Modern Money Mechanics

A Workbook on Bank Reserves and Deposit Expansion

Federal Reserve Bank of Chicago

Page 16

Changes in the Amount of Currency Held by the Public

Changes in the amount of currency held by the public typically follow a fairly regular intramonthly pattern. Major changes also occur over holiday periods and during the Christmas shopping season - times when people find it convenient to keep more pocket money on hand. (See chart.)

The public acquires currency from banks by cashing checks. When deposits, which are fractional reserve money, are exchanged for currency, which is 100 percent reserve money, the banking system experiences a net reserve drain. Under the assumed 10 percent reserve requirement, a given amount of bank reserves can support deposits ten times as great, but when drawn upon to meet currency demand, the exchange is one to one. A $1 increase in currency uses up $1 in reserves.

Suppose a bank customer cashed a $100 check to obtain currency needed for a weekend holiday. Bank deposits decline $100 because the bank customer pays for the currency with a check on his or her transaction deposit; and the bank's currency (vault cash reserves) is also reduced $100. See illustration 15.

Now the bank has less currency. It may replenish its vault cash by ordering currency from its Federal Reserve Bank - making payment by authorizing a change to its reserve account. On the Reserve Bank's books, the charge against the bank's reserve account is offset by an increase in the liability item "Federal Reserve notes." See illustration 16. The Reserve Bank shipment to the bank might consist, at least in part, of U.S. coins rather than Federal Reserve notes. All coins, as well as a small amount of paper currency still outstanding but no longer issued, are obligations of the Treasury. To the extent that shipments of cash to banks are in the form of coin, the offsetting entry on the Reserve Bank's books is a decline in its asset item "coin".

The public now has the same volume of money as before, except that more is in the form of currency and less is in the form of transaction deposits. Under a 10 percent reserve requirement, the amount of reserves required against the $100 of deposits was only $10, while a full $100 of reserves have been drained away by the disbursement of $100 in currency. Thus, if the bank had no excess reserves, the $100 withdrawal in currency causes a reserve deficiency of $90. Unless new reserves are provided form some other source, bank assets and deposits will have to be reduced (according to the contraction process described on pages 12 and 13) by an additional $900. At that point, the reserve deficiency caused by the cash withdrawal would be eliminated.

When Currency Returns to Banks, Reserves Rise

After holiday periods, currency returns to the banks. The customer who cashed a check to cover anticipated cash expenditures may later redeposit any currency still held that's beyond normal pocket money needs. Most of it probably will have changed hands, and it will be deposited by operators of motels, gasoline stations, restaurants, and retail stores. This process is exactly the reverse of the currency drain, except that the banks to which currency is returned may not be the same banks that paid it out. But in the aggregate, the banks gain reserves as 100 percent reserve money is converted back into fractional reserve money.

When $100 of currency is returned to the banks, deposits and vault cash are increased. See illustration 17. The banks can keep the currency as vault cash, which also counts as reserves. More likely, the currency will be shipped to the Reserve Banks. The Reserve Banks credit bank reserve accounts and reduce Federal Reserve note liabilities. See illustration 18. Since only $10 must be held against the new $100 in deposits, $90 is excess reserve and can give rise to $900 of additional deposits.

To avoid multiple contraction or expansion of deposit money merely because the public wishes to change the composition of its money holdings, the effects of changes in the public's currency holdings on bank reserve normally are offset by System open market operations.

The same balance sheet entries apply whether the individual physically cashes a paper check or obtains currency by withdrawing cash through at automatic teller machines.

Under current reserve accounting regulations, vault cash reserves are used to satisfy reserve requirements in a future maintenance period while reserve balances satisfy requirements in the current period. As a result, the impact on a bank's current reserve position may differ from that shown unless the bank restores its vault cash position in the current period via changes in its reserve balance.

Page 17

15. When a depositor cashes a check, both deposits and vault cash reserves decline.

16. If the bank replenishes its vault cash, its account at the Reserve Bank is drawn in exchange for notes issued by the Federal Reserve.

17. When currency comes back to the banks, both deposits and vault cash reserves rise.

18. If the currency is returned to the Federal Reserve, reserve accounts are credited and Federal Reserve notes are taken out of circulation.

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