Money and reserves

I wanted to offer some clarification on stories about all the money that the Federal Reserve is supposedly printing. It depends, I guess, on your definition of “money.” And your definition of “printing.”

When people talk about “printing money,” your first thought might be that they’re referring to green pieces of paper with pictures of dead presidents on them. The graph below plots the growth rate for currency in circulation over the last decade. I’ve calculated the growth rate over 2-year rather than 1-year intervals to smooth a little the impact of the abrupt downturn in money growth in 2008. Another reason to use 2-year rates is that when we’re thinking about money growth rates as a potential inflation indicator, both economic theory and the empirical evidence suggest that it’s better to average growth rates over longer intervals.

Currency in circulation has increased by 5.2% per year over the last two years, a bit below the average for the last decade. If you took a very simple-minded monetarist view of inflation (inflation = money growth minus real output growth), and expected (as many observers do) better than 3% real GDP growth for the next two years, you’d conclude that recent money growth rates are consistent with extremely low rates of inflation.

Two year growth rate (quoted at annual percentage rate) of currency in circulation. Data source:

But if the Fed didn’t print any money as part of QE2 and earlier asset purchases, how did it pay for the stuff it bought? The answer is that the Fed simply credited the accounts that banks that are members of the Federal Reserve System hold with the Fed. These electronic credits, or reserve balances, are what has exploded since 2008. The blue area in the graph below is the total currency in circulation, whose growth we have just seen has been pretty modest. The maroon area represents reserves.

Currency in circulation (blue) and reserve balances with Federal Reserve Banks (maroon), in billions of dollars

Are reserves the same thing as money? An individual bank is entitled to convert those accounts into currency whenever it likes. Reserves are also used to effect transfers between banks. For example, if a check written by a customer of Bank A is deposited in the account of a customer in Bank B, the check is often cleared by debiting Bank A’s account with the Fed and crediting Bank B’s account. During the day, ownership of the reserves is passing back and forth between banks as a result of a number of different kinds of interbank transactions.

To understand how the receipt of new reserves influences a bank’s behavior, the place to start is to ask whether the bank is willing to hold the reserves overnight. Prior to 2008, a bank could earn no interest on reserves, and could get some extra revenue by investing any excess reserves, for example, by lending the reserves overnight to another bank on the federal funds market. In that system, most banks would be actively monitoring reserve inflows and outflows in order to maximize profits. The overall level of excess reserves at the end of each day was pretty small (a tiny sliver in the above diagram), since nobody wanted to be stuck with idle reserves at the end of the day. When the Fed created new reserves in that system, the result was a series of new interbank transactions that eventually ended in the reserves being withdrawn as currency.

All that changed dramatically in the fall of 2008, because (1) the Fed started paying interest on excess reserves, and (2) banks earned practically no interest on safe overnight loans. In the current system, new reserves that the Fed creates just sit there on banks’ accounts with the Fed. None of these banks have the slightest desire to make cash withdrawals from these accounts, and the Fed has no intention whatever of trying to print the dollar bills associated with these huge balances in deposits with the Fed.

Of course, the situation is not going to stay this way indefinitely. As business conditions pick up, the Fed is going to have to do two things. First, the Fed will have to sell off some of the assets it has acquired with those reserves. The purchaser of the asset will pay the Fed by sending instructions to debit its account with the Fed, causing the reserves to disappear with the same kind of keystroke that brought them into existence in the first place. Second, the Fed will have to raise the interest rate it pays on reserves to give banks an incentive to hold funds on account with the Fed overnight.

Doing this obviously involves some potentially tricky details. The Fed will have to begin this contraction at a time when the unemployment rate is still very high. And the volumes involved and lack of experience with this situation suggest great caution is called for in timing and operational details. Sober observers can and do worry about how well the Fed will be able to pull this off.

But that worry is very different from the popular impression by some that hyperinflation is just around the corner as a necessary consequence of all the money that the Fed has supposedly printed.

71 thoughts on “Money and reserves

  1. dis737

    Why don’t the banks buy a higher yielding (longer dated) treasury note with this reserve money. It’s highly liquid and pays alot more than 0.25%?

  2. Ed Hanson

    It is a good lesson explaining base money.
    It would be interesting, as in fun if not particularly instructive, if you put a graph showing the actual measured amount of currency that has been printed but not destroyed. The number is many times the currency in circulation. Put it under the heading of “Where Did It All Go.”
    Another, more instructive, currency number you might publish is the amount of currency within the US border and that which is outside the world. The world still likes our little green pieces of paper.

  3. baychev

    what worries me is that the fed has paid top dollar for these assets and interest rates have moved unfavorably thus far.
    if the fed begins to sell, as you are suggesting, in order to withdraw liquidity while the treasury is running huge deficits, it will create a significant disbalance between buyers and sellers of treasuries (or agencies). this could have very disturbing impact on yields by first increasing the borrowing cost of the treasury and second by deepening the loss between what the fed has bought at and what it is selling at these assets.
    do you really think that the fed can actually sell any assets before the budget deficit issue is rectified?

  4. cargocultist

    Do you have any evidence that the Federal Reserve credited money to the Bank’s reserves as you claim?

    If the Federal Reserve had actually created the approximately $1.5 trillion that was shifted into the reserve holdings, then this would presumably have appeared in the M2 figures as well, since they record the total of all bank deposits in the system. However there is no matching increase there – and it would stick out like a sore thumb with an increase on this magnitude.

    What actually appears to have happened is that when the payment of interest on reserve accounts was announced Banks shifted existing money into reserve accounts at the Federal Reserve Banks. Of necessity electronically represented money must always be on deposit somewhere in the system. Whether they did this by reclassifying their depositor’s accounts to attract a reserve requirement, or by simply putting their overnight funds in there, is hard to say – most probably both.

    Further, in an Electronic Banking system the distinction being made here between physical currency and bank deposits is not very useful. Physical currency is currently printed on demand, and its growth is a reflection of the steady growth in the amount of money represented as on deposit in the banking system. The real question that needs to be addressed is why this increase has been occurring, independently of any QE measures, in almost all Basel regulated banking systems for over 10 years.

