Purpose and Introduction

The purpose of this booklet is to describe the basic process of money creation in a 'fractional reserve' banking system. The approach illustrates the changes in bank balance sheets that occur when deposits in banks change as a result of monetary action by the Federal Reserve System - the central bank of the United States. The relationships shown are based on simplifying assumptions and should not be interpreted to imply a close and predictable relationship between a specific central bank transaction and the quantity of money.

Money is such a routine part of everyday living that its existence and acceptance ordinarily are taken for granted. A user may sense that money must come into being either automatically as a result of economic activity or as an outgrowth of some government operation. But just how this happens all too often remains a mystery.

What Is Money?

If money is viewed simply as a tool used to facilitate transactions, only those media that are readily accepted in exchange for goods, services, and other assets need to be considered. Today, in the United States, money used in transactions is mainly of three kinds:

• Currency - Paper money and coins in the pockets and purses of the public
• Demand deposits - Non-interest-bearing checking accounts in banks
• Other checkable deposits - Such as negotiable order of withdrawal (NOW) accounts at all depository institutions

Travelers checks are also included in the definition of transactions money. Since $1 in currency and $1 in checkable deposits are freely convertible into each other and both can be used directly for expenditures, they are money in equal degree. However, only the cash and balances held by the nonbank public are counted in the money supply.

Money Supply Classifications

• M1 Money Supply: The transactions concept of money designated as M1 in the Federal Reserve's money stock statistics.
• Broader Money Concepts: M2 and M3 include M1 as well as certain other financial assets (such as savings and time deposits) which are relatively liquid but believed to represent principally investments rather than media of exchange.
• Money Distribution: Transaction deposits make up the majority of the money supply, highlighting the importance of banking in the modern economy.

What Makes Money Valuable?

In the United States neither paper currency nor deposits have value as commodities. Intrinsically, a dollar bill is just a piece of paper, deposits merely book entries. Coins do have some intrinsic value as metal, but generally far less than their face value.

What makes these instruments acceptable at face value is mainly the confidence people have that they will be able to exchange such money for other financial assets and for real goods and services whenever they choose to do so. Money, like anything else, derives its value from its scarcity in relation to its usefulness.

Control of the quantity of money is essential if its value is to be kept stable. Money's real value can be measured only in terms of what it will buy. Therefore, its value varies inversely with the general level of prices. Assuming a constant rate of use, if the volume of money grows more rapidly than the rate at which the output of real goods and services increases, prices will rise.

Who Creates Money?

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

The actual process of money creation takes place primarily in banks. As noted earlier, checkable liabilities of banks are money. These liabilities are customers' accounts. They increase when customers deposit currency and checks and when the proceeds of loans made by the banks are credited to borrowers' accounts.

This unique attribute of the banking business was discovered many centuries ago. It started with goldsmiths who initially provided safekeeping services, making a profit from vault storage fees for gold and coins deposited with them. Bankers discovered that they could make loans merely by giving their promises to pay, or bank notes, to borrowers. In this way, banks began to create money.

Key Players in Money Creation

What Limits the Amount of Money Banks Can Create?

If deposit money can be created so easily, what is to prevent banks from making too much - more than sufficient to keep the nation's productive resources fully employed without price inflation?

The modern bank must keep available, to make payment on demand, a considerable amount of currency and funds on deposit with the central bank. The bank must be prepared to:

1. Convert deposit money into currency for depositors who request currency
2. Make remittance on checks written by depositors and presented for payment by other banks
3. Maintain legally required reserves, in the form of vault cash and/or balances at its Federal Reserve Bank

The legal reserve ratio together with the dollar amount of bank reserves are the factors that set the upper limit to money creation.

What Are Bank Reserves?

Currency held in bank vaults may be counted as legal reserves as well as deposits (reserve balances) at the Federal Reserve Banks. Both are equally acceptable in satisfaction of reserve requirements. A bank can always obtain reserve balances by sending currency to its Reserve Bank and can obtain currency by drawing on its reserve balance.

