I flushed my brain of all I thought I knew about our money, now I just need help plz!

[gonegolfin]

Thank you much!

You are welcome.

Your last couple posts helped out quite a bit. Now I'm up to about 10% certainty with what I think I know about economics. It's pretty bad when I knew I didn't know much to begin with, but then I ask about the stuff I thought I knew and it turns out that that wasn't even right.

So just to be sure, the banks - via interest on loans - are pretty much the only direct creators of inflation.

You are leaving out the money that is borrowed into existence when the banks lend.

And smokey is absolutely correct (and provides an elegant explanation). Banks technically do not create the inflation. The result of the lending (from the perspective of the bank) or the borrowing (from the perspective of the borrower) creates the inflation.

However, there is one thing that is missing. Expansion of the money supply also happens when the banks take excess reserves and invest. For example, a bank can take some of its excess reserves and purchase treasuries in a Treasury auction or treasuries in the open market. This would result in an expansion of the money supply (inflation).

The Fed, however, provides the fuel for how much inflation occurs. Is this about right? You know what, please just say yes even if it's not. lol

Yes, the Fed provides the fuel (reserve expansion) for the expansion of credit. The fuel is the monetary base. However, as I noted previously, there are some rare instances where Fed purchases actually increase the money supply. They just do not happen often.

Brian

 

[smokey]

However, there is one thing that is missing. Expansion of the money supply also happens when the banks take excess reserves and invest. For example, a bank can take some of its excess reserves and purchase treasuries in a Treasury auction or treasuries in the open market. This would result in an expansion of the money supply (inflation).

Brian

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We may have a different definition of reserves.

This is how I understand it:

Banks invest deposits in securities (mostly US treasuries) in order to gain income from liabilities not needed by depositors. Reserves are the portion of checkable deposits not invested, but held in order to fund withdrawals by customers and payments to other banks.

Some central banks require that banks hold a certain percentage of deposits in reserve for these daily transactions. In the Fed system it is 10% for banks having over $43.9 million in checkable deposits. Excess reserves are the bank reserves held over the required ratio.

Therefore excess reserves used to invest in securities like US treasuries do not add to the money supply since they come from demand deposits.

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[smokey]

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When banks sell treasuries to the Fed, the money supply increases. However since they bought the treasuries, the net effect on the money supply would only be the difference between the buy/sell price.

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[gonegolfin]

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We may have a different definition of reserves.

This is how I understand it:

Banks invest deposits in securities (mostly US treasuries) in order to gain income from liabilities not needed by depositors. Reserves are the portion of checkable deposits not invested, but held in order to fund withdrawals by customers and payments to other banks.

Some Central Banks require that banks hold a certain percentage of deposits in reserve for these daily transactions. In the Fed system it is 10% for banks having over $43.9 million in checkable deposits. Excess reserves are the bank reserves held over the required ratio.

Therefore excess reserves used to invest in securities like US treasuries do not add to the money supply since they come from demand deposits.

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Reserves are not created by deposits. They are created by the Federal Reserve. When a deposit is made to a bank, that particular bank's reserves increase. But the aggregate amount of reserves in the system does not change. Correspondingly, the Fed (and only the Fed) can also drain reserves from the system.

It is important to remember that the banking system does not create reserves.

Thus, when the Fed creates reserves (such as when it purchases securities in the secondary market), the reserve account of the primary dealer (the seller of the securities) is credited with the correct amount of reserves (amount of purchase). This increases the amount of aggregate reserves in the system. However, the money supply has not increased, only the monetary base. The bank could then choose to invest (in lieu of lending off of its increased reserves) any excess reserves in securities. This will result in a deposit somewhere (a Treasury deposit in a bank if treasury securities are purchased) which will increase the money supply.

Brian

 

[smokey]

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This is a good discussion, Brian.

Some web definitions of bank reserves:

Bank deposits allocated for a specific purpose. Legal Reserves are funds that banks maintain in a noninterest earning account at a Federal Reserve Bank or at a correspondent bank, plus vault cash, to meet their Reserve Requirements.

(That one is not quite accurate since the Fed now pays interest for reserves held at their banks.)

The cash and deposits that a bank is required to keep at a central bank to meet the required reserve ratio.

The following is the most thorough explanation:

Term bank reserves.... Definition:

The "money" that banks use to conduct day-to-day business, including cashing checks, satisfying customers's withdrawals, and clearing checks between accounts at different banks. The "money" in question includes vault cash and Federal Reserve deposits. Specifically, vault cash is the paper money and coins that a bank keeps on the bank premises (both in the vault and in teller drawers), which is used to "cash" checks and otherwise provide the funds that customers withdraw. Federal Reserve deposits are accounts that banks keep with the Federal Reserve System, which are used to process, in a systematic, centralized fashion, the millions of checks written each day by customers of one bank that are deposited by customers of another bank. Using these deposits, the Fed acts as a central clearing house for checks, being able to simultaneously debit the account of one bank and credit the account of another. More on the importance of bank reserves can be found under fractional-reserve banking.

