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Modern Money Mechanics. The purpose of this booklet is to desmmbe the basic process of money creation in a ~actional reserve" bank- ing system. l7ze. MODERN MONEY MECHANICS. A Workbook on Bank Reserves and Deposit Expansion. Federal Reserve Bank of Chicago. This complete booklet is was. Modern Money Mechanics is a publication written by the Federal Reserve Bank of Chicago to explain how the Fed works (or doesn't as the case may be).

Modern Money Mechanics Pdf

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The text of this work needs to be migrated to Index:Modern Money yazik.info . If you would like to help, please see Help:Match and Split. Abstract: In this article, the issues of organization of currency circulation in the United States of America are studied as an example. "Modern Money Mechanics" was a booklet published and distributed by the Federal Reserve Bank of Chicago, originally written by Dorothy M.

At the end of every day, a commercial bank will have to examine the status of their reserve accounts.

Those that are in deficit have the option of borrowing the required funds from the central bank, where they may be charged a lending rate sometimes known as a discount rate on the amount they borrow.

On the other hand, the banks that have excess reserves can simply leave them with the central bank and earn a support rate from the central bank. Some countries, such as Japan , have a support rate of zero. The surplus banks will want to earn a higher rate than the support rate that the central bank pays on reserves; whereas the deficit banks will want to pay a lower interest rate than the discount rate the central bank charges for borrowing. Thus they will lend to each other until each bank has reached their reserve requirement.

In a balanced system, where there are just enough total reserves for all the banks to meet requirements, the short-term interbank lending rate will be in between the support rate and the discount rate.

If on a particular day, the government spends more than it taxes, reserves have been added to the banking system see vertical transactions. This will typically lead to a system-wide surplus of reserves, with competition between banks seeking to lend their excess reserves forcing the short-term interest rate down to the support rate or alternately, to zero if a support rate is not in place.

At this point banks will simply keep their reserve surplus with their central bank and earn the support rate. In this case, there may be a system-wide deficit of reserves. As a result, surplus funds will be in demand on the interbank market, and thus the short-term interest rate will rise towards the discount rate.

Thus, if the central bank wants to maintain a target interest rate somewhere between the support rate and the discount rate, it must manage the liquidity in the system to ensure that the correct amount of reserves is on hand in the banking system.

On a day where there are excess reserves in the banking system, the central bank sells bonds and therefore removes reserves from the banking system, as private individuals pay for the bonds. On a day where there are not enough reserves in the system, the central bank downloads government bonds from the private sector, and therefore adds reserves to the banking system.

It is important to note that the central bank downloads bonds by simply creating money — it is not financed in any way. If a central bank is to maintain a target interest rate, then it must necessarily download and sell government bonds on the open market in order to maintain the correct amount of reserves in the system. Federal Reserve total assets, treasuries, and mortgages Proponents of MMT claim that it provides a better framework for understanding quantitative easing QE than the traditional textbook money multiplier model.

Modern Money Mechanics

Paul Sheard argues that, when the central bank downloads government debt securities as opposed to private sector risk assets, QE is best viewed as a debt refinancing operation of the consolidated government. Sheard argues that QE can be seen as the third stage in this process, turning the government debt securities back into reserves. The unwinding of QE just reverses this yet again. MMT economists regard the concept of the money multiplier , where a bank is completely constrained in lending through the deposits it holds and its capital requirement, as misleading.

According to MMT, bank credit should be regarded as a "leverage" of the monetary base and should not be regarded as increasing the net financial assets held by an economy: only the government or central bank is able to issue high-powered money with no corresponding liability. Exports, on the other hand, are an economic cost to the exporting nation because it is losing real goods that it could have consumed.

Cheap imports may also cause the failure of local firms providing similar goods at higher prices, and hence unemployment but MMT commentators label that consideration as a subjective value-based one, rather than an economic-based one: it is up to a nation to decide whether it values the benefit of cheaper imports more than it values employment in a particular industry. In this case the only way the government can sustainably repay its foreign debt is to ensure that its currency is continually in high demand by foreigners over the period that it wishes to repay the debt — an exchange rate collapse would potentially multiply the debt many times over asymptotically, making it impossible to repay.

In that case, the government can default, or attempt to shift to an export-led strategy or raise interest rates to attract foreign investment in the currency. Either one has a negative effect on the economy.

