The Federal Reserve

Most of you probably aren’t interested but for those of you who are, here’s a self-description of the operations of the Federal Reserve. The booklet is now out of print but through the wonders of the Internet it’s available online. Here’s a snippet:

Suppose the Federal Reserve System, through its trading desk at the Federal Reserve Bank of New York, buys $10,000 of Treasury bills from a dealer in U. S. government securities.(3) In today’s world of computerized financial transactions, the Federal Reserve Bank pays for the securities with an “telectronic” check drawn on itself.(4) Via its “Fedwire” transfer network, the Federal Reserve notifies the dealer’s designated bank (Bank A) that payment for the securities should be credited to (deposited in) the dealer’s account at Bank A. At the same time, Bank A’s reserve account at the Federal Reserve is credited for the amount of the securities purchase. The Federal Reserve System has added $10,000 of securities to its assets, which it has paid for, in effect, by creating a liability on itself in the form of bank reserve balances. These reserves on Bank A’s books are matched by $10,000 of the dealer’s deposits that did not exist before. See illustration 1.
How the Multiple Expansion Process Works

If the process ended here, there would be no “multiple” expansion, i.e., deposits and bank reserves would have changed by the same amount. However, banks are required to maintain reserves equal to only a fraction of their deposits. Reserves in excess of this amount may be used to increase earning assets – loans and investments.

The emphasis is mine.

For large banks the reserve requirement is 10%. Since 2008 the Federal Reserve has been paying interest on both required and excess reserves. The rate isn’t enormous but the total reserves are so huge that the interest paid amounts to quite a sum. The interest that the Fed is paying the member banks can be held in the form of reserves, used to increase earning assets, i.e. loans and investments, or they can be paid out in the form of dividends, bonuses, or wages. This should give you some idea of the quantities involved. As you can see, most of the reserves retained are excess reserves.

Paying interest on reserves means that for it to make financial sense for banks to make loans or investments the return on the earning assets much be greater than what’s being paid by the Fed in interest, commensurate with risk. Presumably, the reason for the Fed’s relatively new policy is to discourage banks from taking excessive risks.