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Working Paper 95 14
DEFINING THE MONETARY BASE IN
A DEREGULATED FINANCIAL SYSTEM
by E.J. Stevens
E.J. Stevens is a consultant and economist at the Federal
Reserve Bank of Cleveland. He thanks Ann Dombrosky,
Julie Powell, and Cheryl Edwards for past help in
penetrating the intricacies of reserve and clearing-balance
accounting, and Jerry Jordan for useful comments on earlier
drafts of this paper. However, he claims sole responsibility
for any remaining errors.
Working papers of the Federal Reserve Bank of Cleveland
are preliminary materials circulated to stimulate discussion
and critical comment. The views stated herein are those of
the authors and are not necessarily those of the Federal
Reserve Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.
December 1995
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Abstract
The monetary base typically is defined as a measure of the money-supply "impulse"
originating from the stock of high-powered, central-bank money. In addition to
nonbanks' demand for hand-to-hand currency, banks have demanded base money in the
United States since 1913 to satisfy two needs. One is a reserve need, to fulfill a Federal
Reserve regulatory requirement. The other is an operational need, to protect against teller
shortages of coin and currency and against daylight and overnight overdrafts of banks'
accounts at Reserve Banks. As the level of reserve requirements declines, the aggregate
demand for base money originating from banks reflects reserve requirements less and
less, and reflects operating needs more and more. Moreover, the adjusted measure of the
monetary base, combining the quantity of base money with an adjustment for changes in
reserve requirements, becomes unreliable. It includes adjustments for banks that are, in
fact, unaffected by changes in reserve requirements.
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A definition is something fundamental, something that precedes the application of
a logical model. Defining the monetary base, therefore, might seem to be no different in
a deregulated than in a regulated monetary system.' However, the problem is to identify
what kind of monetary system would exist in a deregulated world in order to know what
institutional form the monetary base might assume. Without agreement about a monetary
system, it is difficult to distinguish between expendable regulation and the indispensable
legal framework of an unregulated market system.
This is not a normative matter, but a positive question about what kinds of
monetary arrangements a truly free market system would produce. According to Selgin
and White (1994),
at least three strands of literature ...can be distinguished according to the different
sorts of payment media each predicts would predominate under laissez faire...
...a modern free banking literature that...proposes that an unregulated money
and banking system would have a single distinct base money, possibly, but not
necessarily a precious metal, and private-bank-issued monies in the traditional
forms of banknotes and transferable deposits made redeemable in base money;
a small but influential group of works that associate the competitive supply of
money with parallel private fiat-type monies, that is, plural brands of noncommodity base money issued by private firms;
related literatures known as the "new monetary economics" and the "legal
restrictions theory" that envision competitive payments systems without any
base money, with common media of exchange consisting entirely of claims,
paying competitive rates of return, on banks or money market mutual funds.
One approach would be to jump into the middle of this apocalyptic tangle and
define the monetary base along each strand, or along the "right" strand. This paper takes
a more pedestrian approach. It addresses the question of how successive stages of
piecemeal deregulation affect the construction of an empirical counterpart to the a priori
definition of monetary base. The first step is where we are today in the United States--in
the midst of effectively eliminating reserve requirement regulations. Future steps might
'
Two matters of semantics: First, many people use the phrase "monetary base" to refer to the adjusted
base. However, for present purposes, "monetary base" or simply "base" will always mean unadjusted; the
adjusted base measures of St. Louis and the Board will be designated as "adjusted base" and "breakadjusted base," respectively. Second, I use the word "bank" to mean "depository financial institution."
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involve investigating the redefinitions needed to incorporate the effects of eliminating
central bank clearing services and then eliminating central bank interbank-settlement
services. All three steps would still fall short of the place where Selgin and White begin-the disestablishment of government-fiat currency.
The subject is largely institutional, focused as it is on the probable outcome of
market competitors driving regulation out of business, and the probable effect of
deregulation on the appropriate measure of the monetary base. The approach is to
examine the economic implications of changes in the financial sector for the proper
measure of the monetary base.
To explore these matters it is necessary to know what a monetary base is, how it is
measured today, and what deregulation means. The first section of the paper considers
these background questions. The next section investigates the already diminishing role of
reserve requirements in the banking system, as the first of what seem to me to be
plausible stages of deregulation. Two major conclusions emerge. First, as a simple
matter of accuracy, the existing time series of the monetary base and its components
needs to be tuned up to account for modern banking and central banking practices.
Second, as a matter of logic and institutional fact, the two publicly available data series
measuring the adjusted monetary base are becoming obsolete because the role of reserve
~.~
these assertions can be
requirements in the banking system is d i m i n i ~ h i n Whether
verified empirically, and, if so, what to do about it, are matters for future research.
