Money Mechanics

Money Mechanics

Chapter 4

Banks accept deposits and withdrawals from customers. However, withdrawals by customers rarely surpass the amount the banks receive as deposits. A bank is, therefore, left with a small inventory of cash to operate with. This is what is referred to as the bank's cash reserves. Most of the deposits made into banks are deposited into the Federal Reserve. They form reserve deposits. The total of a bank's cash reserve and its reserve deposit balance is referred to as the bank's primary reserve. Each bank is mandated by law to preserve a certain minimum quantity of its primary reserves.

The minimum primary reserve percentage as set by banking regulations is known as reserve requirement, while the amount is required reserve. A small fraction of the amount is set aside as vault cash while the rest is deposited in the Federal Reserve Banks (Feinman, p570). It is common practice for banks to hold more than the minimum required amounts. This is accomplished by increasing the bank's primary reserve and an additional amount called a working reserve.

The significance of the working reserve is brought into play when a bank experiences more withdrawals than deposits (net withdrawals). When this happens, the bank is forced to pay out one more dollar than it has received from its customers. Since banks can't use their customers' money to mitigate net withdrawals, the extra dollar has to be raised from the working reserve.

Banks are also profit-making institutions; so, they have to generate revenue to cover their expenses and make profits. They do this by levying fees for the banking services and majorly by putting up excess reserves. This is the excess of both required reserve and desired working reserve. A small portion of the excess reserves is used to buy US Treasury securities which are safe and generate revenues. This is known as secondary reserve and it acts as a backup to primary reserves. The amount of money that remains after the purchase of secondary reserves is used to create loans for customers.

It is interesting to note that banks create money by giving out loans. This is because the amount of the loan is drawn from the bank's excess reserves and loaded into the borrower's account. This amount remains with the bank as the borrower will not immediately withdraw all of it at once. Therefore, increased bank lending leads to a corresponding increase in money supply.

Banks have to be able to acquire excess reserves if they hope to give out loans. This can be achieved by maintaining a certain percentage of the net deposits, which would yield excess reserves. The bank can then use excess reserves to create new money by extending loans to their clients.

However, banks may be forced to cut back on their loaning ventures. This happens when a bank's excess reserves dwindle. A decline in a bank's excess reserves may be precipitated by a number of factors. They include Federal Reserve open market sale of Treasury security holdings and increases in bank reserve requirements. Other contributing factors are net cash withdrawals by a bank's clients and a major decision by banks to operate with a larger working or secondary reserves.

Chapter 5

The Federal Reserve System adopts three major ways of controlling the nation's money supply. These are the open market operations, reserve requirements adjustments and discount rate alterations.

The Federal Reserve System employs the open market operations to create and break bank reserves as a way of controlling the size of banks reserves (FRB, p862). This is achieved by purchasing and selling outstanding Treasury securities in the nation's open public securities markets. The exercise is supervised by the Federal Open Market Committee, and which is required to meet at least four times every year. The aim of the meetings is to formulate a proper directive for open market operations. The directive is communicated to the Manager of Systems Open Market Account based at the Federal Reserve Bank of New York.

Secondly, reserve requirement adjustments present another tool for controlling bank reserves. Subject to this requirements are the transaction accounts, otherwise referred to as checking accounts. As of 2011, the reserve requirements for each bank are: 0% of the bank's first $10.7 million in total customer checking account balances, 3% of total customer checking account balances exceeding $10.7 million but less than but including $58.8 million, 10% (but which is adjustable) of total customer transaction account balances in excess of $58.8 million, and 0% for the bank's total customer non-personal time deposits. This structure was created by Congress and is administered by the Federal Reserve (FRB, p570).

Thirdly, there are the discount rate alterations. When a banks excess reserves fall below the minimum required by an amount equaling 90% of the net withdrawals, a need for borrowing sufficient reserves arises. The affected bank may approach the federal funds market or the Federal Reserve System. Financially sound banks receive a primary credit discount rate. Banks wallowing in financial quagmires are offered a secondary credit discount rate, which is one half of a percentage point. Other banks need seasonal financial help. Such banks are treated to a seasonal credit rate.

A combination of the three strategies used to regulate the amount of bank reserves creates what is known as the monetary policy. The purpose of a monetary policy is to control levels of interest rates, prices, employment and output. Its goals are specified in the Federal Reserve Act. Monetary policies are usually restrictive as they control the growth of money supply.

A monetary policy is needed to underwrite economic growth. In this regard, an easing of policy efforts is required in order to enhance the free flow of huge amounts of money that underline economic growth. This is done by using one or more open market purchases, cutting back on reserve requirements, and a reduction in discount rates. The policy efforts may increase banks' excess reserves; however, there are other factors that may affect the growth of these reserves. Therefore, the Fed should monitor the results of its policy implementation and make adjustments whenever necessary. Otherwise, a tightening of a monetary policy may be necessary. This could be accomplished by increasing the open market sales, reserve requirements and discount rates.

Chapter 6

Banks play a crucial role in the distribution of money. This is known financial intermediation. In the process of intermediation, banks encounter three groups of people or institutions. These are: those