Overview: Banks Create Money
These readings introduce you to one of the mysteries of macroeconomics, that banks create the
money of modern economic systems. The idea of banks creating money sounds strange to
someone who thinks of money as gold or silver. However, for several centuries now most money
has been in the form of bank debt. A checking account is nothing more than money that the bank
owes you, and paper money represents something that the Federal Reserve System owes you.
(Try to collect this debt from the Federal Reserve, though, and see what you get.) When one sees
the creation and destruction of money as the creation and destruction of bank debt, the process is
less mysterious.
These readings explain how bank-debt money evolved from commodity money and how
transactions in the banking system can be analyzed using balance sheets. They explain how
checks clear through the system, and how in the process of trying to maximize the return on their
assets, banks create money. Thus, money creation is a side-effect of banking. Finally, we look at
how central banks control the system of money creation in modern economies.
After you complete this unit, you should be able to:
•
•
•
•
•
•
•
•
List the main assets and liabilities of a commercial bank.
Show, using balance sheets, how a check clears; the effects of a bank making a loan; the
effects of a bank selling a bond to the public or to another bank.
Define legal reserves.
Distinguish between state and national banks.
Outline the structure and powers of the Federal Reserve System.
Given data on two of deposits, required reserve ratio, and required reserves, compute the
missing one.
Given data on required reserves and legal reserves, compute excess reserves.
Using balance sheets, show how the three policy tools of the Federal Reserve can
influence the amount of money banks create.
Copyright Robert Schenk
From Commodity to Bank-Debt Money
Commodity monies have almost entirely disappeared, having been replaced by bank-debt
money. It is unlikely that you ever use a commodity money. The dollars in your wallet are
debt of the Federal Reserve, and if you examine one carefully, you can determine which of
the twelve Federal Reserve banks issued it. The money you have in your checking account
money is debt of a commercial bank or of some closely related financial institution (such as a
savings and loan association or a savings bank).
The story of how our present monetary system evolved from commodity money is an
interesting example of actions and decisions that had consequences totally unforeseen by
those taking the actions. It is an important story because the quantity theory of money says
that changes in the amount of money in circulation are important, and one cannot understand
how changes in the amount of money come about unless one understands how the banking
system creates money.
A commodity money of gold or silver has serious shortcomings. The metals are heavy, storing
large amounts in one's home is risky and expensive, and carrying them on long trips is
dangerous. If one uses gold or silver in an uncoined form, there is difficulty in determining
the quality and there is bother in determining the weight. If gold is coined, practices called
shaving and sweating appear. People will file a bit from each coin they obtain before they
pass it on for face value, saving the filings (this is shaving), or they will shake coins together
in a leather bag, causing tiny flakes of gold to chip off, which they save (this is sweating). In
either case, not all gold coins are the same, and some of the advantages of coinage are lost.
In response to these deficiencies, banks evolved in 16th and 17th century England. The
goldsmiths were an occupation that often evolved into bankers. Other merchants needed
places to temporarily store large amounts of gold, and they chose to store them with the
goldsmiths because the goldsmiths had the best security systems of the day. When merchants
stored gold, the goldsmith would give them a statement indicating how much gold the
merchant had deposited.
Once merchants began to store gold, paper money developed rapidly. When a merchant
wanted to buy something, he could return to the goldsmith and reclaim his gold, or he could
sign over the statement he had from the goldsmith to someone else and let that person collect
the gold. Because the second option was popular, the goldsmiths innovated and issued
statements made out not to a specific person, but to the bearer--whoever presented the
statement to the goldsmith could collect the gold. At this point the statement issued by the
goldsmith was money because it was something with which people bought things. The
invention of paper money was successful because for some purposes it had more desirable
qualities as a money than gold or silver had.
Balance Sheet A shows the situation that our story has now reached. Because all gold in the
goldsmith's vault is considered something the goldsmith owns, it is an asset for him.
Balancing this gold is the paper money that he has issued to people and his net worth.