The Concept of the Monetary Base
Karl Brunner seems to have coined the term "monetary base" no later than his
1961 article, "A Schema for the Supply Theory of Money." His intent there was to
develop a supply function of money, starting from the microfoundation of an individual
bank managing its cash position in the context of settling customers7payments. The
result was an aggregate theoretical relationship in which, as he summarized it, "[tlhe
money stock is explained in terms of some component of the public's demand functions
for currency and time deposits, the monetary base adjusted for the cumulated reserve
2
One of these data series is published by the Federal Reserve Board, the other by the Federal Reserve
Bank of St. Louis.
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liberations, the interbank deposit structure, and a specific component of the banks'
demand for Federal Reserve Money" (italics added). That is7the money stock was a
function of the monetary base (adjusted for changes in the effective reserve requirement)
and of certain demand factors determined by institutional practices, preferences, and
market conditions.
At about the time Brunner was writing, Gurley and Shaw (1960) coined the phrase
"outside money" to fit a similar definition. As the phrase implies, their focus was on
nonmarket control of the money-supply impulse of the monetary base. They specifically
excluded from outside money any funds that the monetary authority loaned directly to
banks. For the same concept, James Tobin (1961) used the more cumbersome name "net
non-interest-bearing government debt." Distinguishing between gross and net monetary
base sometimes has been a significant issue. In the United States, the difference arises
from the discount window at which the Federal Reserve Banks will lend base money,
essentially on demand in the very short run. As a result, the gross volume of the
monetary base, while entirely high-powered, may not be entirely within the precise
control of the monetary authority.
Within two years of Brunner's article, Friedman and Schwartz published their
Monetary History (1963), emphasizing the monetary-base concept as one of the
proximate determinants of the money stock. What's more, they provided an actual timeseries measure of the stock of base money in the United States covering almost an entire
century, albeit without adjusting for changes in reserve requirements. Instead of calling
their measure the "monetary base," however, they used the old-fashioned designation,
"high-powered money." They traced this phrase back to the 1936 second edition of The
Reserve Banks and the Money Market, by W. Randolph Burgess, a long-time officer of
the Federal Reserve Bank of New York and brother-in-law of Leonard P. Ayres, the
celebrated prewar economic guru of the Cleveland Trust Company (Friedman and
Schwartz [1963]; Boone [1944]). The concept of high-powered money, with associated
multiple expansion and contraction of bank deposits, was not new in 1936, however.
Tom Humphrey (1992) has traced the notion back another 110 years, through
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C. A. Phillips, Davenport, Marshall, Joplin, and Torrens, locating its first use by James
Pennington in 1826.
Within seven years of Brunner's article, Leonall Anderson and Jerry L. Jordan
(1968) devised a time-series measure of the monetary base adjusted for changes in reserve
requirements. They emphasized the need to define a single, unified measure for tracking
the monetary policy impulse of the central bank, observing that "the Federal Reserve, by
varying the supply of the monetary base, causes commercial banks and the nonbank
public to adjust their spending on real and financial assets so as to bring the amount
demanded of the base into equilibrium with the amount supplied. In the course of these
adjustments, the path of economic activity is affected." The St. Louis Federal Reserve
Bank has been publishing this measure for 27 years, with occasional revisions because of
changes in data availability and monetary institutions.
It was not until eighteen years after Brunner's article, eleven years after Anderson
and Jordan, and after some prodding by the blue-ribbon Advisory Committee on
Monetary Statistics, that statistical tables in the Federal Reserve Bulletin began including
a monetary-base measure, slightly different from the St. Louis m e a ~ u r e .If~ the Fed's only
influence were as the source of base money, a time series measured at the source would
record that influence. Karl Brunner, Anderson and Jordan, and the Board all reasoned,
however, that changes in reserve requirements would alter the monetary impulse of a
given quantity of base money. A time series would give more useful, direct readings of
the monetary impulse if it were corrected for changes in reserve requirements.
Initially, the Board's base had no adjustments for changes in levels of reserve
requirements or methods of computation and maintenance, but as the months went by,
footnotes appeared, containing data with which users might adjust for such changes.
Then, in January 1981, again without comment, the current "break adjusted monetary-
Members of the committee, appointed by the Board in 1974, included George Leland Bach (Stanford),
Phillip D. Cagan (Columbia), Milton Friedman (Chicago), Clifford G. Hildreth (Minnesota), Franco
Modigliani (MIT) and Arthur Okun (Brookings). See "Improving the Monetary Aggregates," Report of the
Advisory Committee on Monetary Statistics, Washington, D.C., Board of Governors of the Federal Reserve
System, June 1976. For an explanation of the Board of Governors' monetary base series, see "Reserves of
Depository Institutions," Board of Governors of the Federal Reserve System (mimeo), March 1995.