Because either can be used to support a much larger volume of deposit liabilities of banks, currency in circulation and reserve balances together are often referred to as 'high-powered money' or the 'monetary base.' Reserve balances and vault cash in banks, however, are not counted as part of the money stock held by the public.

For individual banks, reserve accounts also serve as working balances. Banks may increase the balances in their reserve accounts by depositing checks and proceeds from electronic funds transfers as well as currency. Or they may draw down these balances by writing checks on them or by authorizing a debit to them in payment for currency, customers' checks, or other funds transfers.

Where Do Bank Reserves Come From?

Increases or decreases in bank reserves can result from a number of factors. From the standpoint of money creation, however, the essential point is that the reserves of banks are, for the most part, liabilities of the Federal Reserve Banks, and net changes in them are largely determined by actions of the Federal Reserve System.

Thus, the Federal Reserve, through its ability to vary both the total volume of reserves and the required ratio of reserves to deposit liabilities, influences banks' decisions with respect to their assets and deposits. One of the major responsibilities of the Federal Reserve System is to provide the total amount of reserves consistent with the monetary needs of the economy at reasonably stable prices.

Bank Deposits - How They Expand or Contract

Let us assume that expansion in the money stock is desired by the Federal Reserve to achieve its policy objectives. One way the central bank can initiate such an expansion is through purchases of securities in the open market. Payment for the securities adds to bank reserves. Such purchases (and sales) are called 'open market operations.'

When the Federal Reserve Bank purchases government securities, bank reserves increase. This happens because the seller of the securities receives payment through a credit to a designated deposit account at a bank which the Federal Reserve effects by crediting the reserve account of that bank.

Expansion takes place only if the banks that hold these excess reserves increase their loans or investments. Loans are made by crediting the borrower's deposit account, i.e., by creating additional deposit money. This is the beginning of the deposit expansion process.

How Much Can Deposits Expand in the Banking System?

The total amount of expansion that can take place is illustrated in the booklet. Carried through to theoretical limits, the initial $10,000 of reserves distributed within the banking system gives rise to an expansion of $90,000 in bank credit (loans and investments) and supports a total of $100,000 in new deposits under a 10 percent reserve requirement.

The deposit expansion factor for a given amount of new reserves is thus the reciprocal of the required reserve percentage (1/.10 = 10). Loan expansion will be less by the amount of the initial injection. The multiple expansion is possible because the banks as a group are like one large bank in which checks drawn against borrowers' deposits result in credits to accounts of other depositors, with no net change in total reserves.

How Open Market Sales Reduce Bank Reserves and Deposits

Just as purchases of government securities by the Federal Reserve System can provide the basis for deposit expansion by adding to bank reserves, sales of securities by the Federal Reserve System reduce the money stock by absorbing bank reserves. The process is essentially the reverse of the expansion steps.

When the Federal Reserve Bank sells government securities, bank reserves decline. This happens because the buyer of the securities makes payment through a debit to a designated deposit account at a bank, with the transfer of funds being effected by a debit to that bank's reserve account at the Federal Reserve Bank.

Contraction proceeds through reductions in deposits and loans or investments in one stage after another until total deposits have been reduced to the point where the smaller volume of reserves is adequate to support them.

Bank Reserves - How They Change

Money has been defined as the sum of transaction accounts in depository institutions, and currency and travelers checks in the hands of the public. Currency is something almost everyone uses every day. Therefore, when most people think of money, they think of currency. Contrary to this popular impression, however, transaction deposits are the most significant part of the money stock.

Since the most important component of money is transaction deposits, and since these deposits must be supported by reserves, the central bank's influence over money hinges on its control over the total amount of reserves and the conditions under which banks can obtain them.

Factors Affecting Reserves

• Independent Factors: Bank reserves are affected in several ways that are independent of the control of the central bank. Most of these 'independent' elements are changing more or less continually.
• Policy Actions: The Federal Reserve System can affect bank reserves through open market operations, loans to depository institutions, and changes in reserve requirement percentages.

