Question

How has paying interest on reserves held at the Fed affected the following: money multiplier, lending and the money supply? Bear in mind we are dealing with a number of different platforms here, so think through your answer.

Answer 1

IOR affects banks’ incentives to hold both required and excess reserves. Paying interest on required reserves avoids the implicit tax that reserve requirements impose on banks, which is equal to the income banks could have earned by using those funds for profit generating loans and investments. Like many taxes, this is distortionary. Because reserve requirements often exceed the amount of cash banks require to settle daily business transactions, in the absence of IOR banks will expend valuable resources moving their customers’ deposits into “sweep” accounts (accounts, like money market accounts, that are not subject to reserve requirements) at the end of each business day. Under IOR, banks can devote those resources to more productive ventures. Beyond eliminating a distortionary tax, paying interest on excess reserves is intended to help the Fed achieve its target federal funds rate, and therefore its influence over other market interest rates. This task had become more difficult once the Fed began providing liquidity to financial markets through new lending facilities first launched in late2007toeasedislocations in credit markets

Federal Reserve policy is the most important determinant of the money supply. The Federal Reserve affects the money supply by affecting its most important component, bank deposits.

Here is how it works. The Federal Reserve requires depository institutions (commercial banks and other financial institutions) to hold as reserves a fraction of specified deposit liabilities. Depository institutions hold these reserves as cash in their vaults or Automatic Teller Machines (ATMs) and as deposits at Federal Reserve banks. In turn, the Federal Reserve controls reserves by lending money to depository institutions and changing the Federal Reserve discount rate on these loans and by open-market operations. The Federal Reserve uses open-market operations to either increase or decrease reserves. To increase reserves, the Federal Reserve buys U.S. Treasury securities by writing a check drawn on itself. The seller of the treasury security deposits the check in a bank, increasing the seller’s deposit. The bank, in turn, deposits the Federal Reserve check at its district Federal Reserve bank, thus increasing its reserves. The opposite sequence occurs when the Federal Reserve sells treasury securities: the purchaser’s deposits fall, and, in turn, the bank’s reserves fall.

If the Federal Reserve increases reserves, a single bank can make loans up to the amount of its excess reserves, creating an equal amount of deposits. The banking system, however, can create a multiple expansion of deposits. As each bank lends and creates a deposit, it loses reserves to other banks, which use them to increase their loans and thus create new deposits, until all excess reserves are used up.

If the required reserve ratio is 10 percent, then starting with new reserves of, say, $1,000, the most a bank can lend is $900, since it must keep $100 as reserves against the deposit it simultaneously sets up. When the borrower writes a check against this amount in his bank A, the payee deposits it in his bank B. Each new demand deposit that a bank receives creates an equal amount of new reserves. Bank B will now have additional reserves of $900, of which it must keep $90 in reserves, so it can lend out only $810. The total of new loans the banking system as a whole grants in this example will be ten times the initial amount of excess reserve, or $9,000: 900 + 810 + 729 + 656.1 + 590.5, and so on.

In a system with fractional reserve requirements, an increase in bank reserves can support a multiple expansion of deposits, and a decrease can result in a multiple contraction of deposits. The value of the multiplier depends on the required reserve ratio on deposits. A high required-reserve ratio lowers the value of the multiplier. A low required-reserve ratio raises the value of the multiplier.

In 2004, banks with a total of $7 million in checkable deposits were exempt from reserve requirements. Those with more than $7 million but less than $47.6 million in checkable deposits were required to keep 3 percent of such accounts as reserves, while those with checkable accounts amounting to $47.6 million or more were required to keep 10 percent. No reserves were required to be held against time deposits.

Even if there were no legal reserve requirements for banks, they would still maintain required clearing balances as reserves with the Federal Reserve, whose ability to control the volume of deposits would not be impaired. Banks would continue to keep reserves to enable them to clear debits arising from transactions with other banks, to obtain currency to meet depositors’ demands, and to avoid a deficit as a result of imbalances in clearings.

The currency component of the money supply, using the M2 definition of money, is far smaller than the deposit component. Currency includes both Federal Reserve notes and coins. The Board of Governors places an order with the U.S. Bureau of Engraving and Printing for Federal Reserve notes for all the Reserve Banks and then allocates the notes to each district Reserve Bank. Currently, the notes are no longer marked with the individual district seal. The Federal Reserve Banks typically hold the notes in their vaults until sold at face value to commercial banks, which pay private carriers to pick up the cash from their district Reserve Bank.

The Reserve Banks debit the commercial banks’ reserve accounts as payment for the notes their customers demand. When the demand for notes falls, the Reserve Banks accept a return flow of the notes from the commercial banks and credit their reserves.

The U.S. mints design and manufacture U.S. coins for distribution to Federal Reserve Banks. The Board of Governors places orders with the appropriate mints. The system buys coin at its face value by crediting the U.S. Treasury’s account at the Reserve Banks. The Federal Reserve System holds its coins in 190 coin terminals, which armored carrier companies own and operate. Commercial banks buy coins at face value from the Reserve Banks, which receive payment by debiting the commercial banks’ reserve accounts. The commercial banks pay the full costs of shipping the coin.

In a fractional reserve banking system, drains of currency from banks reduce their reserves, and unless the Federal Reserve provides adequate additional amounts of currency and reserves, a multiple contraction of deposits results, reducing the quantity of money. Currency and bank reserves added together equal the monetary base, sometimes known as high-powered money. The Federal Reserve has the power to control the issue of both components. By adjusting the levels of banks’ reserve balances, over several quarters it can achieve a desired rate of growth of deposits and of the money supply. When the public and the banks change the ratio of their currency and reserves to deposits, the Federal Reserve can offset the effect on the money supply by changing reserves and/or currency.

If the Federal Reserve determines the magnitude of the money supply, what makes the nominal value of money in existence equal to the amount people want to hold? A change in interest rates is one way to make that correspondence happen. A fall in interest rates increases the amount of money people wish to hold, while a rise in interest rates decreases that amount. A change in prices is another way to make the money supply equal the amount demanded. When people hold more nominal dollars than they want, they spend them faster, causing prices to rise. These rising prices reduce the purchasing power of money until the amount people want equals the amount available. Conversely, when people hold less money than they want, they spend more slowly, causing prices to fall. As a result, the real value of money in existence just equals the amount people are willing to hold.