Remember, the paper he has issued is a promise to pay gold on demand. Thus, this newly
discovered form of money was quite clearly a liability or debt to the goldsmith. The net worth
indicates that he owned some gold even before he began to issue the IOUs that began to be
used as money. At this point in the story, no additional money has been created. Although the
paper the goldsmith has issued is money, the gold he is holding in his vaults should not be
counted because it cannot be spent without retiring paper.
Balance Sheet A
Assets
100 pounds of gold
Liabilities + Net
Worth
80 promises to pay
gold to depositors
20 net worth
Next we see how early goldsmiths learned to create money and thereby became bankers.
After the goldsmiths began issuing paper notes that circulated as money, they quickly noticed
that the gold deposited in their vaults was rarely withdrawn because the gold-backed paper
notes were a popular way of making payments. They saw an opportunity to profit from this
situation. They could lend gold and collect a fee, or interest, in the transaction. If the
goldsmith lent 30 pounds of gold, his balance sheet would change from that in Balance Sheet
A to Balance Sheet B. As a result of this transaction, the amount of money in circulation
increased. The promises to pay depositors, which were circulating as paper money, were still
there, but now 30 pounds of gold that had previously been in the vault "backing up" the paper
was also circulating as money.
Balance Sheet B
Assets
70 pounds of gold
30 promise to pay
gold to goldsmith
Liabilities + Net
Worth
80 promises to pay
gold to depositors
20 net worth
Balance Sheet C shows another way that borrowing could take place. Here someone borrowed
30 pounds of gold from the goldsmith, but instead of taking the loan in the form of gold, the
person accepted the paper IOUs of the goldsmith. Since people accepted these paper IOUs as
money, this transaction also increases the amount of money in circulation. When the
goldsmiths began to create money, their careers as bankers began.
Balance Sheet C
Assets
100 pounds of gold
30 promises to
pay gold
Liabilities + Net
Worth
110 promises to pay
gold to depositors
20 net worth
Note that it was not the intention of the goldsmith to create money. He simply wanted to
rearrange his portfolio. Money creation was a by-product of the making of the loan. As a
result, it is not surprising that many bankers have not understood that they do create money.
Some scholars maintain that during the first ten years that the Federal Reserve System was in
existence, that is, until the middle of the 1920s, most of the officials of the system, almost all
of whom were successful commercial bankers, did not understand that banks create money.
If one focuses on the amount of money, one sees that as a result of the loan, the paper money
is no longer 100% backed by gold. Yet from the goldsmith's view, it is still completely
backed. It is partially backed by gold in his vault, and partially by other people's promises to
pay him in gold.
Although the bank created money, it was limited by the possibility that holders of the paper
would bring in the paper and demand gold. To maintain the ability to pay off the paper
money, banks held reserves of gold, and they needed larger amounts of gold as they issued
more paper money. There was no fixed ratio of gold to paper money, but rather the ratio
depended on the optimism or pessimism of the bankers. When bankers were optimistic and
times were good, they would issue more paper for each pound of gold than when they were
pessimistic and worried about redemptions of paper money that they issued.
This system of bank-issued money partially backed by gold had many of characteristics of a
commodity money but it did not have as much stability. The amount of money could change
not only because the amount of gold changed, but also because changes in the optimism or
pessimism of bankers changed the amount of paper money in circulation.
Although the logic of money creation is easiest to see in the case of paper money issued by
the banks, our banks no longer issue paper. Because they rely on checking account money, we
next turn to that.
Checking-Account Money
The process by which banks create money changed slightly when banks shifted to issuing
checking accounts rather than paper money. Unfortunately the story of money creation is
more difficult to understand with checking-account money because checking account money
moves around in the banking system in a way paper notes did not.1 With the aid of balance
sheets we can see what happens when payments are made by check, and once we understand
how checks clear, we can understand how a modern banking system creates money. A key
idea to keep in mind is that in a world where bank debt serves as money, we need to
understand how banks create and destroy debt to understand the monetary system.
Bank Balance Sheets
Central Bank
Liabilities +
.
Assets
Net Worth
government
securities
gold
Bank A
Liabilities +
.
Assets
Net Worth
paper money
loans
deposits of .
