve injects reserves, it
is really adding to the monetary base
Public may elect to hold some of the excess
reserves as cash instead of demand deposits
Draining of currency into the hands of the
public depletes bank’s excess reserves
Shifts between Currency and
Checking Deposits
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Cash held by the nonbanking public becomes
part of the money supply, but it reduces the
banking system’s ability to expand
demand deposits
Due to the uncertainty of the public’s reaction
to additional reserves and desire to hold cash,
the Fed has more control over the monetary
base than total reserves
Shifts between Time Deposits
and Check Accounts
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The public may desire to hold time
deposits rather than demand deposits
Since the required reserves for time
deposits is smaller than for demand
deposits, placing of funds in time
deposits will increase the banking
system’s ability to expand credit.
Shifts between Time Deposits
and Checking Accounts
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Since time deposits are not part of
M1, movement of funds into time
deposits will reduce the expansion of
the money supply (M1)
The reserve multiplier consequences for
broader money supply definitions are
more complicated than for M1
The Role of Interest Rates
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Banks not being able or willing to lend all
their excess reserves
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Funds may remain idle in the bank
Since banks will be more inclined to lend or
purchase securities at higher interest rates,
this raises the possibility that the money
supply (multiplier) is a function of interest
rate levels
Implications
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The Federal Reserve’s ability to control
the money supply is not precise
It must deal with leakages of money
from the demand deposit expansion
cycle, factors that are generally
determined by public preferences
The Money Multiplier During
the Great Depression
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Between 1929 and 1933 bank holdings
of excess reserves rose from $25 million
to over $2 billion.
The currency-to-deposits ratio increased
from approximately 17 percent to 33
percent.
The Money Multiplier During
the Great Depression
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Why do you think these changes
occurred?
If the money multiplier is equal to
1
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(rdd  c / dd )
what happened to M1 during this time?
How could the Fed have improved the
situation?