The Federal Reserve Board and the Money Supply, Part 1

The reason for spending valuable time on the Fed is that it plays an inordinate role in our lives. Interestingly, it is not so much the role that we are use to seeing in the papers. Periodically, during the year the Board of the FRS gets together and sets some policies. The one policy that everyone pays attention to is the setting of the “discount rate”. Few people know what it is discounting, but they know that it has something to do with interest rates. Everyone, it seems, wants the rate to be low.

No, the role the Fed plays in our lives has to do with money, i.e., the amount of money. The Fed is the primary source for the enormous growth in money floating around in our economy. It is my intention here to try and explain how that happens.

The Fed has been in existence since 1913. As far as I can tell, nothing significant has changed in its structure or purpose since then. It has been doing harm for 96 years nearly unchecked. To learn about its early years form a free market oriented historian, read Economics and the Public Welfare by Benjamin McAlester Anderson. It is an excellent history of the U.S. economy from before WW1 to after WW2. I picked up that book from NBI in 1969 and have had a pretty good understanding of what was happening ever since.

In this first part of my explanation I will talk about “reserves”. In part two, I explain what the Fed does with them.

Okay, reserves. This is the “reserves” in “The Federal Reserve System”. For once, here is a government name that gives you a key as to what is what. Yet, in spite of my last statement, “reserves” is also a misnomer. It is an anti-concept. It is also there to mislead you.

When you think of a reserve you think of something that is there when you need it. As these are bank reserves, you may think that this may be good because banks need reserves. They need reserves against unexpected demands for cash, changes in the economic climate, loan failures, and any number of reasons. So reserves are good, right.

However, the reserves at the Fed are not available to the bank. When a bank places their legally required reserves at the Fed that money is there to stay. The bank can’t get at it or use it. The money is actually a deposit. That is what I will call them, deposits. I think that “deposit” makes the whole thing clearer.

So, a federally chartered bank is required to deposit part of its demand deposits at the Fed. (I am not going to discuss why a bank would be federally chartered. There are benefits and requirements.) What is a “demand deposit”? “Demand deposit” is a fancy name for a checking account. Money deposited in a checking account may be demanded at any time the bank is open, without notice. As opposed, for example, to a savings account, which does require you to give notice. Yes, I know, you never have. But if you read the fine print in your savings account agreement with your bank you will see that the bank has the right to require you to give notice, at the banks discretion. So, a checking account is a demand deposit.

The federally chartered bank, which is nearly all banks, certainly all of the big banks, must place a portion of its demand deposits with the Fed. There are different percentages, depending upon the size and location of the bank, but almost all of the total dollar demand deposits in the country have the same percentage and that percentage is the only one I’ll use here. When I checked last in May, 2009, the percentage was 10%. Historically, that is pretty low.

Therefore, the Fed has about 10% of all checking account deposits in the country in its accounts. What a toy!