LINK

If I was a bank and there were hundreds of customers depositing cash in my bank every day, why would I need to obtain reserves from the Fed in order to fund day-to-day transactions?

Remember the goldsmiths who originated the fractional reserve banking system. They kept a fraction of the gold that was deposited in order to fund withdrawals from their customers. That fraction of the gold deposited was called "reserves".

Therefore as smokey understands it:

Reserves are the portion of deposits not used to invest but which are held in order to fund withdrawals from customers and payment demands from other banks.

When the system does not have enough reserves to fund operations; or when the Fed wants to lower the interest rate charged by the market, it adds reserves by purchasing securities from the public.

And when there is an overabundance of reserves in the system, or the Fed wants to raise the rate, they sell securities thereby extracting reserves from the system and decreasing the supply.

So the Fed can adjust the amount of reserves in the system in order to obtain its objectives, but the reserves themselves are the products of credit demanded from the economy and deposited in the banks.

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[smokey]

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To state this more clearly:

New credit increases deposits in the system which increases the demand for reserves regardless of the reserve requirement.

In order to prevent this new demand from putting upward pressure on the overnight Fed funds rate, the Fed must add reserves to the system by purchasing securities from the public.

Therefore Brian is correct. Since all deposits in the system originated from credit, the Fed has created all the reserves in the system.

Within one bank however, reserves can be created by selling securities to the market or by borrowing them from other banks or the Fed itself.

Excess reserves can be used to purchase securities in the market. This can increase the money supply if the securities are not sold by a depository institution. In that case the funds stay in the monetary base.

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[gonegolfin]

Yes, we are in sync on the definitions you cited. There are also what are called "Contractual Clearing Balances" (optional to the member banks), which are in addition to Required Reserves (RR) and any Excess Reserves (ER). But these are good definitions and are entirely useful in this discussion.

If I was a bank and there were hundreds of customers depositing cash in my bank every day, why would I need to obtain reserves from the Fed in order to fund day-to-day transactions?

I assume that this was a rhetorical question setting up your discussion below.

Therefore as smokey understands it:

Reserves are the portion of deposits not used to invest but which are held in order to fund withdrawals from customers and payment demands from other banks.

More specifically, Required Reserves (RR), yes. Not Excess Reserves (ER).

When the system does not have enough reserves to fund operations; or when the Fed wants to lower the interest rate charged by the market, it adds reserves by purchasing securities from the public.

Yes ... and as we are now seeing ... when the Fed wishes to keep the banks solvent (and attempt to recapitalize them), while at the same time prevent the flood of newly created reserves from entering the money supply by paying interest on excess reserves (a form of sterilization). In other words, attempting to save the banking system without causing inflation.

And when there is an overabundance of reserves in the system, or the Fed wants to raise the rate, they sell securities thereby extracting reserves from the system and decreasing the supply.

Yes.

I should also note that with the proposed issuance of Fed interest bearing debt, if implemented this will also be a mechanism by which they Fed can drain reserves. So, this is another form of sterilization in addition to the paying of interest on excess reserves.

So the Fed can adjust the amount of reserves in the system in order to obtain its objectives, but the reserves themselves are the products of credit demanded from the economy and deposited in the banks.

In normal times, yes. But as we are seeing (and I explained above), the Fed is creating reserves that are not the products of credit demanded from the economy (in this insolvency crisis).

Brian

 

[gonegolfin]

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To state this more clearly:

New credit increases deposits in the system which increases the demand for reserves regardless of the reserve requirement.

In order to prevent this new demand from putting upward pressure on the overnight Fed funds rate, the Fed must add reserves to the system by purchasing securities from the public.

Not the public, but the banks. The Fed typically does this in the form of "temporary open market operations" (TOMOs). Permanent or Outright operations are much more rare. Although this year, they are becoming more commonplace. Especially when the Fed was sterilizing the effects of some of its liquidity injections programs (Ex. TAF) by selling treasuries from its SOMA portfolio.

Therefore Brian is correct. Since all deposits in the system originated from credit, the Fed has created all the reserves in the system.

Within one bank however, reserves can be created by selling securities to the market or by borrowing them from other banks or the Fed itself.

Excess reserves can be used to purchase securities in the market. This can increase the money supply if the securities are not sold by a depository institution. In that case the funds stay in the monetary base.

Yes, they remain as reserves.

Brian

 

[smokey]

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Great responses, Brian.

I think tggroo7 got his money's worth on this thread.

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[gonegolfin]

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Great responses, Brian.

I think tggroo7 got his money's worth on this thread.

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Thanks. I hope we did not chase him off.

Brian