In mainstream economics, monetary policy i. Kelton claims that cutting interest rates is ineffective in a slump, because businesses expecting weak profits and few customers will not invest at even very low interest rates.

Modern Money Mechanics

Government interest expenses are proportional to interest rates, so raising rates is a form of stimulus it increases the budget deficit and injects money into the private sector, other things equal , while cutting rates is a form of austerity. Achieving full employment can be administered via a federally funded job guarantee , which acts as an automatic stabilizer.

When private sector jobs are plentiful, the government spending on guaranteed jobs is lower, and vice versa. Under MMT, expansionary fiscal policy i. In mainstream economics, expansionary fiscal policy i. Harvey explained several of the premises of MMT and their policy implications in March The private sector treats labor as a cost to be minimized, so it cannot be expected to achieve full employment without government creating jobs as well, such as through a job guarantee.

The public sector's deficit is the private sector's surplus and vice-versa, by accounting identity, a reason why private sector debt increased during the Clinton-era budget surpluses. Idle resources mainly labor can be activated by money creation.

Not acting to do so is immoral. Demand can be insensitive to interest rate changes, so a key mainstream assumption, that lower interest rates lead to higher demand, is questionable. Banks may increase the balances in If deposit money can be created so easily, what is to their reserve accounts by depositing checks and proceeds prevent banks from making too much -more than sufti- from electronic funds transfers as well as currency.

Or cient to keep the nation's productive resources fully em- they may draw down these balances by writing checks on ployed without price inflation?

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Like its predecessor, the them or by authorizing a debit to them in payment for modem bank must keep available,to make payment on currency, customers' checks, or other funds transfers. The bank must be prepared balances, each bank must maintain, on the average for the to convert deposit money into currency for those deposi- relevant reserve maintenance period, reserve balances at tors who request currency.

It must make remittance on the Reserve Bank and vault cash which together are equal checks written by depositors and presented for payment to its required reserves, as determined by the amount of by other banks settle adverse clearings.

Finally, it must its deposits in the reserve computation period. Increases or decreases in bank reserves can result The public's demand for currency varies greatly, but from a number of factors discussed later in this booklet. The effects on bank funds of these variations in the essential point is that the reserves of banks are, for the amount of currency held by the public usually are offset by most part, W i t i e s of the Federal Reserve Banks, and net the central bank, which replaces the reserves absorbed by changes in them are largely determined by actions of the currency withdrawals from banks.

Oust how this is done Federal Reserve System. Thus, the Federal Reserve, will be explained later. For all banks taken together, there through its abiity to vary both the total volume of reserves is no net drain of funds through clearings. A check drawn and the required ratio of reserves to deposit liabilities, on one bank normally will be deposited to the credit of influences banks' decisions with respect to their assets and another account, if not in the same bank, then in some deposits.

One of the major responsibilities of the Federal other bank. Reserve System is to provide the total amount of reserves consistent with the monetary needs of the economy at These operating needs influence the minimum reasonably stable prices. Such actions take into consider- amount of reserves an individual bank will hold voluntarily.

Such expansion cannot The reader should be mindful that deposits and continue beyond the point where the amount of reserves reserves tend to expand simultaneouslyand that the Fed- that all banks have is just sufficient to satisfy legal require- eral Reserve's control often is exerted through the market- ments under our "fractional reserve" system.

For example, place as individualbanks find it either cheaper or more if reserves of 20 percent were required, deposits could expensive to obtain their required reserves, depending on expand only until they were five times as large as reserves.

The lower the percentage requirement, the greater While an individual bank can obtain reserves by the deposit expansion that can be supported by each addi- bidding them away from other banks, this cannot be done tional reserve dollar.

Thus, the legal reserve ratio together by the banking system as a whole. Except for reserves with the dollar amount of bank reserves are the factors that borrowed temporarily from the Federal Reserve's discount set the upper limit to money creation.

What Are Bank Reserves? Moreover, a given increase in bank reserves is not Currency held in bank vaults may be counted as necessarily accompanied by an expansion in money equal legal reserves as well as deposits reserve balances at the to the theoretical potential based on the required ratio of Federal Reserve Banks.

Both are equally acceptable in reserves to deposits. What happens to the quantity of satisfaction of reserve requirements. A bank can always obtain reserve balances by sending currency to its Reserve Bank and can obtain currency by drawing on its reserve balance.