Bank A
government
securities
deposits of
Bank B
deposits at
central bank
checking
accounts
savings
accounts
other
paper money
********************************************
Bank B
Public
Liabilities + Net
Liabilities + Net
Assets
Assets
Worth
Worth
loans
government
securities
deposits at
central bank
checking
accounts
deposits at
banks
loans from
banks
paper money
net worth
.
savings
accounts
other
government
securities
paper money
The table above has balance sheets of the main players in our story: a central bank,
commercial banks, and the public. You should notice that almost everything that is in the
liability column of a balance sheet has an equivalent entry in an asset column of a different
balance sheet because what one person owes, another person owns. For example, the checking
and savings accounts that are liabilities of commercial banks appear on the public's balance
sheet as the asset "deposits at banks." Any debt, which is a liability to the person who owes
the money, is an asset to the person to whom the money is owed.
The commercial banks have some assets, such as loans and government securities, that earn
interest. Both securities and loans are debt owed to the bank. Loans are usually debt contracts
that the bank has negotiated directly with the borrower, while securities are debt contracts that
the bank buys without negotiating the terms of the contract. The bank has other assets, such as
deposits at the central bank and paper money held in its vaults.2 In the past these assets earned
no interest and there wass a cost--foregone interest--to holding these non-interest bearing
assets. A bank must hold some because it must stand ready to pay depositors who want to
exchange deposits for cash. However, modern banks have another reason to hold these assets.
Governments, usually acting through their central banks, have laws and regulations that
establish the amount of these assets that a bank must have. We will call these required assets
legal reserves, or bank reserves, or simply reserves.
Checking Clearing and Money Creation
Bank reserves play a role in the most common banking transaction, the clearing of checks. A
check clears in the system when a person writes a check that is deposited in another bank.
Suppose Jones, a depositor at Bank A, writes a check for $100 to Smith that Smith deposits in
Bank B. When Bank B receives this check, it pays Smith $100 by increasing his checking
account. Bank B has now paid for this piece of paper, and in turn wants to be paid. It could
send the check on to Bank A and demand payment. Bank A legally must pay, and one way it
could pay would be to ship paper money to Bank B.1 Bank A would now have paid for this
piece of paper, and it in turn wants to be paid. It is paid when it subtracts $100 from Jones'
checking account. The table below shows the end result of the story. Bank A has lost deposits
and reserves and Bank B has gained them.
The Logic of Check Clearing
Bank A
Liabilities +
Assets
.
Net Worth
- $100 paper
money
- $100 Jones' .
checking
account
Bank B
Liabilities +
Assets
.
Net Worth
+ $100 paper
money
+ $100 Smith's
checking
account
Paying by check sets into motion a chain of transactions. Although the table above shows the
logic of how a check clears, the chain is usually more complex than in this story. Bank B
could have sent the check to Central Bank for payment. Central Bank would have paid Bank
B by increasing the deposits Bank B has at Central Bank, and then sent the check on to Bank
A with a note saying that its deposits at Central Bank had been reduced by $100. In this case,
Bank A would have lost not paper money but deposits at Central Bank and Bank B would
have gained them.2
Once you understand how a check clears, you are ready to understand how modern banks
create and destroy money. Suppose Bank A decides that it has $100 more of reserves than it
wants. This means that it would prefer to hold an interest-bearing asset rather than noninterest bearing reserves. To obtain such an asset, it can write a check on itself and buy
government securities (debt of the government that earns interest) from the public. The public
now has a reduction in its security holdings and a check for $100 from Bank A. Suppose this
check is deposited in Bank B. The check will clear as any check, and the end result will be the
changes in this table:
Creating Money
Central Bank
Liabilities +
.
Assets
Net Worth
--
Bank A
Liabilities +
.
Assets
Net Worth
deposits of
Bank A
.