  5. Rodney Chun

    JDH, Thank you for a very timely and relevant post. You write:

    “None of these banks have the slightest desire to make cash withdrawals from these accounts…”

    This indicates that the only use of these resources is loaning them out in the fed funds interbank market or keeping them on deposit at the Fed (incentivized by the interest on reserves).

    Is it possible that the opportunity costs of these excess reserves could change such that other alternatives become appealing to banks, leading to an outflow of reserves to other uses?

    The Fed claims that they could adequately respond to such a contingency (by raising the IOR or soaking up liquidity through reverse repos), but none of these actions have any historical precedence and leads to speculation that the excess reserves could lead to an increase in the money supply and inflation.

    Thanks for any comments.

  6. markg

    You say “of course the situation is not going to stay this way indefinitely”.
    I ask why not? What’s the difference in banks holding reserves (which you recently called short term govt securities) or holding longer term govt securities? Excess reserves do not allow banks to make more loans. Some countries have zero reserve requirements. Banks in those countries make loans. If reserves were required for banks to make loans than banks in those countries would not be able to make loans. To make loans banks have capital requirements, credit requirements, and customer requirements, but reserves are not needed to make loans. Excess reserves will not lead to excess lending. So what’s the big deal about excess reserves?

  7. Mike Sproul

    This is a modern version of the Law of Reflux in operation. Money that is not wanted in circulation will just return to its issuers. In the days of full-bodied coins, unwanted coins would be melted and would ‘reflux’ to bullion. Nowadays, unwanted paper money can reflux to reserves, and unwanted reserves can reflux to bonds.

  8. JDH

    cargocultist: You are confusing two completely different things: (1) deposits banks have in their accounts with the Fed, which are the reserve balances shown in the graph, and have never been included in M2; (2) deposits customers have in their accounts with their banks, which are included in M2.

    dis737 and Rodney Chun: Absolutely, at some point longer term assets will be perceived as more attractive than short-term T-bills yielding essentially nothing, and that is the point at which short-term rates have to rise and the Fed will be forced to take the steps I discuss.

    markg: The overnight interest rate on safe investments is not going to remain stuck at zero. When that changes, the Fed would have to increase the interest on reserves if it wanted to keep excess reserves at current levels.

  9. Tudor

    How is what’s happened different from the Fed basically stepping in and taking over the inter-bank loan market?
    It appears that, instead of lending to each other on the overnight market, the banks are just lending to the Fed instead. My impression was that the motivation for these direct financing interventions came about not just to generate monetary stimulus but also to mitigate counterparty risk in the overnight lending market.
    If you were to compare the value of total currency in circulation, reserve balances with Federal Reserve Banks, and the overnight loan balances between banks, would you still see an overall expansion in the monetary supply?

  10. MarkS

    “Second, the Fed will have to raise the interest rate it pays on reserves to give banks an incentive to hold funds on account with the Fed overnight.”
    Balderdash!! The FED does not have to bribe banks to hold “excess” reserves, all it has to do is to RAISE the effective reserve requirement. If the argument is that some individual bank becomes encumbered because the FED decides to liquidate its overvalued mortgage security, I say: What kind of free ride do you want? I say the banking system is better off replacing badly managed over-leveraged institutions with healthy smaller banks.
    If the argument is that the credit (money) supply will contract if reserve ratios are increased. I say …DUH… Isn’t that the point? Isn’t the problem that the level of debt in America exceeds the economy’s ability to service it?

  11. Bob_in_MA

    I have to second Johannes’ point. The Greenspan/Bernanke regime has made repeated mistakes/omissions during the upswings, and rarely acknowledge the fact. And at a confab in Georgia last year, they both seemed dumbfounded that anyone would criticize their asymmetric policies.
    The question isn’t whether the unwinding could be handled adroitly, but whether it will be handled adroitly.
    Look at it this way: what would require greater finesse, adjusting rates and regulations to mitigate the housing/lending bubble during the expansion of 2002-2005, or unwinding the excess reserves in the near future? If they couldn’t (or wouldn’t) do the fairly straight-forward, why would you expect them to be able (or willing) to do the very complicated?
    The problem is compounded by the fact that the market is likely to find the Fed’s assurances of its tough mindedness rather hard to believe.

  12. bturnbull

    What happens to reserves, when Treasury sells new $80B worth of bonds to the banks, and then the banks sell $80B worth of Treasury bonds to Federal Reserve?

    Would it not provide US government with “fresh” $80B for government to spend?

    Even if excess reserves are increased to prevent banks from multiplying them, would it not provide new $80B to the government without offsetting it against current or future claims for goods and services, (unless, in some future time, if ever, Federal Reserve decides to sell its Treasury bonds)?

  13. markg

    JDH wrote “The overnight interest rate on safe investments is not going to remain stuck at zero. When that changes, the Fed would have to increase the interest on reserves if it wanted to keep excess reserves at current levels.”
    What mechanism will change the rate? Doesn’t the fed set the rate? Japan’s has been set at zero for many many years. No inflation there or devalueing of the Yen. Please explain why the dollar is different.

  14. cargocultist

    Can you substantiate that reserves held at the Federal reserve banks are not classed as M2?

    According to the St. Louis Federal Reserve:

    the increase in the reserves is primarily a result of excess reserve holding by the banks, and they attribute the increase as a direct result of the money injected in as part of the TARP bailout. i.e. a rather more circuitous route than simply depositing directly to the reserve accounts.

    If this money is not counted as part of M2, then it does represent a real risk of inflation – if it is, then it doesn’t, since the increases in M2 over that period aren’t nearly as dramatic as the increases in the base money holdings. However, if money in the reserves is not counted as part of the money supply when it is in there, then a very large question has to be raised over the nature of the bailout itself, since part of the rational behind that was to prevent quantitative money deflation arising from the bank collapses. M2 increases steadily over this entire period – without the money in the excess reserves it would have decreased – but only if they actually get counted.

  15. Dave

    Why would the banks not want to use those reseves to seek higher rates of return it emerging markets?
    Can’t the banks use the excess reserves to increase their lending–as a multiple of thier increased reserves–for ventures in emerging markets?

