First of Series: Learning Loops

The First Loop -
Some Background on the Fed

Because of the current inflation problem, it may be time to examine widely held assumptions about the Fed and its influence on the money supply and interest rates. To examine some of these assumptions, I need to explain a few things about the operation of the Fed. I will couch this explanation in terms of the current structure and operation of the Fed.

Total Reserves

Most banks in the U.S. maintain deposit liability accounts with the Fed. The Fed holds no assets in the names of their depositor banks. These accounts amount to book entries depicting a liability due from the Fed to the account holding banks. The Fed agrees to transfer these liabilities to other banks, but it has nothing to transfer.

The Fed uses dollar denominations to record these account balances and refers to them as "Total Reserves." The Fed cannot transfer bank reserve liabilities to entities other than banks, and individual entities cannot have accounts at the Fed.

Required Reserves

The Fed required each member bank to maintain a balance in their reserve accounts equal to a predetermined percentage of their deposit liabilities due to the bank's customers. The required balances are commonly called "Required Reserves." Reserve requirements serve a single purpose: to limit the number of deposit liabilities a bank can have due to its customers at any time. If the Fed has a reserve requirement of 50%, banks must have a balance of one dollar for every two dollars of deposit liabilities due to their customers.

Reserve requirements have never been as high as 50% and have varied significantly over the years. In the early 1970s, reserve requirements were about 17.5% on-demand accounts and 5% on-time accounts. In the 1990s, the Fed lowered reserve requirements to 10% on-demand accounts and 0% on-time accounts. Today the Fed has a zero reserve requirement on all accounts.

Excess reserves

The Fed referred to the amount by which total reserves exceed required reserves as excess reserves. This figure has a great deal of significance in the money-creation process. A bank's excess reserves indicate the amount it can add to its deposit liabilities to its customers.

If a bank has $1,000 in deposit liabilities, total reserves of $1,000, and a 50% reserve requirement, it would have excess reserves of $500. Thus, that bank could add another $1,000 in deposit liabilities (create $1,000 of new dollars) and remain within the required reserve limits. (Remember, the $1,000 held by the Fed in the reserve account would not act as money.)

Excess reserves have played a significant role in banking and money expansion in the past. The Fed's role in monetary policy has mostly been regulating excess reserves. Increase excess reserves, and banks tend to create more money. Reduce excess reserves, and banks tend to reduce money creation.

Conclusion

Historically The Fed has influenced the number of dollars that banks can create ex nihilo (from or out of nothing). The Fed or banks have never created "money." Only the market can decide what to use as money. But, based on the system described above, the assumption that the Fed had significant influence, if not control, over the creation of money dollars, seemed like a sound premise for a theory about dollar creation.

The time has come to examine that premise.

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