Changes in the Amount of Currency Held by the Public

Changes in the amount of currency held by the public typically follow a fairly regular intramonthly pattern. Major changes also occur over holiday periods and during the Christmas shopping season - times when people find it convenient to keep more pocket money on hand.

The public acquires currency from banks by cashing checks. When deposits, which are fractional reserve money, are exchanged for currency, which is 100 percent reserve money, the banking system experiences a net reserve drain. Under the assumed 10 percent reserve requirement, a given amount of bank reserves can support deposits ten times as great, but when drawn upon to meet currency demand, the exchange is one to one. A $1 increase in currency uses up $1 of reserves.

When currency returns to the banks, reserves rise. The customer who cashed a check to cover anticipated cash expenditures may later redeposit any currency still held that's beyond normal pocket money needs. This process is exactly the reverse of the currency drain.

Changes in U.S. Treasury Deposits in Federal Reserve Banks

Reserve accounts of depository institutions constitute the bulk of the deposit liabilities of the Federal Reserve System. Other institutions, however, also maintain balances in the Federal Reserve Banks - mainly the U.S. Treasury, foreign central banks, and international financial institutions. In general, when these balances rise, bank reserves fall, and vice versa.

An important nonbank depositor is the U.S. Treasury. Part of the Treasury's operating cash is kept in the Federal Reserve Banks, and part is kept in depository institutions all over the country, in so-called 'Treasury tax and loan' (TT&L) note accounts. Disbursements by the Treasury, however, are made against its balances at the Federal Reserve.

Transfers from banks to Federal Reserve Banks are made through regularly scheduled 'calls' on TT&L balances to assure that sufficient funds are available to cover Treasury checks as they are presented for payment. Calls on TT&L note accounts drain reserves from the banks by the full amount of the transfer as funds move from the TT&L balances to Treasury balances at the Reserve Banks.

Changes in Federal Reserve Float

A large proportion of checks drawn on banks and deposited in other banks is cleared (collected) through the Federal Reserve Banks. Some of these checks are credited immediately to the reserve accounts of the depositing banks and are collected the same day by debiting the reserve accounts of the banks on which the checks are drawn. All checks are credited to the accounts of the depositing banks according to availability schedules related to the time it normally takes the Federal Reserve to collect the checks.

The reserve credit given for checks not yet collected is included in Federal Reserve float. As float rises, total bank reserves rise by the same amount. As the Federal Reserve's account at the Foreign Central Bank is charged, the foreign bank's reserves at the Foreign Central Bank increase.

Changes in Service-Related Balances and Adjustments

In order to foster a safe and efficient payments system, the Federal Reserve offers banks a variety of payments services. The Monetary Control Act directed the Federal Reserve to offer its services to all depository institutions, to charge for these services, and to reduce and price Federal Reserve float.

The advent of Federal Reserve priced services led to several changes that affect the use of funds in banks' reserve accounts. As a result, only part of the total balances in bank reserve accounts is identified as 'reserve balances' available to meet reserve requirements. Other balances held in reserve accounts represent 'service-related balances and adjustments (to compensate for float).'

Service-related balances are 'required clearing balances' held by banks that use Federal Reserve services while 'adjustments' represent balances held by banks that pay for float with as-of adjustments.

Changes in Loans to Depository Institutions

Prior to passage of the Monetary Control Act of 1980, only banks that were members of the Federal Reserve System had regular access to the Fed's 'discount window.' Since then, all institutions having deposits reservable under the Act also have been able to borrow from the Fed.

Under conditions set by the Federal Reserve, loans are available under three credit programs: adjustment, seasonal, and extended credit. When a bank borrows from a Federal Reserve Bank, it borrows reserves. The acquisition of reserves in this manner differs in an important way from the cases already illustrated. Banks normally borrow adjustment credit only to avoid reserve deficiencies or overdrafts, not to obtain excess reserves.

To repay borrowing, a bank must gain reserves through either deposit growth or asset liquidation. Unlike loans made under the seasonal and extended credit programs, adjustment credit loans to banks generally must be repaid within a short time since such loans are made primarily to cover needs created by temporary fluctuations in deposits and loans relative to usual patterns.