-$100
deposits at
central bank $100
--
deposits of
government
Bank B
securities
+100
+$100
********************************************
Bank B
Public
Liabilities + Net
Liabilities + Net
Assets
Assets
Worth
Worth
deposits at
central bank
+$100
deposits of
public +$100
.
government
securities $100
--
deposits at
Bank B +$100
Notice that the public now has $100 more in checking accounts than it previously had: money
has been created. This creation of money is not readily apparent to anyone in the banking
system. Bank A did not intend to create more money--it merely wanted to exchange noninterest bearing assets for assets that earn interest. Bank B receives the new money, but this
new money looks to it just the same as the "old" money that it received when Jones wrote a
check to Smith. The creation of money, an aspect of the banking system that economists
consider central, is to the banking system merely a side effect or by-product of its quest for
profit.
Banks also create money when they lend money to borrowers and they destroy money when
loans are repaid. But banks cannot create money in unlimited amounts. Their ability to create
money is limited by the amount of legal reserves they have and by regulations that tell them
how much reserves they must hold. Banks cannot create or destroy these reserves, but the
central bank can. Hence it is the central bank that ultimately determines how much money
circulates in an economy.
The Federal Reserve and Monetary Policy
The Federal Reserve regulates banks by requiring them to hold a certain amount of their
assets as either cash or deposits with the Federal Reserve. Prior to the Depository Institutions
Deregulation and Monetary Control Act (DIDMCA) passed in 1980, only banks that were
members of the Federal Reserve system had to obey these regulations. National banks, banks
that had received their charter from the Comptroller of the Currency, which is part of the U.S.
Treasury Department, had to belong to the system. But state banks, which had obtained their
charters from state banking authorities, did not have to belong, and most did not. Because the
regulations to hold assets that did not earn interest (prior to October, 2008, the Fed did not
pay interest on bank deposits) were costly for most banks, most new banks during the 1960s
and 1970s were chartered as state banks, and the percentage of deposits held in member banks
declined during this period. This decline worried government policy makers and was a major
reason for the change in regulations in DIDMCA. Now all financial institutions that issue
deposits against which checks can be written are subject to the same reserve requirements.
We saw that banks created money as a by-product of their quest for profit. Banks are limited
in the process of money creation by the need to hold some assets in the form of reserves. In
the early days of banking, banks needed reserves so that they could redeem deposits or notes
on demand. Today the amount of reserves and the form that they take are determined by
government regulation. In the United States only vault cash or deposits held at a Federal
Reserve Bank can serve as reserves. The amount of reserves that banks must hold is
calculated as a percentage of the deposits they hold. This percentage is called the required
reserve ratio. In equation form, required reserves are computed as:
(1) Required Reserves = (Required Reserve Ratio)x(Deposits).
Banks can hold more reserves than are required. Any reserves above what are required are
excess reserves, or:
(2) Excess Reserves = Legal Reserves - Required Reserves.
In October of 2008 Congress granted the Federal Reserve the authority to pay interest on bank
reserves, a seemingly small change that marks a major break in the way the Federal Reserve
conducts monetary policy. To consider what the Fed is doing now it is best to first explain
how monetary policy worked before October, 2008.
When reserves earned no interest, banks preferred not to hold excess reserves because in
doing so they sacrifice the opportunity to hold other assets that earned interest. Between 1960
and 2008 the amount of excess reserves held in the banking system was only a small fraction
of total reserves.1
When banks try to minimize excess reserves, any change in either reserves or in the required
reserve ratio will change the amount of deposits people hold, and thus the amount of money
in circulation. Banks by themselves can change neither. Although the public can cause
changes in both, most changes in them were the result of the Federal Reserve System using
three policy tools.
The first policy tool, which has not been used as a tool of monetary policy for decades, is the
ability to change the required reserve ratio. If the Federal Reserve increases this ratio, the
banking system is forced to destroy money, and if the Federal Reserve decreases this ratio, the
system is encouraged to create money.2
Although it too has been a minor policy tool in the past two or three decades, the discount
rate is a second policy tool the Federal Reserve possesses. One way a bank can obtain
reserves is by borrowing them from the Federal Reserve. When the Federal Reserve charges a
high interest rate for these borrowings, banks will not borrow as much reserves as when the
Federal Reserve charges a low interest rate.