  16. cargocultist


    There are some quite interesting differences between the dollar and the Yen. Taking the M2 US dollar measure, and removing the Money Market Funds fields (since they are typically held in debt instruments), shows the number of dollars in the american banking system to have roughly doubled over the last 10 years.

    The Yen on the other hand has been fairly stable quantitatively. It’s not clear why, but most probably it’s a residual effect of their banking crisis in the 1980’s, in conjunction with their not having any significant amount of Asset Backed Securities in their financial system. In addition they are net exporters, so their currency has steadily deflated in value versus the others.

    Banking systems vary considerably between countries in the details of their implementation – and unfortunately (for economics) – these details can matter enormously.

  17. Bryce

    Prof. Hamilton, I appreciate your efforts to elucidate this subject.
    M1 is currently 12% higher than it was a year ago. Since late 2008, M1 has averaged growing at ~10% annual rate.
    That strikes me as rather significant growth in quickly spendable money relative to GDP (what you spend it on). I submit to you that quite a lot of inflation has occurred in investment goods (commodities, bonds, stocks) in consequence.
    What I here you suggesting is that smart gov’t bureaucrats can benevolently trick the economy…making fiat money appear & disappear. I know this doesn’t do justice to what you expressed. Any additional thoughts?

  18. Jim Baird

    “When the Fed created new reserves in that system, the result was a series of new interbank transactions that eventually ended in the reserves being withdrawn as currency.”
    This is incorrect. The banks never magically decided to order more cash in response to the Fed adding reserves.
    Under the old system, the Fed had to add or subtract however many reserves were demanded by the banks (in line with minimum reserve requirements) to keep the FF rate at it’s desired level. The Fed had no discretion in this; since only transactions with the Fed can add or remove reserves from the system, any general excess of reserves leads to the overnight interest rate going to zero, and any general shortage leads to essentially infinite rates, as there are not enough reserves for all banks to be in compliance.
    Open market operations, under the old regime, were always about price, and never about quantity.
    The purpose of IOR is to allow the the Fed to set a nonzero base interest rate under conditions of excess reserves. Without it, the Fed would first have to drain all the excess reserves to get back to the pre-2008 condition. With it, they can directly set the rate at whatever they want, whenever they want, without having to go through the inefficent open market process.

  19. Ekim

    The banking system is electronically printing credit. This has the same effect as printing money with respect to confiscating resources from fixed income citizens et al. However, since it is credit and not cash, the debt to GDP ratio continuously rises. This leads to an eventual credit crises.
    Think of it this way. The central bank and its member banks are confiscating approx 10% of GDP annually from citizens, and lending those goods back to those same citizens (in the aggregate). It is not a frictionless exchange though. For example, because of financial sector costs (e.g., salaries, leveraged speculation), the process gradually siphons goods away from the non financial sector, and redistributes those goods to the financial sector.

  20. Carl Lumma

    @Bob_in_MA The account given above, though popular, is highly misleading. First off, the excess reserves shown are mostly due to MBS, not bonds. Since this MBS investment is not currently being sterilized by the Fed, new money is flowing into the economy and this is inflationary. Please note this does NOT necessarily mean we will experience an undesirable rise in the net inflation rate, or even any rise at all.

    So the Fed doesn’t have to worry too much about containing these reserves. Given the slow rate of recovery expected, it can probably just start sterilizing its MBS proceeds at some point and call it a day.

    That was QE1. QE2 is being done with bonds, and these aren’t sterilized either. So you’re right: when the Fed buys gov’t bonds, the government spends new money into the economy, permanently offsetting future tax revenue requirements. That economists miss this in their ongoing bafflement over the ‘mechanism of QE2’ is amazing to me.

  21. cargocultist

    I think it’s actually doing both. The credit printing is from securitization, the “endogenous money growth” as economists like to refer to it (seriously guys, it’s the 21st century, recursive systems aren’t that hard to analyse), probably has several causes – one is certainly allowing debt to be counted as part of regulatory capital. But as you say, the credit supply growth is doing more damage as it is increasingly concentrating money in the financial sector.
    The central banks aren’t directly doing this though – except in their failure to correct the regulatory flaws allowing it to occur.

  22. don

    dis737 asked: “Why don’t the banks buy a higher yielding (longer dated) treasury note with this reserve money. It’s highly liquid and pays alot more than 0.25%?”
    If you buy longer term assets, you risk a capital loss if interest rates rise. This can quickly wipe out any short-term interest differential between the short and long rates.
    If you are willing to take the risk by going longer term, and the Fed reduces the reward from the carry trade between long and short term U.S. bonds by buying longer term Treasuries, I think a natural response would be a shift to safe foreign bonds, such as German government bonds. This adds exchange rate risk, but the markets are huge, so a change in relative rewards can induce large flows before the incentive is eliminated. That is why I think, in practice, Ben’s QE results in little more than beggar-thy-neighbor exchange rate policy.
    markg said “What mechanism will change the rate? Doesn’t the fed set the rate? Japan’s has been set at zero for many many years. No inflation there or devalueing of the Yen. Please explain why the dollar is different.”
    I think the idea is that if the economy is recovering, the Fed may need to raise the rate to prevent inflation. In my opinion, Japan’s QE kept the yen artificially depressed by spurring the yen carry trade. The effect was dramatic at first (pushing the yen to 130 to the dollar), and the yen never went to its proper level (in my view) until just recently, when it finally fell from 100 to the dollar to about 80. By keeping the yen undervalued, Japan’s zero-rate policy and QE helped its export sector. That is fine with a healthy ROW. But right now the world is in a condition of acute deficiency in AD and policies of competitive depreciation are of questionnable help.