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base series appeared in the regular Bulletin tables. That is, like both the St. Louis
measure and Karl Brunner's original concept, the Board's version of the base was
adjusted for changes in the structure of reserve requirements.4
These four concepts--monetary base, outside money, net non-interest-bearing
government debt, and high-powered money--all represent variants of the same core idea.
The Federal Open Market Committee controls the volume of central-bank money in the
fiat money regime of the modem United States. This is high-powered money that can be
used as reserve assets backing reservable bank deposits. It is also outside money, the
liability of an institution outside the private sector. Until 1980, high-powered, outside
monetary base was the non-interest-bearing debt of the federal government, because the
Federal Reserve Banks paid no explicit interest on either their currency or deposit
liabilities. Since the Monetary Control Act of 1980, however, some of the deposit portion
of the high-powered, outside monetary base explicitly yields interest in the form of credits
that can be used to pay for Reserve Bank services. No longer is it true that the highpowered, outside monetary base is the equivalent of non-interest-bearing federal
government debt.
Degree of control has been another matter of interest in isolating an outside
monetary impulse that is exogenous to, or determined independently of, market forces.
The Federal Reserve's willingness to lend means that the monetary base can be an
endogenous variable. For example, as market interest rates rise relative to the discount
rate, banks can be expected to overcome some of their bashfulness about being in debt to
the authorities. This has suggested that only the nonborrowed base should be viewed as
the exogenous variable, an indicator of the outside control exercised by the monetary
authority.
I was an imperfectly informed participant-observer of the Federal Reserve System at that time, but my
recollection is that the Board staffs apparent reluctance to produce a measure of the monetary base was
more than sour grapes. True, there might have been some reaction to the success of the St. Louis research
department in popularizing an implementable form of monetarism. However, the real reluctance was more
a reflection of the Board's growing involvement in large-scale, aggregate econometric models of the
economy and the application of control theory to the policy process. A single summary time series index of
the money supply impulse simply was out of place in the more elegant system of demand and supply
equations.
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The meaning of exogeneity has evolved over the years. At about the time
Anderson and Jordan published the first St. Louis adjusted-base series, Patric Hendershot
published estimates of what he called the "neutralized money stock." His idea was to
measure the central bank's monetary impulse purified of the influence of shifts in
demand, whether from changes in reserve requirements or from cyclical income
variations. The neutralized money stock would measure the extent to which the monetary
authority was raising or lowering the trend growth rate of money. Since that time, with
the development and estimation of large structural and multiplier models of the economy,
and later of rational expectations models, measuring exogenous actions of the monetary
authority has moved to the residuals from a rationally perceived reaction function, far
from the simple nonborrowed adjusted monetary base.
Deregulation
The American economy teems with regulations. In searching for those regulations
whose extinction would be relevant to the monetary base, it is helpful to differentiate
between the Reserve Banks as sources of assets held by the banking and nonbanking
public, and the reserve accounting regulatory framework that governs the uses of the base.
Interest in reconstructing the base comes on both fronts. New sources, for example,
might come from the unregulated emergence of stored-value cards. Suppose that
software providers, brokerage houses, or travel- and entertainment-card companies were
to act as warehouses of funds stored on their branded cards but not yet spent at the many
merchants who would accept them. Unless these warehouse facilities maintained
100 percent reserves in central-bank money, stored value might be considered another
type of base money, fully commensurate with high-powered bank reserves. After all, they
might be better than deposits at the Fed in being generally acceptable, and better than
Federal Reserve notes in being electronically transferable in making anonymous
payments.
However, concerns about deregulation are more often based on new uses. This is
the realm in which the probability of movement toward a deregulated monetary system
seems very high. Actually, this would be "further movement," for it would simply
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continue the trend toward deregulation that followed the regulatory high tide of the 1930s
and World War 11.
Interest-rate controls are gone. The prohibition of interest on demand deposits
remains on the books, but has been rendered largely ineffective by the long-standing
banking practice of implicit interest payments on compensating balances and by the more
recent introduction of sweep accounts and interest-bearing NOW accounts.
As to the future, consider the following:
Current efforts to repeal Glass-Steagall restrictions on bank powers involve
serious debate about how significant a role the Federal Reserve Banks should
retain in supervising and examining financial institutions, one of their longstanding functions.
Repeated efforts have been made to eliminate the role of Federal Reserve
Bank presidents on the Federal Open Market Committee. These efforts surely
will continue.
The Monetary Control Act of 1980 requires the Federal Reserve Banks to
price their services to recover full cost, including imputations for interest on
long- and short-term funding and return on capital at levels comparable to
those of private competitors. The imperative to cover costs, plus
technological changes such as securities depositories and regulatory changes
such as nationwide branching, raise serious questions about the continued
viability of the traditional check, ACH, Fedwire, and noncash-collection
product lines offered by the Federal Reserve Banks. Without vigorous new
approaches to serving the needs of present and potential customers, the decline
of Reserve Banks' market share in payment services seems unlikely to stop.