A third and the only policy tool of importance before October, 2008 was open-market
operations.3 In open-market operations the Federal Reserve buys or sells U.S. government
securities, usually T-bills, in the secondary market.4 When the Federal Reserve buys
securities, it creates the funds with which it buys T-bills. It pays with a check drawn on itself,
and when a commercial bank submits this check for payment, the bank gets reserves that did
not previously exist.5 The process by which the Federal Reserve creates bank reserves
parallels the process by which banks create money. A major difference is that the creation of
bank reserve is not a by-product of a quest for profit. On the contrary, any profit is a byproduct of an attempt to maintain some level of reserves. Indeed, if a modern central bank set
out to maximize profit, it is doubtful that the monetary system could long survive.
In October 2008 the Fed gained and began to use a fourth policy tool, setting interest rates on
reserve deposits that banks hold at the Federal Reserve. This policy tool is discussed in a later
section.
Decisions about how these tools will be used are reached by twelve voting members of the
Federal Open Market Committee (the FOMC). The FOMC meets each month and
determines what the monetary policy of the United States will be. This control over monetary
policy means that the twelve people who vote on this committee are among the most powerful
people in Washington. Seven of these twelve make up the Board of Governors of the Federal
Reserve System. The governors are appointed by the President and confirmed by the Senate
for 14-year terms. The other five are presidents of the Reserve banks. The president of the
Federal Reserve Bank of New York always votes on the FOMC, and the other four positions
rotate as one-year terms among the other eleven presidents.
An explanation of monetary policy can be systematically done using balance sheets.
Monetary Policy and Balance Sheets
Much of the difficulty in understanding the process of money creation is due to the ability of
checking-account money to flow through the system, disappearing from one bank and
reappearing at another. If the only money in the economy were government-issued paper,
money creation would be easy to understand. Money would be created when the government
printed more to pay its bills. If money did not need to be redeemable in terms of precious
metal, there would be no limits to the amount of money that the government could print.
Alternatively, the government could destroy money by collecting it through taxes and burning
it.
Although the underlying principles are not much different in our modern monetary system,
they are obscured by the money that banks issue. The role of the government in money
creation and destruction is illustrated precisely and concisely with the aid of bank balance
sheets. A set of bank balance sheets for an economy with only two banks is given below.
Bank Balance Sheets
(amounts in millions of dollars)
Central Bank
Bank A
Liabilities +
Liabilities +
.
.
Assets
Assets
Net Worth
Net Worth
securities 20
other 5
deposits of
Bank A
5
.
deposits of
Bank B
10
reserves 5
deposits 50
securities 30
other 5
loans 15
other 5
other 10
********************************************
Bank B
Public
Liabilities + Net
Liabilities + Net
Assets
Assets
Worth
Worth
reserves 10
securities 40
deposits 100 .
other 10
securities 200
other 450
deposits at
banks 150
loans 50
other 100
other 10
If the required reserve ratio is 10%, both banks exactly meet the reserve requirement. In Bank
A, 10% of $50 million is $5 million, and in Bank B, 10% of $100 million is $10 million. Now
suppose that John Smith who banks in Bank B gives a check for $1 million to Joe Doe who
deposits it in his account at Bank A. Bank A pays for the check by increasing Doe's deposits
by $1 million. It then sends the check to the Central Bank for payment. The Central Bank
pays by increasing the deposits of Bank A (which are part of A's reserves) by $1 million, and
in turn wants payment from Bank B. It obtains payment by subtracting $1 million from the
deposits of Bank B (which are part of B's reserves), and sends the check on to Bank B. Bank
B receives payment for the check by subtracting $1 million from John Smith's deposits.
As a result of this transaction, Bank A has deposits of $51 million and reserves of $6 million.
It needs reserves of 10% of $51 million, or $5.1 million, so it has excess reserves of $.9
million. Bank B has deposits of $99 million and reserves of $9 million. It has a reserve
deficiency of $.9 million because it should have $9.9 million.
Bank B can make up its reserve deficiency in a number of ways. It can simply borrow the
excess reserves of Bank A. Or it can sell $.9 million of interest-earning assets to Bank A in
return for $.9 million in reserves. Or it can reduce its loan portfolio by refusing to make new
loans until enough old loans have been repaid so that it no longer has a reserve deficiency. If
it takes this option, it will destroy money. However, if Bank A is making extra loans because
it now has excess reserves, there need be no change at all in the total bank loans outstanding
as a result of the shift in deposits.