  23. Jeremy

    I have to third Johannes’ point.
    I sold all my shares in 2007 – totally exited except for mandatory stuff that was in company related pension funds.
    I took large piles of cash out during the crisis in order to be able to buy food and feed the family in the event of a run on the banks (when Lehman failed and things looked positively scary).
    Once it became clear that “bailouts” was the new black. I ploughed everything back in to the markets in late 2009.
    I believe Greenspan caused most of our problems – people thought he was a god – he turned out to be badly wrong about sub-prime. Unfortunately people listened to him – to the point where many warning signs were missed – he seemed to be the great sage of the day – perhaps Groupthink among experts blinded everyone.
    Anyway, if a mere individual like me can see it coming then I tend to agree with Johannes – where were the experts – or x-spurts?
    I am consistently told I am stupid and dumb on most blog sites.
    Well here is my next stupid and dumb prognosis – INFLATION – watch out folks it is coming big time!! (Despite what ALL the experts say)
    And to add a little bit of guilt to this whole sorry story – and this I know will resonate with Menzie – I feel that our current system is favoring the wealthy (those with assets) and I worry that ordinary folks who live from paycheck to paycheck and rent and have debts are being shafted. I know this is wrong – so I do what I can to help those close around me who are trapped by the system…
    Anyway I must give credit and thanks to Johannes, JDH and many others in the blogosphere because I would not have avoided the crisis had it not been for insights gained in the blogosphere.
    In all honesty, I have now come to regard the mainstream media is a thinly veiled vehicle used simply to control the sheeple. I do not trust ANY of the mainstream media anymore.

  24. The Rage

    Bryce, your “rise in M2” is completely and privately made. The FED can provide “liquidity”, which Q2 really is to help the rise, but it doesn’t create it.
    This is the problem people seem to be having. Moves in investment and commodities will always be up in this type of money demand. The key thing to notice is how the ‘inflation’ is being exported. Which the FED REALLY wants to increase “globally”. Basically like giving a bad child a bottle of wine to get really drunk and sick. Hence, the “absorbers” of the inflation will finally give up their domestic policies slowing down global growth internationally but raising domestic competetiveness domestically in the US thus internal US growth as we “reabsorb” our inflation. You understand why they are so resistant.
    “True” US/FED printing is the “hail mary”. That is when all money demand in the private sector has ceased and the economy is essentially dead. “Printing” would cut the necks of the banks the FED serves themselves and make them irrevelant as the FED would have to act on behalf of the United States to raise the money supply. Doing so is why Bernanke’s “helictoper” statement was a fictious fantasy, one never he would or want to fulfill.

  25. JDH

    cargocultist at February 16, 2011 11:04 AM: You can find the definition of M2 here and verify for yourself that it is just as I said.

    bturnbill: My position is that the $80 billion raised in this manner is essentially identical to $80 billion by an original issue of T-bills by the Treasury and leaving it at that.

    Dave: Sure, banks can use reserves to buy anything, and they do. The current term structure of interest rates is such that banks are willing to hold T-bills and reserves paying essentially nothing even though long-term bonds and emerging debt pay more. The time will come when they would only be willing to do so with a higher yield on T-bills and reserves.

    Jim Baird: Nothing magical about this. Your position that the fed funds rate must be either zero or infinity is nonsense. In the old system, the quantity of reserves can and did change every day, and the fed funds rate can and did change every day in response. See for example this paper.

  26. Joseph

    How does the Fed pay interest on reserves? Does it just create more reserves? If they do this for too long, when it comes time to withdraw reserves, there will be a lot more reserves than the Fed has assets to sell.

  27. Lee

    Great article. All the news ever mentions is the printing money side of the story. It’s nice to see a more complete look with a graphical depiction of the reserve increase.

  28. JDH

    Joseph: Yes, but don’t forget the Fed is earning a substantial flow of income as interest on the assets it already holds. At the moment, the interest it earns vastly exceeds the interest it’s paying, and the Fed is returning a great deal of profit back to the Treasury. But again, the situation could get much trickier once short rates start to rise.

  29. Qc

    While I appreciate your attempt at describing monetary and banking operations , there are still many wrongs with your descritpion, particularly regarding the following statement:
    “The overall level of excess reserves at the end of each day was pretty small (a tiny sliver in the above diagram), since nobody wanted to be stuck with idle reserves at the end of the day. When the Fed created new reserves in that system, the result was a series of new interbank transactions that eventually ended in the reserves being withdrawn as currency.”
    First, banks does not demand currency because their excess reserves is earning 0% at the Fed. There are absolutely no relatioship between “demand for currency” from private banks and “interest on excess reserves” .
    Second, transactions in the interbank market has absolutely no implications on reserves being withdrawn as currency.
    Third, excess reserves in the system were small prior to the crisis because the Fed decided so. Similarly, excess reserves in Canada (called deposits at the Central Bank) are tiny because the Bank of Canada decides so -although these deposits currently earn the target rate minus 0.25% in Canada.
    Fourth, with excess reserves at zero, and if the Fed wants to maintain reserve requirements stable, then in order to obtain more currency, private banks need to sell US treasuries to the Fed, just like banks in Canada, in a world of zero reserves, sell Canadian Government bonds to the Bank of Canada to obtain currency. As long as there is sufficient Government debt in circulation (even if reserves are at zero), access to currency is never a problem.
    Five, be carefull overinterpreting the growth of currrency in circulation in the case of the US dollars. Much of the increase is caused by demand from abroad. This is particularly in the last few years.

  30. JDH

    Qc: Here’s an example of how an interbank transaction in normal times can result in an increase in currency in circulation. Bank A sees the best use of its $1,000 funds to be extending a new loan. Loan recipient uses the funds to write a check to customer in Bank B, causing $1,000 reserves to be transferred from Bank A to Bank B and $1,000 increase in total checking accounts customers have with banks. If customers of Bank B have a target ratio of currency held to their checking account balances, some of that $1,000 in new checking accounts at Bank B end up as currency held by the public.

  31. Dave

    Maybe you didn’t understand my question. If a bank has reserves they are able to lend a multiple of those reserves right? So if they have even more reserves that have been debited to their accounts electronically by the Fed wouldn’t that enable them to make a loan to say a hedge fund or their own investment arm for higher return bets on commodities or emerging markets?

  32. Mark

    So is it then accurate to say: the Fed purchased all the MBS assets it bought, like Maiden Lane, with funds it created out of thin air which, in turn, it’s paying .25% interest on to keep out of circulation. The Fed also has a one-way option on either letting its costs of borrowing rise or risking inflation by allowing the funds it created to trickle back into the economy.