Because either can be used to support a much ZPartof an individual bank's reserve account may represent its reserve larger volume of deposit liabilities of banks, currency in balance used to meet its reserve requirements while another part may be its required clearing balance on which earnings credits are generated to circulation and reserve balances together are often refer- pay for Federal Reserve Bank services.

A number of slippages may occur.


What amount of resmes will be drained into the public's currency holdings? To what extent will the increase in total reserves remain unused as excess reserves? How much will be absorbed by deposits or other liabiities not defined as money but against which banks might also have to hold reserves? How sensitive are the banks to policy actions of the central bank? The significance of these questions will be discussed later in this booklet.

The an- swers indicate why changes in the money supply may be different than expected or may respond to policy action only after considemble time has elapsed. In the succeeding pages, the effects of various trans- actions on the quantity of money are described and illus- trated. The basic working tool is the T account, which provides a simple means of tracing, step by step, the effects of these transactions on both the asset and liabity sides of bank balance sheets.

Changes in asset items are entered on the left half of the T and changes in liabiities on the right half. For any one transaction, of course, there must be at least two entries in order to maintain the equality of assets and liabiities. The important fact is that these deposits do not tives. One way the central bank can initiate such an expan- disappear.

They are in some deposit accounts at all times.

Such that they did not have before. However, they are not downloads and sales are called "open market operations.

All they need to retain, under a 10 percent and deposits? Of pays for the securitieswith an "electronic" check drawn course, they do not really pay out loans from the money on itself! Via its "Fedwire" transfer network, the Federal they receive as deposits. If they did this, no additional Reserve notifies the dealer's designated bank Bank A money would be created.

What they do when they make that payment for the securities should be credited to de- loans is to accept promissory notes in exchange for credits posited in the dealer's account at Bank A At the same to the borrowers' transaction accounts. Reserves are is credited for the amount of the securities download. See illustration 3. See illustration 1. How the Multiple Expansion Process Works If the process ended here, there would be no "multi- ple" expansion, i.

Reserves in excess of this amount may be used to increase earning assets -loans and investments. Unused or excess reserves earn no interest Under current regulations,the reserve requirement against most transac- tion accounts is 10 percent5 Assuming, for simplicity,a uniform 10 percent reserve requirement against all transac- tion deposits, and further assuming that all banks attempt to remain fully invested, we can now trace the process of 3Dollar amounts used in the various illustrations do not necessarily bear any resemblanceto actual transactions.

For example,open market opera- expansion in deposits which can take place on the basis of tions typically are conducted with many dealers and in amounts totaling the additional reserves provided by the Federal Reserve several billion dollars. System's download of U. Apart from the timing of posting, the accounting entries are the same whether a transfer is made with a paper check or electronically.

The Bank A, depending on what the dealer does with the mon- term "check,"therefore, is used for both types of transfers. The low tem's open market download.

The Garn-St Germain Act of further modiied these requirements by received them. Like the low reserve tranche, the exemptlevel is adjusted eachyear to reflectgrowth in reservable liabilities. This happens because the seller of the securities receives payment through a credit to a designated deposit account at a bank Bank A which the Federal Reserve effects by crediting the reserve account of Bank A Assets Liabilities Assets Liabilities U.

Total reserves gained from new deposits Loans are made by Assets Liabilities crediting the borrower's deposit account, i. Loan expansion the banks rise by an amount equal to the excess reserves will be less by the amount of the initial injection.

The multi- existing before any loans were made 90 percent of the ple expansion is possible because the banks as a group initial deposit increase. See illustration 4. See illustration 5. Suppose that the demand for loans at The lending banks, however, do not expect to retain some Stage 1banks is slack These banks would then the deposits they create through their loan operations. If the sellers of the securities Borrowers write checks that probably will be deposited in were customers, the banks would make payment by credit- other banks.Usually you need to give something up in return.

When private sector jobs are plentiful, the government spending on guaranteed jobs is lower, and vice versa. System's download of U. For Juror's, Sheriff's, Bailiff's, and Justice's. Most academic texts teach that money is created first by someone making a deposit and then the bank waits for someone to come along and borrow it.

Others, however, hold money for longer periods. The unwinding of QE just reverses this yet again. This work begins with a mini-treatment of money and banking theory, and then plunges right in with the real history of the Federal Reserve System. A job guarantee program could also be considered an automatic stabilizer to the economy, expanding when private sector activity cools down and shrinking in size when private sector activity heats up.