We have a two tiered monetary system, where one type of money is used when transacting with the Fed and between commercial banks (reserves), and another type of money is use when transacting with everyone else (bank deposits). This note explains the two types of money, and how they interact with each other.
Reserves are an unsecured liability of the Fed that can only be held by entities with an account at the Fed. Think of it as a checking account at the Fed, except that deposits in the account can only be used to pay entities who also have a checking account at the Fed. Broadly speaking, only depository institutions like commercial banks or credit unions are eligible to have accounts at the Fed. But there are also other notable entities such as the U.S. Treasury, GSEs like Fannie Mae, and clearing houses like the CME. When these entities make payments to each other, they pay in reserves.
Since reserves can only be sent to entities who also have a Fed account, the total level of reserves in the financial system cannot be changed by account holders. Reserves can never leave the Fed’s balance sheet and are simply shifted from one Fed account to another on the Fed’s balance sheet. It is a closed system. The total level of reserves is determined by Fed actions, which create or destroy reserves. Reserves are created when the Fed expands its balance sheet by buying assets, and extinguished when those assets are repaid. One exception to this is that reserves can be converted to currency at the request of commercial banks. If a commercial bank needs $1 million in currency, it calls the Fed, who then sends an armored truck carrying $1 million in currency to the commercial bank. The Fed then deducts $1 million in reserves from the commercial bank’s Fed account.
Bank deposits are an unsecured liability of a commercial bank that can be held by anyone with an account at the commercial bank. Bank deposits are what constitute the vast majority of what people think of as “money.” When you logon to your online bank account, you are simply seeing how many bank deposits you have—how much your bank owes you.
Bank deposits are created when a commercial bank purchases assets or creates loans. When a bank makes a $1 million dollar to you, it is simply adding $1 million to your bank account. A commercial bank does not lend out bank deposits, it creates bank deposits. That being said, the commercial bank has to make sure its deposits are backed by sound loans and that it has enough liquidity to meet payments to other commercial banks.
Each commercial bank creates its own bank deposits, but depositors are able to transfer deposits from one bank to another. While the aggregate level of commercial bank deposits is determined by the collective actions of commercial banks, each individual commercial bank can lose or gain bank deposits as its customers make or receive payments. For example, if you take your $1 million on deposit and pay a contractor who banks at another bank then your bank will experience a deposit outflow of $1 million.
Although you are paying your contractor, behind the scenes your bank is paying your contractor’s bank. Payments between banks are settled in reserves, which are a risk free (Fed cannot default on reserves, but commercial banks can default on their deposits). Both commercial banks have accounts at the Fed, so your bank will wire $1 million in reserves to the contractor’s bank. If your bank doesn’t have enough reserves to settle the payment, it can go borrow the reserves.
Interaction Between the Two Tiers: Quantitative Easing
I will use quantitative easing as an example of how the two tiers of money interact. In quantitative easing the Fed purchases Treasury securities from an investor (via a primary dealer, which I will omit for simplification) and pays for the securities with reserves it creates.
Although the investor is not eligible to hold reserves, its commercial bank is eligible. When the investor sells the Treasury to the Fed, the Fed will create reserves to pay for it. The reserves will be deposited in the Fed account of the investor’s commercial bank. The commercial bank will in turn credit the investor’s account with bank deposits. At the end of the day, there are more reserves and bank deposits in the financial system.