  33. Qc

    The operationnal reality is that deposits result from loan creation, not the other way around (I am sorry but when guys familiar with banking/monetary operations hear the money multiplier story, they can’t stop laughing).
    So loan creation on the asset side of Bank A results in a corresponding amount of deposit on the liability side of Bank A. If I am the borrower, and use this loan to buy a house, and the house contractor has an account at Bank B, then the deposits will be transferred from Bank A to Bank B. Bank A will then have to borrow the amount on the interbank market from Bank B. This is in a nutshell the operationnal reality: loans create deposits. Demand for currency is completely independant from the process just described. If the house contractor want some of its deposits at Bank B to be converted to currency, then all Bank B has to do is to sell Government securities to the Central Bank. There is no such thing as transaction in the interbank resulting in an increase in demand for currency. The two are completely independant events. You would note if the contractor had an account at Bank A, the deposits would have simply switch between accounts within Bank A (ie. no need for Bank A to borrow on the interbank market). This would not have stopped the contractor from asking that some of its deposits be converted to currency. To accomodate this, Bank A would simply sell government securities to the Central Bank.

  34. Anonymous

    Prof. JDJ:

    Yes, I understand that money raised by manner of QE2 are essentially similar to a bank buying a Treasury bond and repoing it to Federal Reserve.

    However, Federal Reserve exercises significant control over banking system, and there have been a number of recent adjustments to the system to allow current Federal Reserve execution.

    So, unless it can be shown that current large Federal deficits are not financed in any significant way with new money (which may not be retired for a long time, if ever), can all of the following be asserted:

    1. Federal reserve does Not print money.
    2. Federal reserve does Not monetize debt.
    3. There are no inflationary effects on food, imports or commodities, only on stocks.
    4. QE2 (and probably QE3, QE4, etc.) do Not enable large Federal deficits.
  35. JDH

    Qc: There are a variety of assets that I as a member of the public might hold– checking accounts, currency, whatever. You have just described a situation in which assets held in checking accounts must rise in equilibrium. It seems very odd to claim that this could occur with no consequences for the demand for any other asset.

    I think of demand for all assets as simultaneously determined as a function of their corresponding rates of return, real income, and prices. You seem to think of demand for every asset as perfectly elastic. In my view of the world, when the supply of one asset changes, all kinds of other magnitudes have to adjust in response.

  36. Declan

    I have to agree with Jim Baird and QC in not following your logic on why reserves shot up after 2008. I thought the reason for the increase was being up against the lower bound (0 normally, or .25 if that’s the interest the Fed decides to pay on reserves).
    Prior to hitting the lower bound, any extra reserves put into the system by the Fed would lower interest rates, resulting in more loans, more money circulating, and more need for deposits (and of course with the Fed targeting a specific rate, they’d have to add or remove reserves accordingly to get to a situation where there were (effectively) no reserves outstanding at that particular rate), but after hitting the lower bound, rates couldn’t go lower so the reserves just accumulated.

  37. ppcm

    Professor Hamilton
    How is the weather in San Diego?Is the breeze not too hot,not too cold.Are the palm trees gently curving their heads dancing to the rhythm of the waves.Is Elliot still there dreaming of its equities theory? or may be it is Otis Redding – (Sittin’ On) The Dock of the Bay ?
    The above money supply is homotetic of almost degree 1 with equities markets,not only the SP,not only the Dax, but the CAC,the SMI… save the time lag.
    Lining up Pigou s pockets has been a successful story throughout this decade.Not included in the money supply the derivatives,this “fausse monaie” kindly replaced by central banks through real money every time a market mis behavior is noticeable,that is every time someone else is no longer playing the game.Called cashing in in the real world.
    When are we going to read a digest of the progresses made by the G+n through their n+1 meetings including banking reforms,veracity of accounts published,leverage.
    Where is the macro stabilization digest, addressing the current accounts,the foreign exchanges,public debts?
    Bloomberg data may assist to compare above chart with stock market index throughout the same period.

  38. baychev

    you have not addressed my question, and at the same time it looks you are trying to steer us into thinking that the fed can influence the amount of money in the system regardless of the economic interests of other participants.
    let’s just remind ourselves that this whoe QE sequel started with the intention to recapitalize by stealth the banks and fund the treasury. do you really think it will be reversed in a way that it generates a net loss to banks? what could make a bank buy treasuries or agencies from the fed at a higher than the market price?
    it looks to me you(academics in general) are really oversimplifying monetary policy making it look as if it is only a matter of pumping money in and out of a system and that has no impact on the economy besides your stated initial intention, let alone on highly levered and not very healthy banks or a government with growing borrowing needs.
    do economic interests not matter at all in your academic exercises? why would you call yourself an economics professor if you subscribing to theories that disregard the economic interests of agents?
    it is really baffling to see such sterile theories still being touted around.

  39. Barbara Sutter

    It has been mentioned by others such as dis737 or Dave:
    The banks can use their excess reserves to buy some other asset with a higher yield. The common view among economists is, though, that banks do not want to do so and therefore just hold on to their excess reserves.

    My question is: Is there any proof for this claim?

    First, when no IOR is paid, the argument is that banks will lend out their excess reserves in search for yield. Now that IOR is paid, it is still close to zero. Banks have lots of liquidity in excess of the required amount, so why would banks not use their excess reserves to buy some higher yielding asset?

    The point is that we do not observe what is actually going on.
    If bank A sells a Treasury bond to the Fed, its reserves with the Fed increase. Suppose bank A uses these reserves to buy some other asset, eg. commodities, from bank B. What happens is that excess reserves remain unchanged, they are simple transferred from bank A to bank B’s account with the Fed. At the same time, however, commodity prices increase.

    So how do we know this is not what is going on? I just refuse to believe that banks are happy with 0.25% IOR..

    If we ignore cash for the moment, the only way banks can reduce excess reserves is by issuing loans, which turns excess into required reserves. The total amount of reserves remains unchanged. Banks have not been willing to extend loans in any significant way. Thus, if no loans are issued, only the Fed is able to change the amount of excess resreves.

    Or am I missing something?