Bank Balance Sheets After Sale By Central Bank
(amounts in millions of dollars)
Central Bank
Bank A
Liabilities +
Liabilities +
.
.
Assets
Assets
Net Worth
Net Worth
securities 20
19
other 5
deposits of
Bank A
54
.
deposits of
Bank B
10
reserves 5 4
deposits 50 49
securities 30
other 5
loans 15
other 5
other 10
********************************************
Bank B
Public
Liabilities + Net
Liabilities + Net
Assets
Worth
Assets
Worth
reserves 10
securities 40
deposits 100 .
securities 200
201
other 450
other 10
loans 50
deposits at
banks 150 149
other 10
other 100
There is a very different outcome when the Central Bank sells $1 million in government
securities from its portfolio. Suppose Joe Doe buys them, paying for them with a check drawn
on Bank A. The Central Bank will want to be paid for this check, and will collect by
subtracting $1 million from the deposits that Bank A has with it. The check will then be sent
back to Bank A, which will collect on the check by subtracting $1 million from the account of
Joe Doe. Starting from the table above, the sale of $1 million in securities by the Central Bank
yields the table below, where the changes are indicated by a strike-out of the old number and
a bold version of the new one.
The public still has the same amount of assets, but it has less money and more securities than
it had previously. Bank B is unaffected by these changes and still meets its reserve
requirements. Bank A, however, needs $4.9 million in reserves but only has $4 million. It
must try to find more reserves. It cannot borrow them from Bank B, so it may try to get
reserves by changing the composition of its assets. It can do this by selling $.9 million of
securities to the public.
Suppose the $.9 million of securities are bought by John Smith who banks at Bank B. He pays
for them by writing a check. After the check has cleared, Bank A will have gained $.9 million
in reserves and lost $.9 in interest-earning assets. The bankers at Bank A see no changes at all
in the money stock as a result of this transaction. However, at Bank B there was a reduction of
both deposits (and hence money held by the public) and of reserves. Bank B now has reserves
of $9.1 million and deposits of $99.1 million. It has a reserve deficiency of $.81 million. Bank
A got rid of its reserve deficiency only by passing it on (though in a slightly smaller form) to
Bank B.
As a result of the sale of $1 million in securities by the Central Bank, total bank reserves are
now $14 million. With this level of bank reserves, the banking system can only support $140
million in deposits. Bank A and Bank B will each try to shift funds into legal reserves from
interest-earning assets. But the amount of reserves is fixed; whatever one gains, the other
loses. The attempts by the banks to rearrange their portfolios would be met with perpetual
frustration if it were not for something both banks may be unaware of: their attempts to shift
their assets from loans and securities into legal reserves will gradually reduce customer
deposits and thus the need for reserves.
Open-market operations are used both when the Federal Reserve wants to change bank
reserves and when it wants to prevent a variety of factors that it does not control from
changing them. When open-market operations are intended to keep bank reserves from
changing, they are defensive. The balance sheet of the Federal Reserve has a number of items
(most of which can be left for you to explore in more advanced courses). The logic of balance
sheets says that any change in one account must cause a change in another. In practice, most
changes in the Federal Reserve's balance sheet cause changes in deposits of banks, or bank
reserves.
Consider, for example, changes in Treasury balances. When the Internal Revenue Service
(IRS) collects taxes, it deposits the receipts into accounts at commercial banks. There is a
shift in deposits in the commercial banks from individuals and businesses to the government,
but the total amount of deposits and of bank reserves is unchanged. The Treasury then
transfers these funds to accounts at the Reserve banks from which the U.S. government pays
its bills. When these funds are transferred to the Federal Reserve banks, banks lose both
deposits and bank reserves. When the government spends these funds, the deposits shift back
to the banks and pull reserves along with them. Since there is considerable variability in this
process and in the Treasury's account at the Reserve banks, the Federal Reserve usually
offsets the effects of these transactions with open-market operations.1
What limits the amount of money in circulation in this system of bank debt? Nothing but the
good sense of the people who control the central bank. There is no limit to the amount of
money that can be created with this sort of system--German hyperinflation is an example. The
German hyperinflation could not have happened if Germany had based its monetary system
on a commodity.