Changes in Reserve Requirements

It is also possible to influence deposit expansion or contraction by changing the required minimum ratio of reserves to deposits. The authority to vary required reserve percentages for banks that were members of the Federal Reserve System was first granted by Congress to the Federal Reserve Board of Governors in 1933.

The 1980 Monetary Control Act established reserve requirements that apply uniformly to all depository institutions. The 1980 law initially set the requirement against transaction accounts over $25 million at 12 percent and that against nonpersonal time deposits at 3 percent.

When reserve requirements are lowered, a portion of banks' existing holdings of required reserves becomes excess reserves and may be loaned or invested. An increase in reserve requirements, on the other hand, absorbs additional reserve funds, and banks which have no excess reserves must acquire reserves or reduce loans or investments to avoid a reserve deficiency.

Foreign-Related Transactions

The Federal Reserve has engaged in foreign currency operations for its own account since 1962. In addition, it acts as the agent for foreign currency transactions of the U.S. Treasury, and since the 1950s has executed transactions for customers such as foreign central banks.

Perhaps the most publicized type of foreign currency transaction undertaken by the Federal Reserve is intervention in the foreign exchange markets. Intervention, however, is only one of several foreign-related transactions that have the potential for increasing or decreasing reserves of banks, thereby affecting money and credit growth.

The key point to remember is that the Federal Reserve routinely offsets any undesired change in U.S. bank reserves resulting from foreign-related transactions. As a result, such transactions do not affect money and credit growth in the United States.

Federal Reserve Actions Affecting Its Holdings of U.S. Government Securities

In discussing various factors that affect reserves, it was often indicated that the Federal Reserve offsets undesired changes in reserves through open market operations, that is, by buying and selling U.S. government securities in the market.

Outright purchases and sales of securities by the Federal Reserve in the market occur infrequently, and typically are conducted when an increase or decrease in another factor is expected to persist for some time. Most market actions taken to implement changes in monetary policy or to offset changes in other factors are accomplished through the use of transactions that change reserves temporarily.

The impact on reserves of various Federal Reserve transactions in U.S. government and federal agency securities includes outright transactions, temporary transactions, and redemption of maturing securities.

The Reserve Multiplier - Why It Varies

The deposit expansion and contraction associated with a given change in bank reserves, as illustrated earlier in this booklet, assumed a fixed reserve-to-deposit multiplier. That multiplier was determined by a uniform percentage reserve requirement specified for transaction accounts. Such an assumption is an oversimplification of the actual relationship between changes in reserves and changes in money, especially in the short run.

For a number of reasons, the quantity of reserves associated with a given quantity of transaction deposits is constantly changing. One slippage affecting the reserve multiplier is variation in the amount of excess reserves. In the real world, reserves are not always fully utilized. There are always some excess reserves in the banking system, reflecting frictions and lags as funds flow among thousands of individual banks.

Slippages also arise from reserve requirements being imposed on liabilities not included in money as well as differing reserve ratios being applied to transaction deposits according to the size of the bank. In addition, the reserve multiplier is affected by conversions of deposits into currency or vice versa.

Money Creation and Reserve Management

Another reason for short-run variation in the amount of reserves supplied is that credit expansion - and thus deposit creation - is variable, reflecting uneven timing of credit demands. Although bank loan policies normally take account of the general availability of funds, the size and timing of loans and investments made under those policies depend largely on customers' credit needs.

In the real world, a bank's lending is not normally constrained by the amount of excess reserves it has at any given moment. Rather, loans are made, or not made, depending on the bank's credit policies and its expectations about its ability to obtain the funds necessary to pay its customers' checks and maintain required reserves in a timely fashion.

Although every bank must operate within the system where the total amount of reserves is controlled by the Federal Reserve, its response to policy action is indirect. The individual bank does not know today precisely what its reserve position will be at the time the proceeds of today's loans are paid out. Nor does it know when new reserves are being supplied to the banking system.