Chapter 20

Understanding
Movements in
Bank
Reserves

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Learning Objectives

• Analyze the Federal Reserve balance sheet and

how changes in its assets and liabilities impact
the money supply
• Explain how the U.S. Treasury Department’s
spending decisions impact the money supply
• Understand the bank reserve equation
• Define the monetary base

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Introduction

• The balance sheet of the Fed shows the movements of

reserves in the system
• Very complicated since many things can impact the
level of reserves
– Open Market operations and Discounting
– Other entries may offset movements in reserves
– The Fed does not control many of these items
– US Treasury can add or absorb bank reserves through fiscal
spending or tax revenue

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Introduction (Cont.)

• Bank Reserve Equation

– The expanded view of reserve movements
– A summary sheet for sources and uses of reserves
– Useful for monitoring trends in reserves—
fundamental framework of monetary control.

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The Fed’s Balance Sheet

• Table 20.1 is a simplified balance sheet of the Federal

Reserve System in mid-2003
• Every item on the balance sheet (asset or liability) has
an effect on reserves
– Total assets = total liabilities
– Fed’s total liabilities include reserves—“bank deposits” in
the Fed plus cash in bank vaults
– Therefore, bank reserves must equal total Federal Reserve
assets minus all other Fed liabilities
– Anything affecting a Fed’s asset or liability must alter
reserves, unless it is offset somewhere else in the balance
sheet
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 TABLE 20.1 The Federal Reserve’s Balance
Sheet (March, 2008, in billions of dollars)

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The Fed’s Balance Sheet (Cont.)

• ASSETS
– Gold certificates
• Gold purchased from abroad or from domestic mines
• US Treasury purchases gold with a check drawn on its deposit in the
Fed
• To replenish its checking account with Federal Reserve, Treasury
issues a “gold certificate” and the Fed credits the Treasury’s deposit
account by the same amount
• Federal Reserve assets have risen, but reserves are not affected (by
this transaction) since a liability other than reserves (Treasury
deposits) has risen simultaneously
• However, the net result of both the above transactions is an increase
in bank reserves

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The Fed’s Balance Sheet (Cont.)

• ASSETS (Cont.)
– Coins—Coins and bills issued by the Treasury that the Fed
has in its vaults
– Loans—Bank borrowings from the Fed through the discount
window
– Term Auction Facility (TAF)—Federal Reserve auctions
short-term funds to banks who can then deliver a wide variety
of assets as collateral
– US government and agency securities
• Securities acquired by the Fed through open market operations
• Purchase of securities expands reserves
• Sales of securities by the Fed lowers reserves

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The Fed’s Balance Sheet (Cont.)

• ASSETS (Cont.)
– Items in process of collection
• Arises in process of clearing checks
• “Deferred credit items” on the liability side.
• The difference between the two is the “float”
• Occurs because many checks are not collected within the specified
time period
• Float can fluctuate considerably, either adding to or subtracting from
reserves
• Can cause serious short-term disruptions in bank reserves
• As the use of electronic payment systems increases, float will
diminish in size and importance

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The Fed’s Balance Sheet (Cont.)

• ASSETS (Cont.)
– Other Federal Reserve Assets
• Consists primarily of securities denominated in foreign
currencies
• Purchases and sales of foreign securities usually occur in
connection with foreign exchange operations of the Fed

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The Fed’s Balance Sheet (Cont.)

• Liabilities
– Federal Reserve Notes Outstanding
• Liability to the Fed, but an asset to holder of the currency
• The change in this account does not alter bank reserves—notes
outstanding rises, bank deposits at Fed falls
• Impacted by the decision of the public to hold more currency, which
lowers bank reserves.
– US Treasury Deposits—Represents the “working balance”
of the Treasury reflected in spending and tax revenues

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The U.S. Treasury’s Monetary
Accounts

• Purchase of gold
– Treasury, not the Fed, that officially buys and sells gold for
the government
– After purchasing gold by depleting reserves on deposit, the
Treasury issues an equal amount of gold certificates
– The Fed purchases these gold certificates to replenish the
Treasury’s deposit account
– When the Treasury buys gold, bank reserves rise and
when the Treasury sells gold, bank reserves fall

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The U.S. Treasury’s Monetary
Accounts (Cont.)

• Changes in the Treasury’s deposits at the Federal

Reserve banks will affect bank reserves
• Currency issued by the Treasury
– The Treasury also issues a small amount of currency,
including all coins
– There is no difference between currency issued by
the Treasury or Fed, all coins and bills in bank vaults
count as reserves.