  40. AmirS


    Great post. More people need to understand this stuff. I thought I’d share a simpler explanation of why this part is wrong:

    > When the Fed created new reserves in that system, the result was a series of new interbank transactions that eventually ended in the reserves being withdrawn as currency.

    Choosing to withdraw reserves as currency is an independent decision dictated by operational requirements.

    Banks who had excess reserves (paying 0%) would actually use them to buy Treasury securities (T-Bills, Notes, Bonds) from the Fed through open markets operations so they can earn interest.
    If a the banking system had overall too few reserves (maybe as a result of withdrawing them as currency), then the Fed would buy Treasury securities from banks in exchange for newly created reserves. So it’s the other way around, if anything.

    Dave: Banks make loans independent of the amount of reserves they have. If they want to make a loan and they don’t have enough reserves to meet requirements, then they’d just borrow more reserves, or sell or repo a Treasury security to the Fed in exchange for reserves. Conversely, if they don’t want to make a loan, then in the old system (0% in excess reserves) they just lend out excess reserves to other banks or buy Treasury securities with it, while in the new system they can just keep reserves earning interest in their account at the Fed.

    Reserve multiples and ratios are irrelevant where you can make up a shortfall by borrowing reserves.

    As to why a bank wouldn’t want to make new loans, that’s because all loans or investments carry risk, and they’re making the decision that the risk isn’t worth the profit. They’re also limited by the total risk they can carry, which is proportional to the capital they have – see the Basel rules.

  41. Jim Baird

    “In the old system, the quantity of reserves can and did change every day, and the fed funds rate can and did change every day in response.”
    Of course the quantity of reserves changed every day in line with treasury operations (which the Treasury tried to smooth out using TT&L accounts), and the FF rate might move slightly – mostly because the Fed only intervenes once a day, and sometimes doesn’t get it right (not to mention the fact that reserve requirements are averaged over a 2-week period, so banks don’t absolutely have to have their requirements met every night).
    But that doesn’t change the fact that, given a general shortage, there is no bid high enough to bring out more reserves, since the banking system itself cannot “manufacture” them – only the Fed can. And if every bank has enough to meet it’s requirements, the bid has to drop to zero because no one will have any more need for them.
    Really, Qc is right – people who understand operations laugh at the bedtime stories economists tell each other…

  42. cargocultist

    Thank you Professor I stand corrected, I thought Base Money was rolled up into M2 in the Federal Reserve statistics but apparently not according to the footnotes.

    Unfortunately, that would seem to suggest the Inflationistas are in fact right. If the ~$1 trillion in base money is not counted in M2, then total potential money supply for the USA is at least 10% larger than currently represented. But what is also critical is how exactly that money is currently being accounted for by the Banks. If it is part of their assets, and not part of the reserve being held on Net Transaction Accounts, then when it is moved back into the banking system it will have a multiplier effect on total money supply as the loan-redeposit process kicks off when banks have profits available to increase their Equity Capital holdings. Indeed the continuing growth in the M2 money supply – in the presence of widespread loan defaults would suggest that it already is doing exactly that as base money has been dropping slightly over the last months.
    Cui bono?

  43. Qc

    I do not disagree with your statement. Banks provide loans on the basis of their risk/return tradeoff assessment (not on the basis ofn excess reserve they hold). I use the deposit on the basis on my own assessment of the risk return tradeoff, and all of us doing this has an impact on yields/assets prices.
    I am not totally clear what was your point, but anyhow, back to your earlier comment, I reiterate that interbank transactions that drive the interbank rate to zero -because of all the excess reserves in the system earning 0%- will have no impact on demand for currency, and therefore, no impact on the amount of excess reserves in the system. Japan have been been working with an elevated level of excess reserves and a near zero percent interbank rate for a very long time, this had no implications on demand for currency.
    Excess reserves will be brought back to zero when the Fed will decide so. No matter the amount of trasactions in the interbank market, private banks are powerless to make these reserves disapear.

  44. Ricardo

    JDH wrote:
    All that changed dramatically in the fall of 2008, because (1) the Fed started paying interest on excess reserves, and (2) banks earned practically no interest on safe overnight loans. In the current system, new reserves that the Fed creates just sit there on banks’ accounts with the Fed. None of these banks have the slightest desire to make cash withdrawals from these accounts, and the Fed has no intention whatever of trying to print the dollar bills associated with these huge balances in deposits with the Fed.
    I am not sure you have adequately explained why the banks have no desire to withdraw these excess reserves with the the FED. The FED is paying an extremely small interest rate on reserves, much less than a bank could earn if it was lending out the reserves commercially rather than letting them sit idle. There has to be some compelling reason that the banks are willing to take 0.25% rather than 3%.

  45. JDH

    Qc and others: Of course reserve creation in the present situation has no effect on the demand for currency or currency in circulation. That’s my point.

    Where we have irreconcilably different views of the world is how things function when we return to a more normal situation in which the demand for reserves is no longer infinitely elastic.

  46. Qc

    I would appreciate if you could explain in details (perhaps in a future post) how, acccording to your view of the economic world, in a “normal” situation reserve creation has an impact on demand for currency or currency in circulation. Also, how this additionnal currency in circulation will generate inflation.
    Remember though this undisputed modern operationnal fact: any additionnal currency in circulation is born out of Government debt (whether it is government debt in the form of reserves or Government debt in the form of T-Bills or bonds).

  47. dilbert dogbert

    Just scanned through the comments.
    My reading is that the commenters are fearful of the blowup of the “Full Faith And Credit” of the US. I don’t have the inclination to obtain a working knowledge of the system such as you and the commenters have. I do enjoy the back and forth between JDH and the commenters. That is the reason I am here. JDH and Menzie engage the commenters and I learn a little bit with each engagement.

  48. markg

    I think a phrase in your last statement tells it all: “demand for reserves “. Exactly, banks demand reserves based on the deposits created when banks make loans. Like QC and Jim said, the money multiplier is a myth. The Fed does not supply reserves so banks can make loans up to a multiple of the reserves. Banks make loans which create deposits and then DEMAND reserves. The Fed has no choice but to supply the reserves to keep the FFR where it wants. So one can conclude that reserve positions is not a factor when a bank makes a loan. That includes having insufficient reserves or excess reserves. There you have it, excess reserves will not lead to excess lending since reserves are not a factor in lending.