Big Changes 2008
In September 2008 the United States and the world faced a financial panic that dwarfed all
financial panics of the previous 70 years when Lehman Brothers, a large investment bank,
was allowed to fail. As people questioned the safety of other financial institutions, lending
grounded to a halt and the credit markets, where short-term loans are made, froze. In the flight
to safety, the yield on U.S. T-bills dropped to .07% on September 17, 2008. (That is not 7%
interest, but less than one tenth of one percent. If you invested $1000 at that interest rate for a
year, you would earn 70 cents interest. At that interest rate, compounded monthly, it would
take about 990 years for your $1000 to double to $2000.)
The Federal Reserve, acting as lender of last resort to the financial system, reacted to this
crisis with a massive purchase of financial assets. The table below shows that between
September and December assets held by the Fed more than doubled.
Reserve Bank Credit and Bank Balances at Fed, 2008-9
Date
Reserve Bank Credit
Reserve Balances with Fed
9-11-2008 $888,283
$7,978
10-8-2008 $1,494,726
$119,749
11-13-2008 $2,198,204
$592,144
12-11-2008 $2,241,457
$777,628
1-8-2009
$2,177,564
$878,178
2-12-2009 $1,830,406
$603,394
Amounts in millions of dollars. Source: Data from
http://www.federalreserve.gov/releases/h41/
The previous section explained that when a central bank purchases assets, it pays for those
assets with funds that it creates, and that these newly created funds usually end up as bank
reserves. That is what happened in this case. Bank deposits at the Fed increased from less than
$10 billion before the panic to over $800 billion in December, 2008. Previous sections have
also explained that when banks get extra reserves, they tend to exchange those reserves for
other assets, and that many of these transactions have a side effect of increasing the amount of
money that the public holds. However, expansion of money stock was very limited in 2008.
Initially banks welcomed the excess reserves because they provided a safe and liquid asset at
a time when there was a rush for liquidity and safety. As mentioned above, T-bills, the best
alternative, were paying a miniscule interest rate.
In October 2008 Congress gave the Fed a new tool for monetary policy, the power to pay
interest on bank reserves. The amount of excess reserves that a bank wants to hold depends on
the difference between the return on reserves and the return that it can earn on alternative
assets. Prior to October 2008 the Fed could do little to affect this amount, but after October
2008 it could manipulate this amount with the interest rate on reserves. Now if it wants banks
to hold more excess reserves, it will raise the interest rate it pays on excess reserves. If it
wants banks to hold fewer excess reserves, it will lower the interest rate it pays on these
reserves.
From the Fed's point of view, this new policy tool seems similar to how it does open-market
operations. For more than two decades it has been setting an interest rate, the Federal-funds
rate, to control the amount of bank reserves in the system. The Federal-funds rate is the
interest rate at which banks lend or borrow deposits at the Fed--bank reserves--among
themselves. Banks do not need excess reserves to make new loans. When they find
opportunities to make profitable loans, they make those loans and then find the needed
reserves, often using the Federal-funds market. If many banks make loans at the same time,
the Federal-funds rate will tend to rise, but the Fed will limit the rise by increasing the supply
of bank reserves.
Once the Fed set a target Federal-funds rate, it passively supplied or withdrew reserves from
the banking system. However, if the FOMC thought bank lending and total bank reserves
were growing too rapidly, it could slow them by raising the target Federal-funds rate. If it
thought bank lending and growth of bank reserves were too low, it could stimulate them by
lowering the Fed-funds rate.1
As of 2010, it is still too early to tell how this new policy tool will be used. The huge increase
in Fed assets and hence the huge increase in bank reserves was a response to a crisis. As the
problems caused by that crisis disappear, the Fed may reduce its assets and return to its
previous ways of conducting policy. Alternatively, it may decide to keep its enlarged balance
sheet and conduct monetary policy using the interest rate on reserve balances as its major
policy tool.