Monetary policy and the reserves market

The initial link between monetary policy and the economy occurs in the market for reserves. The Federal Reserve's policies influence the demand for or supply of reserves at banks and other deposi­tory institutions, and through this market, the effects of monetary policy are transmitted to the rest of the economy. Therefore, to un­derstand how monetary policy is related to the economy, one must first understand what the reserves market is and how it works.

The demand for reserves has two components: required reserves and excess reserves. All depository institutions—commercial banks, saving banks, savings and loan associations, and credit unions—must retain a percentage of certain types of deposits to be held as reserves. The reserve requirements are set by the Federal Reserve under the Depository Institutions Deregulation and Mon­etary Control Act of 1980. At the end of 1993,4,148 member bank's 6,042 non-member banks, 495 branches and agen­cies of foreign banks, 61 Edge Act and agreement corporations, and 3,238 thrift institutions were subject to reserve requirements.

Since the early 1990s, reserve requirements have been applied only to transaction deposits (basi­cally, interest-bearing and non-interest-bearing checking accounts). Required reserves are a frac­tion of such deposits; the fraction—the required reserve ratio—is set by the Board of Governors within limits prescribed by law.

Thus, total required reserves expand or contract with the level of transaction deposits and with the required reserve ratio set by the Board; in practice, however, the required reserve ratio has been ad­justed only infrequently. Depository institutions hold required re­serves in one of two forms: vault cash (cash on hand at the bank) or, more important for monetary policy, required reserve balances in accounts with the Reserve Bank for their Federal Reserve District.

Depositories use their accounts at Federal Reserve Banks not only to satisfy their reserve requirements but also to clear many financial transactions. Given the volume and unpredictability of trans­actions that clear through their accounts every day, depositories need to maintain a cushion of funds to protect themselves against debits that could leave their accounts overdrawn at the end of the day and subject to penalty. Depositories that find their required reserve balances insufficient to provide such protection may open supplemental accounts for required clearing balances. These addi­tional balances earn interest in the form of credits that can be used to defray the cost of services, such as check-clearing and wire transfers of funds and securities, that the Federal Reserve provides.

Some depository institutions choose to hold reserves even beyond those needed to meet their reserve and clearing requirements. These additional balances, which provide extra protection against overdrafts and deficiencies in required reserves, are called excess reserves; they are the second component of the demand for re­serves (a third component if required clearing balances are in­cluded). In general, depositories hold few excess reserves because these balances do not earn interest; nonetheless, the demand for these reserves can fluctuate greatly over short periods, complicat­ing the Federal Reserve's task of implementing monetary policy.

 

The ultimate targets of monetary policy

are specified in law as maximum employment,

stable prices, and moderate

long-term interest rates.

 

 

Components of the Federal Reserves Market
§ Required reserves (percentage of transaction deposits; amount influenced by reserve requirements) § Vault cash (retained on bank premises) § Required reserve balances (held at Federal Reserve Bank) § Excess reserves (held at Reserve Banks to provide additional protection against deficiencies and overdrafts)	§ Borrowed reserves (provided by the Federal Reserve through discount window lending) § Non-borrowed reserves (influenced by the Federal Reserve’s purchase or sale of securities in open market operations)

 

The students are also asked to comment on the components of the reserve market and to compare them with the ones of the reserve market of Ukraine.

 

 

V. Read the text and prepare your comments on the supply of Federal Reserves, using the given below picture.

Supply of Reserves

 

The Federal Reserve supplies reserves to the banking system in two ways:

- Lending through the Federal Reserve discount window

- Buying government securities (open market operations).

Reserves obtained through the first channel are called borrowed reserves. The Federal Reserve supplies these directly to depository institutions that are eligible to borrow through the discount win­dow. Access to such credit by banks and thrift institutions is estab­lished by rules set by the Board of Governors, and loans are made at a rate of interest—the discount rate—set by the Reserve Banks and approved by the Board. The supply of borrowed reserves de­pends on the initiative of depository institutions to borrow, though it is influenced by the level of the discount rate and by the terms and conditions for access to discount window credit.

In general, banks are expected to come to the discount window to meet liquidity needs only after drawing on all other reasonably available sources of funds, which limits considerably the use of this source of funds. Coroner, many banks fear that their use of discount window credit might become known to private market participants, even though the Federal Reserve treats the identity of such borrowers in a highly confidential manner, and that such bor­rowing might be viewed as a sign of weakness. As a consequence, the amount of reserves supplied through the discount window is generally a small portion of the total supply of reserves.

The other source of reserve supply is nonborrowed reserves. Al­though the supply of nonborrowed reserves depends on a variety of factors, many of them outside the day-to-day control of the Fed­eral Reserve, the System can exercise control over this supply through open market operations—the purchase or sale of securi­ties by the Domestic Trading Desk at the Federal Reserve Bank of New York. When the Federal Reserve buys securities in the open market, it creates reserves to pay for them, and the supply of non-borrowed reserves increases. Conversely, when it sells securities, it absorbs reserves in exchange for the securities, and the supply of nonborrowed reserves falls. In other words, the Federal Reserve adjusts the supply of nonborrowed reserves by purchasing or sell­ing securities in the open market, and the purchases are effectively paid for by additions to or subtractions from a depository institution's reserve balance at the Federal Reserve.

 

Table 1

Aggregate reserve measures