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Y2K and Bank Reserves

The Y2K problem involving legacy software that used the 2-digit format to record the year in dates before 2000 is now a thing of the past.  But the threat to our financial system, which is highly dependent, on computers was real enough.  

The Threat 

Banks normally hold reserves amounting to a small fraction of their deposit liabilities.  In early 1999 commercial banks in the aggregate held about $40 billion in reserves to cover checking deposits that totaled over $600 billion.  In anticipation of a demand from the public for a large increase in cash holdings in late 1999, the Fed increased its own stockpile of notes to about $200 billion to be made available to banks as needed.  Even if the public drew down their bank deposits for cash by only one-fifth of that amount, it would have depleted the entire reserves of the banking system. 

Obviously something had to be done or the interbank lending rate, i.e. the Fed funds rate, would have soared as banks scrambled for reserves.  Many banks would have simply been unable to cover the demand for cash withdrawals.  Here is essentially what the Fed did in order to avoid the problem. 

The Fed's Response 

The Fed purchased securities from banks and other financial institutions as required to supply the needed banking system reserves.  By meeting the demand as fast as it arose, it kept the supply and demand in balance at its target Fed funds rate.  Aggregate reserves were thus held relatively unchanged even as the monetary base increased by the amount of cash actually withdrawn, about $40 billion.

After the smoke cleared in early 2000, people returned the unneeded cash into their bank accounts.  That would have flooded banks with excess reserves and caused the Fed funds rate to collapse.  However the Fed sold securities from its own portfolio, to soak up the excess.  Again it did so as fast as necessary to stabilize the Fed funds rate.  The monetary base shrunk accordingly. 

What Really Controls the Monetary Base

The details of what happened are somewhat more complex than described here, but the effects on the monetary base were real.  Whether banks provide cash to depositors or make loans to borrowers, the decisions of the public determines the need for banking system reserves, and therefore the amount that must be supplied by the Fed.  If the Fed failed to do so, it would lose control of the Fed funds rate, the benchmark for all short-term interest rates.  More importantly, the loss of liquidity would endanger the payment system itself in which the banks play a central role.  That is not an acceptable option. 

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