  49. c smith

    There has to be some compelling reason that the banks are willing to take 0.25% rather than 3%.
    There is. They know that carrying values for real estate assets securing $ hundreds of billions in loans on their books are a complete fiction. Therefore some (large) fraction of those reserves will need to be paid out in the future to depositors and creditors.

  50. Ricardo

    c smith,
    I believe in part you are correct. Menzie posted about deleveraging a few weeks ago and I do believe that is a greater driver of excess reserves than the FED paying interest of 0.25%.
    There are two sides to what you have posted. The banks are cautious because of economic conditions, but the borrowers are also cautious and many simply can no longer qualify with homes underwater.
    Banks and borrowers leveraged up and when the bottom fell out the deleveraging has overwhelmed both. This does give is some idea of what needs to be done for recovery. We must stimulate the private sector and increase growth. That simply is not happening, if anything it is just the opposite.

  51. davepowers

    So how big is the overnite Fed Funds market (where banks lend/borrow excess funds at the FED) and has it grown since excess funds skyrocketed with QE1?
    As baychev pointed out above, when we see only the gross level of excess reserves at a trillion plus, we do not see what is going on to the extent so called excess reserves are being moved around and potentially supporting stock and commodity speculation.
    Such speculation might be aided to the extent the fed funds market participants combine their activities with repo/reverse repo agreements or other complex derivative type activity.
    There is at least some evidence that the fed funds market is substantial, notwithstanding the argument that ” In the current system, new reserves that the Fed creates just sit there on banks’ accounts with the Fed. ”
    For example, in the latest Bank of America 10Q, they list assets under the category of Fed Funds Sold and Securities borrowed or bought under repo agreements as a cool $271 bn, up from $189 bn nine months earlier. On the liability side, Fed Funds Purchased and Repo deals are almost $300 bn.
    In the confusing world of bank terminology, the loaning and borrowing of bank reserves is called Fed Funds Sold and Fed Funds Purchased. Go figure.
    Of course, the authorities make things less than clear by allowing combined reporting of fed funds transactions with repo agreements, but the overall activity of fed funds trading is substantial as shown by the BofA financials and has been growing along with the spurt in the general level of excess reserves under QE.
    So again, one must ask if the growth of excess reserves, contrary to claims of sterilization, simply set the stage for moving and shaking in the commodity and stock markets, thereby accounting for at least some of the inflation in the prices of same?

  52. davepowers

    Figuring out what, if any, impact excess reserves have on speculation, is made more important by the big growth in reserves shown in the latest (FEB 9) balance sheet from the FED. For the week, the FED faced a lot of bills to pay, including $25 bn to pay off part of its SFP loan from the Treasury, $55 bn to cover checks the Treasury wrote on its checking account at the FED and almost $29 bn in Treasury paper purchases under QE. The Fed paid for this spending spree by borrowing the money from the banks, causing the level of reserves to increase by $108 bn in just one week.
    Someone above suggested that the level of reserves is meaningless. If so, then it is a most incredible situation that the FED has achieved – being able to pay for anything and cover the cost of Treasury operations just by a data entry on a meaningless line item.

  53. Max

    Now that the Fed is paying interest on reserves, we are halfway to a decent banking system. The other half of the reform, which economists have recommended since the 1930s (if not earlier), is to require banks to hold deposits in trust, i.e. 100% backed by reserves.

  54. flow5

    Once upon a time legal (required) reserves were a credit control device. No longer. The member banks are no longer reserve constrained. And neither can you say that excess reserves represent unused bank lending capacity. These interbank funds, held at the district Reserve banks, are invested. They are bank earning assets. They are IORs.
    Only that tiny amount of interest that accrues at the remuneration rate, is credited to the banks after 15 days, and actually adds to the effective money supply.

  55. 2slugbaits

    Thanks. Good explanation. In fact, I see that it was so good that Krugman is directing readers to your explanation.

  56. LIBERterryAN

    Professor: All this talk of Fed this and that is
    highly confusing.
    The reason that I say this is because I thought
    that almost all money was “bank credit”.
    That is, I always thought that the system worked
    like this: (1) When a bank extends you a loan,
    they simply change the numbers in your account.
    (2) But as you make your loan payments, the bank
    takes the portion (or percentage) of your loan
    payments which are dedicated towards principal
    — remember the money they created out of nothing? — and DESTROY (“extinguish”) that
    money. (3) But they keep the interest.
    Thus, reserves are irrelevent and base money IS
    NOT a part of the circulation.
    But now I’m not so sure.
    Could somebody PLEASE direct me to a book, or
    web adress where I could learn (1) What money is
    (2) Where it comes from (3) And wence it goes?

  57. Nemesis
    Gentlemen, look at what the results are so far of the Fed’s “printing”, i.e., crediting banks with fiat digital debt-money reserves. Rather than lend (with charge-offs and delinquencies at a record high and $2T of bad assets not marked to market), banks have bought Treasuries, agencies, etc., and accumulated cash, whereas bank loans have fallen. With 10% charge-offs, delinquencies and a 3.4% net interest margin, and 0% cost to depositors, banks have little incentive to grow their loan books. 0-4% returns lending to the gov’t and selling to the Fed is a no-brainer during a debt-deflationary slow-motion depression.
    If one looks further at M1 and M2 and accounts for the incremental deficit spending’s effect on the growth of money supply, the contribution to money supply growth by the private sector is negligible to modest at best, suggesting very little net organic private sector growth is occurring, making the private US economy more vulnerable to the high price of oil and gasoline than most e-CON-omists realize, or will admit publicly.
    In the meantime, US equity market capitalization has soared nearly $4T since July-Aug. ’10 (coincident with the QE announcement), and approaching $8T since the Mar. ’09 low, taking MMFs/market cap back to near the levels of previous market tops. The 10-yr. avg. P/E, Q ratio, profits/GDP, and market cap/GDP are at or above the levels of the peaks of secular bull markets going back to the late 19th century.
    By talking up asset and consumer price inflation, the Bernanke Fed has enabled yet another bubble in asset valuations, virtually ensuring low or negative real 3-, 5-, 10-, and 20-yr. returns, as well as encouraged speculative hoarding of commodities, the prices of which are passing through to food prices around the world at a time when the private sector in the US is at sustainable growth.
    And one for Steven:
    With US oil consumption/private GDP now at 7%, there is no precedent for accelerating private sector economic growth since ’70; rather, the previous two times this condition occurred was in ’08 and ’79, the two deepest recessions since the Great Depression.
    $1.5T US fiscal deficits and central bank printing will only exacerbate the misallocation of capital and resources, pushing asset valuations and commodities prices to unsustainable levels, increasing the probability of yet another bubble-bust cycle, only this time at a larger global scale than ever in history.