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The Bank Reserve Equation

• Table 20.2 shown in the textbook

• Record of sources and uses of bank reserves
• Primary difference between Table 20.1 and 20.2 is the
inclusion of Treasury currency in banks vaults which
are counted as reserves
• Consolidation of the Fed’s balance sheet with
Treasury’s monetary accounts
• Bank Reserves = bank deposits with Fed plus
currency in bank vaults

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TABLE 20.2 The Bank Reserve Equation
(March, 2008; in billions of dollars)

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Putting it all to Use

• In Chapter 18 it was assumed that the Fed could control

the volume of reserves by judicious use of open market
operations
• However, the reserve equation demonstrates that other
influences outside control of the Fed can affect reserves
• These outside influences need to be forecasted and
monitored to assist the Fed in controlling the level of
reserves

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Putting it all to Use (Cont.)

• Defensive Measure
– Fed engages in open market operations aimed at
defending a target level of reserves from “outside”
influences.
– Offset transitory changes in reserves which are
trying to push level of reserves outside the range
desired by the Fed
– Extensive use of Repurchase Agreements as
temporary injections or deletions of reserves

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Putting it all to Use (Cont.)

• Dynamic Measures—Open market operations

aimed at either increasing or deceasing the
overall level of bank lending capacity by
changing the level of bank reserves

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Focusing on the Monetary Base

• What specific variable should the Fed attempt to

control to regulate money supply?
• Control variable (operating target) is the immediate
objective of open market operations
• It is suggested that the Fed should attempt to control
the monetary base—total reserves plus currency held
by the nonbank public.
• Reserve equation depicted in Table 20.2 can be altered
to focus on the monetary base.

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Appendix

MONETARY
EFFECTS OF
TREASURY
FINANCING

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Appendix—Monetary Effects of
Treasury Financing

• Budget Deficit—when government spends more than it

receives in taxes
• Financing the deficit is the responsibility of the
Treasury Department
• Could print money to pay the bills, but this
responsibility falls under the Fed
• Treasury prints and sells bonds and uses proceeds to
meet its obligations
• Debt financing/Treasury spending complicates Fed’s
job of controlling money
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Appendix—Monetary Effects of
Treasury Financing (Cont.)

• Taxation
– When taxes are paid, demand deposits at commercial
banks are transferred from private sector to
Treasury’s account
– Initially these funds are held in the Treasury’s
accounts at commercial banks
– Money supply falls since government deposits are
not counted in the money supply

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Appendix—Monetary Effects of
Treasury Financing (Cont.)

• Taxation (Cont.)
– Total bank reserves fall when Treasury moves funds
from commercial banks to the Fed
– Money supply and bank reserves increase to
original level when the Treasury spends the
money

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Appendix—Monetary Effects of
Treasury Financing (Cont.)

• Borrowing from Nonbank Public

– Rather than raise taxes, Treasury engages in deficit
spending— raising the money by selling bonds to
the nonbank public.
– Selling bonds reduces the money supply as funds are
transferred from the private sector to Treasury
accounts
– Reserves also fall when the Treasury shifts funds
from commercial banks to Fed

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Appendix—Monetary Effects of
Treasury Financing (Cont.)

• Borrowing from Nonbank Public (Cont.)

– When the Treasury spends the money, both
money supply and reserves revert to their original
level
– Public winds up with government bonds rather than
a receipt saying they have paid their taxes.

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Appendix—Monetary Effects of
Treasury Financing (Cont.)

• Borrowing from Commercial Banking System

– Banks, rather than the public, purchases bonds
– Two possibilities
• Banks are fully loaned up
– Must dispose of other assets
– Reserves and money supply initially decrease, but are restored when
Treasury spends the money
• Banks have excess reserves
– No need to dispose of other assets
– Increases the money supply when the Treasury spends the money

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Appendix—Monetary Effects of
Treasury Financing (Cont.)

• Borrowing from the Fed

– This method of borrowing does not reduce either the
money supply or bank reserves when the bonds are
sold
– The Treasury sells bonds to the Fed which deposits
the proceeds from the sale in the Treasury’s account
– When the Treasury spends the funds, both demand
deposits and the money supply increase

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Appendix—Monetary Effects of
Treasury Financing (Cont.)

• Printing Money
– If the Treasury could print money, it could deposit
the newly created currency with the Fed
– When it spends the money, both bank reserves and
the money supply could increase
– This method is virtually identical to the case of
borrowing from the Fed

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Appendix—Monetary Effects of
Treasury Financing (Cont.)

• Financing the deficit

– Deficit must be financed by one of the above options
– Fed decides how much will come from new money
and how much must come through the sale of bonds
to the public

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Appendix—Monetary Effects of
Treasury Financing (Cont.)

• Financing the deficit (Cont.)

– Monetizing the Debt—Federal Reserve prints new money to
purchase the new Treasury bonds
• Could make the Treasury’s job easier by printing money—very
inflationary
• Congress created the Fed to keep the printing press from the Treasury
and force the Treasury to pay interest on its debt.
• When the Fed monetizes the debt by buying Treasury bonds, it lets
the Treasury print money through the back door

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