Introduction to Banks

The bulk of all money transactions today involve the transfer of bank deposits.  Depository institutions, which we normally call banks, are at the very center of our monetary system.  Thus a basic knowledge of the banking system is essential to an understanding of how money works.

Bank Deposits and Reserves

The monetary base is created by the Fed when it buys securities for its own portfolio.  Bank deposits themselves are not base money, rather they are claims on base money.  A bank must hold reserves of base money in order to meet its depositors' cash withdrawals and to cover the checks written against their accounts.  Reserves comprise a bank's vault cash and what it holds on deposit at the Fed, known as Fed funds.  The Fed requires banks to maintain reserves of at least 10% of their demand deposits, averaged over successive 14-day periods.  

The Movement of Bank Reserves

When a depositor writes a check against his account, his bank must surrender that amount in reserves to the payee’s bank for the check to clear.  Reserves are constantly moving from one bank to another as checks are written and cleared.  At the end of the day, some banks will be short of reserves and others long.  Banks redistribute reserves among themselves by trading in the Fed funds market.  Those long on reserves will normally lend to those short.  The annualized interest rate on interbank loans is known as the Fed funds rate, and varies with supply and demand.

The reserve requirement applies only to the bank's demand deposits, not its term or savings deposits.  Thus when a bank depositor converts funds in a demand deposit into a term or savings deposit, he frees up the reserves that were held against the demand deposit.  The bank can then use those reserves in several ways.  For example, it can hold them to back further lending, buy interest-earning Treasury securities, or lend them to other banks in the Fed funds market.

Controlling the Fed Funds Rate

The supply of reserves changes whenever base money enters or leaves the banking system.  This occurs when the Fed buys or sells securities or when the public deposits or withdraws cash from banks.  The demand for reserves changes whenever total demand deposits change, which occurs when banks increase or decrease aggregate lending.  The Fed controls the Fed funds rate by adjusting the supply of reserves to meet the demand at its target interest rate.  It does so by adding or draining reserves through its open market operations. 

The Fed funds rate effectively sets the upper limit on the cost of reserves to banks, and thus determines the interest rates that banks must charge the public for loans.  Bank interest rates influence the demand for loans, and thereby the net amount of bank lending.  That in turn determines the liquidity of the private sector, which is important in terms of aggregate demand and inflationary pressures.  The selection and control of the Fed funds rate is the key monetary policy instrument of the Fed.

The Effects of Government Spending

The Fed acts as a depository for the Treasury as well as member banks.  All government spending is paid out of the Treasury's account at the Fed.  Whenever the government spends, the Fed debits the Treasury's account and credits the Fed account of the payee’s bank.  The Treasury replenishes its Fed account with transfers from its commercial bank accounts where it deposits the receipts from taxes, and the sale of its securities.

In order to minimize variations in aggregate banking system reserves, the Treasury maintains a nearly constant balance in its Fed account.  In effect, Treasury payments are simply transfers from its commercial bank accounts to the bank accounts of the public.  Funds move in the reverse direction when the public pays taxes or buys securities from the Treasury.  The Treasury must maintain a positive balance in its commercial bank accounts to avoid having to borrow directly from the Fed.  However it has no need for, and does not accumulate, balances in excess of its near-term payment obligations. 

On average, government spending does not affect the aggregate bank deposits of the private sector.  The Treasury sells or redeems securities as required to balance its inflows against outflows.  However short-term variations occur because receipts cannot be synchronized with spending.  Banking system reserves remain essentially unaffected by government spending because the Treasury transfers funds from its commercial bank accounts to replace the funds spent out of its Fed account.