  58. davepowers

    JDH, thanks for posting references to the December 20, 2010 post on Velocity of Money. It and the comments were very informative.
    At the end there was discussion about how Bernanke could say that the FED is not printing (as he did in a late 2010 60 Minutes’ interview referenced toward the bottom of the comment section), but admit they were effectively printing some 20 months earlier in another 60 Minutes interview.
    FWIW (and it may not be much), I suggest that Bernanke was being accurate on both instances and have posted two comments to that effect.
    The issue is important IMO because the FED oscillates between printing (currency and bank reserves) and borrowing under the SFP as a device to expand its balance sheet. During 2010, the FED was borrowing, not printing, but recently they have shifted heavy into ‘print mode.’
    If this continues (and given purchases required under the rest of QE 2 and the need to payback SFP to the tune of another $150 bn it is likely to do just that), then we’ll see another hefty expansion of bank reserves which are now at $1.2 trillion.

  59. flow5

    “when M1 goes up, the velocity of M1 goes down by an almost exactly offsetting amount”
    This is absolutely wrong. The transactions velocity does not move in concert with income velocity. Income velocity is a contrived figure.
    The turnover of money rarely falls, even in recessions. But the number of transactions does. I.e., the volume of money turning over falls. —Source: G.6

  60. Rogue

    Prof. Hamilton, I have some questions about the operationalization of QE. Since nominal new money will have to be dispersed into the broader economy via an increase in bank reserves, all this additional reserves is expected to lead to additional lending to be effective in stimulating the economy. Do we have enough borrowers? Bank capital? This is the longer explanation of why I’m asking

  61. JDH

    Rogue: My view is that QE has no effect through the usual lending or money-multiplier channels, but operates primarily by changing the supply of long-term bonds held by the public.

  62. JDH

    Qc at February 17, 2011 08:01 AM: Write down any coherent model in which the vector of assets the public desires to hold is a function of the associated vector of yields and other macro variables. It would be a very odd property indeed if your model has the implication that when one changes the supply of, say, checkable deposits, nothing else adjusts in equilibrium. I maintain that instead, all kinds of variables would adjust in the new equilibrium, one of which is demand for currency.

    We’re currently in the unusual situation where the demands and yields are such that we can change the supply of reserves and nothing else need adjust. That is a temporary situation.

  63. Get Rid of the Fed

    “Rogue: My view is that QE has no effect through the usual lending or money-multiplier channels, but operates primarily by changing the supply of long-term bonds held by the public.”

    Held by the public or held by banks that are members of the Federal Reserve System?

  64. Qc

    I commend you for your comment:
    “My view is that QE has no effect through the usual lending or money-multiplier channels, but operates primarily by changing the supply of long-term bonds held by the public.”
    I do not think you would have made the same comment two years ago, which denotes a certain evolution in your economic thinking, which is much to your credit.
    Some operationnal facts as to why demand for currency is not affected by
    QE2. The Fed is buying bonds directly from primary dealers, QE2 transactions will therefore have implications on the asset side only of private banks, it will not affect at all liabilities (notably liability in the form of checking accounts). So you will have the following change on the asset side of private banks.
    minus Governemnt bonds
    plus Reserves
    So I guess your point is that private banks are now caught with low yielding assets in the form of reserves instead of relatively higher yielding assets in the form of longer-term government bonds, so they may be tempted to convert these reserves in the form of currency. To do what exactly? The problem with this assessment is that for banks, holding currency is always and everywhere a cost (this is true even if the rate on excess reserves is at zero).
    Banks dislike currencies, and they dislike them even more when their customers increase their demand for them. When customers, for whatever reasons, increase their demand for currencies, this means automatically that the balance sheet of private banks will shrink, and so are their interest rate revenue. On the liability side, checking deposits will be reduced, while on the asset side, holding of government bonds or reserves will shrink. On top of this, transactions in currencies do not allow banks to collect transaction fees.
    Basically, what I am saying is that demand for reserves is always and everywhere infinitely elastic for the banking sector. Other than maintaining an inventory high enough to respond to customers demand, bankers in all circumstances prefer reserves than stash of cash sleeping in the vault.

  65. DNDoucet, rocketman,

    There were many actions/strategies in play (e.g. reserves, etc), In my opinion, here’s a big one:
    1. Real Estate is the biggest asset held by businesses. R/E values drop approximately 30%
    2. Businesses net worth dropped approximately 30%
    3. Large amounts of CORPORATE bonds were issued.
    4. Proceeds from the CORPORATE bonds went to money market accounts
    5. “FRB” (participating banks) purchased these assets with reserve dollars.
    6. Largest corporate bond underwriter during this period was J P Morgan.
    Hence, (1) the corporations rectified their net worth problems, (2) increased their liquidity [working capital issues, corrected loan covenant violations with their banks], (3) the bank reduced their exposure to loan losses, (4) money market account deposits become the offsetting entry with reserves and (5) CORPORATE bonds were assets purchased by the FRB/participating banks (or any bundled security & combination thereof with MBS).
    My question to all of you: money markets funds have been diminishing….I presume the buyback has been in process. I don’t fully understand yet, because I don’t have access to current bank data and Census records (IRS records).
    However, I have a good idea because I know of “the transactions taking place with bonds and banks and between banks RIGHT NOW.”
    I will share this information, if someone is willing to share with me the data I’m requesting.

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