|
|
|
||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
|
(amounts in millions of dollars) |
||||||
|
|
. |
|
||||
|
|
. |
|
|
. |
|
|
|
|
|
|||||
|
other 5 |
|
5 deposits of Bank B other 10 |
securities 30 loans 15 other 5 |
|
other 5 |
|
|
|
||||||
|
|
.
|
|
||||
|
|
|
|
|
|||
|
|
|
|||||
|
securities 40 loans 50 other 10 |
|
other 10 |
deposits at banks 150 other 100 |
|
|
|
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.
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.
|
(amounts in millions of dollars) |
||||||
|
|
. |
|
||||
|
|
. |
|
|
. |
|
|
|
|
|
|||||
|
other 5 |
|
deposits of Bank B other 10 |
securities 30 loans 15 other 5 |
|
other 5 |
|
|
|
||||||
|
|
.
|
|
||||
|
|
|
|
|
|||
|
|
|
|||||
|
securities 40 loans 50 other 10 |
|
other 10 |
deposits at banks other 100 |
|
|
|
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.2
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.
1China was the first nation to ue paper money. Marco Polo (1254–1354) was so impressed with it that he devoted a chapter in this Travels to it. Paper money arose in the ninth century as merchant debt but was not in widespread use until the government began to issue it. It lasted for several centuries, until the government used the printing press to finance war, causing serve inflation. The inflation led to the abandonment of paper money and its total disappearance in the fifthteenth century. It was replaced with silver, a commodity money.
2Most open market operations offset temporary movements in various Federal Reserve accounts and are done with a temporary purchase of government securities called a "repurchase agreement." Repurchase agreements are described in great detail in a number of publications from the Federal Reserve, but probably take us beyond what we need to know in an introductory course.
Copyright Robert Schenk