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What Happened
to the Money?

In April 1992 the Fed lowered the required reserve ratio on demand deposits from 12% to 10%.  According to textbook theory, that would have freed up enough bank reserves for lending and resulted in a 20% increase in demand deposits.  What actually happened?

First the facts

Here are the monthly average figures for the period January through June 1992, copied from the Fed Board of Governors website.  All dollars are in billions, and non-seasonally adjusted. 

Checkable Deposits
Fed Funds Rate 
Jan 55.8 0.99 550.2 4.03%
Feb 55.2 1.05 546.3 4.06%
Mar 56.3 1.03 556.2 3.98%
Apr 50.5 1.13 574.5 3.73%
May 48.8 1.00 563.5 3.82%
Jun 49.5 0.92 568.6 3.76%
Note the changes between March and April.  It is apparent that the Fed funds target rate was lowered from 4.0% to 3.75% at the same time the reserve ratio was lowered.  The Fed stated that it was encouraging banks to increase their lending. 

The drop in the required reserves ratio should have converted about 2% of the total reserves of $56B, or $1.1B, into excess reserves.  According to the money multiplier, that excess should have resulted in an increase of about $11B in demand deposits.  At first blush that is just about what appears to have happened.  But why did total reserves drop by nearly $6B at the same time? 

Adjusting the Reserves

While the Fed was giving with one hand, it was taking away with the other.  The Fed funds rate (FFR), the overnight lending rate between banks, is a money market rate that the Fed steers towards its target through its control of excess reserves. 

Had the Fed allowed excess reserves to double when it lowered the required reserve ratio, the FFR would have collapsed.  In order to avoid this the Fed sold from its stock of Treasury securities enough to soak up most of the new excess reserves.  This converted what would have been additional excess bank reserves into securities and explains why total reserves dropped by about $6B. 

No Surge in the Money Supply

Demand deposits show the typical seasonal variation, with the usual peak in the tax month of April.  A part of the monthly increase in total reserves and demand deposits is due to the upward trend of a growing economy.  During the previous year, 1991, the average growth rate of total reserves was $0.4B per month, and of demand deposits was $1.9B per month. 

The secular growth rate in demand deposits over the whole six month period shown is just about what would be expected based on the prior year data.  Some part of that growth can also be attributed to the lowering of the Fed funds rate.  Taking these factors into account, there is no evidence of a surge in the money supply as would be expected from the money multiplier effect. 

The lesson here is that the textbook money multiplier has no real explanatory power.  It is merely an after-the-fact observation of the multiple.  The important point is that the money supply increases as a function of demand.  Demand in turn depends on many things, only one of which is the price of money as set by the Fed. 

Why the Fed Changed the Reserve Requirement

The reason the Fed lowered the reserve ratio requirement in 1992 was more than its announced desire to increase bank lending.  It was mainly to improve the financial health and the competitive position of U.S. banks. 

Reserves earn no interest and thus are a drag on bank earnings.  Large banks in particular were not in good shape.  They were still digging out of their bad loans of the 1980s, and were losing the competition with foreign banks, most of which have no reserve requirements.  With the lowered reserve ratio and the further lowering of the FFR, to 3.25% in July and 3.0% in October 1992, the Fed gave a very strong boost to the earnings of banks, for which they can thank the Fed Chairman, Alan Greenspan.

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