Monetary Policy Theory: Part 1 - Fractional Reserves

The next few posts will describe the operation of monetary policy prior to late 1980 when NOW accounts were first widely authorized. NOW accounts enabled banks to begin paying interest on demand deposits, that is, on what were essentially just checking accounts. Prior to the authorization of NOW accounts, checking accounts could not draw interest. NOW accounts were a concession to the rapid growth in money market accounts during the high-interest era of the late 1970's.

How a Fractional Reserve System Works

Under a system of fractional reserves each bank is required to hold a certain percentage of its deposit base in the form of reserves at the Federal Reserve System. For example, if the only form of deposits were checking accounts (demand deposits) and the reserve requirement was 10%, then a bank with demand deposits of $1 million would have to deposit $100,000 at the Fed in a "Required Reserve" balance.

Now assume that only demand deposits are permitted and that the reserve requirement is 10%. If total demand deposits in the system are $10 billion, then the required reserves at the Fed would have to be $1 billion. But the Fed can change the level of reserves in the system at will. All it has to do to add, say, $10 million in reserves, is purchase that dollar amount of securities from the banking system. The bank sends in the securities to the Fed and receives a $10 million increase in its reserve balance at the Fed in return. Because those reserves are not currently needed to be held against deposits they are considered "excess reserves."

And, since the bank doesn't need that additional $10 million as required reserves, it lends out the money either to a customer or by lending it in the fed funds market. As the money circulates from bank to bank, and from customer to customer, and as the economy grows, eventually the total demand deposits in the banking system will rise by $100 million and the $10 million in excess reserves would be converted to required reserves. Thus, by adding reserves to the banking system, the Fed will have allowed the overall banking system (and perhaps the economy) to grow. This is known as a Fed easing.

Effecting a Tightening

To reverse the process, perhaps to cool off an overheating economy or to suppress a rising inflation rate, the Fed withdraws required reserves from the banking system. It does this by selling securities from its portfolio to a bank in the system. Say the Fed wants to reverse the above action. It then sells $10 million of it securities to a bank in the system. The bank takes in the securities and to pay for them has its balance of required reserves at the Fed reduced by $10 million.

Now the banking system has a deficit of required reserves. If the Fed refuses to accommodate that deficit, interest rates will tend to rise and banks will make less loans because they are scrambling for reserves. Ultimately, the deposits in the banking system will diminish to the point where the lower level of reserves is sufficient to meet the reserve requirement.

In theory, this is how a fractional reserve system is supposed to work. That is, to keep the money supply, and consequently the price level of goods and services, stable, the Fed simply provides a constant level of reserves.

Complications

The first complication is that all deposits aren't demand deposits. In fact, savings deposits used to be commonly called time deposits to distinguish them from demand deposits. Each holder of a savings account received clear notification when opening an account that the money couldn't necessarily be withdrawn on less than a few day's notice. Demand deposits, in contrast, could be withdrawn (demanded) immediately.

Because time deposits were judged to be a more stable component of the deposit base of any bank, the Fed set a lower reserve requirement on them. In our present example, let's say that's only 2%. When interest rates were low as was the case for most of the Fed's existence up until the late 1970's, savings balances did remain quite stable, growing along with the economy and not reacting to the level of interest rates.

Once interest rates started rising significantly in the 1970's people started looking for ways to maximize the income on their checking balances. Mutual funds began offering Money Market Funds to people in response. In the beginning, they only permitted the withdrawal of relatively large sums at one time, say $500 or $1,000, so that people wouldn't use them in place of their traditional checking accounts.

However, in time the banks managed to convince the regulators to let them compete with money market funds. That led to the introduction of NOW accounts which were essentially interest-bearing checking accounts with some modest restrictions. Once they came onto the scene most people converted their checking accounts to NOW accounts and many blended both their checking and savings accounts into one NOW account instead.

The Problem Posed by Differing Reserve Requirements

Because NOW accounts were really a blend of demand deposits and savings (time) deposits, they more or less destroyed the fractional reserve system in place until that time because of the differing reserve requirements on demand deposits and savings deposits. Suddenly savings deposits weren't stable anymore. Instead they were mixed in with interest-bearing checking accounts. Furthermore, as will be discussed later in more detail, checking accounts (demand deposits) were no longer minimized by their holders since they now earned interest. That, as will be covered in the next post, had major negative implications for monetary policy as it had been conducted up to that time.

The next post will discuss the period between WWII and the introduction of NOW accounts and will describe how the Fed once had a monetary tool that worked exceptionally well, but let it slip out of their grasp with the introduction of NOW accounts because they never actually understood how it worked. In fact, if they had understood, NOW accounts would never have been authorized and money market funds would have had their usage in daily transactions restricted.

Continue to Monetary Policy: Part 2 - The Stable Decades