Misconceptions About US Bank Reserves

Bank reserves are a throwback to a time when the amount of receipts for money (gold) that could be issued by a bank was limited by the amount of money (gold) the bank held in reserve. Under the current monetary system bank reserves have no real meaning, since it isn’t possible for a dollar in a bank deposit to be genuinely backed by a dollar held somewhere else. The dollar can’t back itself! However, it is still important to understand what today’s bank reserves are/aren’t and how changes in the reserves quantity are linked to changes in the economy-wide money supply. Remarkably, these bank-reserve basics are misunderstood by almost everyone who comments on the topic.

The simplest way for me to deal with the common misunderstandings about bank reserves is in point form, so that’s how I’ll do it. Here goes:

1) Bank reserves aren’t money, that is, they are not considered to be general media of exchange and are not counted in the True Money Supply (TMS). Instead, they provide ‘backing’ for part of the money supply.

2) A corollary of the above is that banks can’t use their reserves to buy things outside the Federal Reserve system.

3) Banks can lend their reserves to other banks, but the banking industry as a whole cannot expand or shrink its reserves. In other words, the banking industry has no control over its collective reserves. The central bank has total control.

4) Bank reserves can be shifted around within accounts at the Fed, but the only way that reserves can leave the Fed and enter the economy is via the withdrawal, by the public, of physical currency from banks. For example, when $100 is withdrawn from an ATM, $100 is converted from deposit currency to physical currency. This doesn’t alter the money supply, but it causes the bank to lose a $100 liability (the bank customer’s deposit) and a $100 asset (the physical currency held in the bank’s vault). When the quantity of physical currency held in a bank’s vault gets too small, the bank will replenish its supply by withdrawing reserves from the Fed in the form of new paper dollars. Although it may appear that this imposes some sort of limit on the supply of physical dollars, the Fed stands ready, willing and able to meet any increase in demand. This is further discussed in point 5).

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