Pressure from private suppliers poses a similar competitive threat to the
Reserve Banks as fiscal agents for the United States government.
Traditionalists seem to assume that the Treasury is somehow required to use
the Reserve Banks for all services, but this is not so. Price competition for the
government's business is intense, and, as the recent episode involving bidding
for electronic funds-transfer of tax payments may demonstrate, products
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associated with new payment technologies may be off-limits for the Reserve
Banks, regardless of price.
These forces suggest that the Federal Reserve Banks, and therefore the central-bank
balance sheet, are not necessarily permanent features on the financial landscape, no
matter how enduring the Federal Reserve Act might seem. Erosion of each of the
Reserve Banks' four basic functions--banking supervision, monetary policy, payments
services, and fiscal agent--is more than conceivable; it is the default mode in which
Reserve Banks already operate. Moreover, a good case can be made that erosion in any
one of the four areas would increase the likelihood of erosion in the others. Therefore, it
is productive to focus discussions of deregulation on stages in the process of statutory or
competitive elimination of the bankers' banks.
Reserve Requirement Deregulation
Deregulation is worth thinking about because it has been happening and is likely
to continue. One of its aspects has been the erosion of reserve requirements as a factor
constraining the behavior of banks, accompanied by a decline in the percentage of the
monetary base needed by banks to satisfy reserve requirements.
The dominant source of base money in the United States today is the balance sheet
of the Federal Reserve Banks, whose purchases of assets in large part create monetary
liabilities of two sorts--banks' deposits at the Fed and Federal Reserve notes held both by
banks and by the nonbank public. Twenty years ago, this central-bank money was only
used as currency in the hands of the public and as reserve assets of the banking system
(vault cash and deposits at Reserve Banks). Over the intervening years, reserve assets
have shrunk from 37 percent to 14 percent of the monetary base, reflecting both the
growth of foreign holdings of U.S. currency and the decline of reserve requirements
(figure 1). Moreover, with growing use of currency and vault cash, reserve deposits,
taken alone, have declined from 30 percent of the base to less than 6 percent today.
Meanwhile, two additional uses of central-bank money have emerged (figure 2).
Surplus vault cash now amounts to about 10 percent of total vault cash. This
is vault cash that is not applied to meeting reserve requirements by those
banks that meet the entire requirement with vault cash.
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Clearing balances at times have amounted to as much as 20 percent of banks'
total deposits at Federal Reserve Banks. These are balances maintained in
addition to required reserves to support operational needs. The Federal
Reserve calls them "service-related balances" or "required clearing balances."
Banks use their surplus vault cash to meet operational needs during the day and at
ATM machines at night. Investing the surplus overnight is either impossible or
unprofitable. Clearing balances are a different story. Although readily available for
overnight investment, they are not invested in the market. Instead, a bank contracts with
a Reserve Bank to maintain a specified average overnight clearing balance during a
reserve-maintenance period. This balance is not segregated in a unique account, but
supplements whatever average reserve deposit balance the bank is required to maintain in
a unified account over the same period. The result is a combined balance with a target
level that the bank deliberately has set higher than reserve-requirement regulations
specify.
A contractual clearing balance has two benefits for a bank. One is that the
Reserve Bank pays interest on clearing balances--at the level of the federal funds rate--in
the form of earnings credits a bank can use (instead of hard dollars) to pay for Reserve
Bank services. This feature alone does not explain why banks would use this roundabout
method to pay for services. Clearly, however, earnings credits do make a clearing
balance more palatable.
The real benefit of a clearing balance is that it reduces the cost of operating in an
uncertain transactions environment (Stevens, 1993a, b). A bank doing a significant
volume of business with its Reserve Bank could find it costly to target a zero overnight
balance in its account, or a balance low enough to avoid wasting reserves. The Reserve
Banks penalize overnight overdrafts and charge fees for excessive daylight overdrafts.
Uncertainty, however, prevents a bank from controlling its overnight balance precisely,
~
and from predicting the intraday sequence of debits and credits to its a c ~ o u n t .The
Until the mid-1980s, the intraday sequence of debits and credits was of little practical concern. The
Reserve Banks had to permit unlimited daylight overdrafts because their deposit-accounting system made
tracking intraday positions almost impossible. Over the past decade, however, the Reserve Banks have
upgraded their accounting systems and now monitor the daylight overdrafts of each bank (ex post, in most
cases) relative to a ceiling above which fees are assessed.
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higher the positive overnight balance a bank targets, the less likely it is to exceed its
daylight overdraft limit during the day, to be overdrawn at the close of business or forced
into last-resort borrowing.
The American banking system is in the midst of a massive migration of banks
from a regulatory to an operational demand for balances at the Reserve Banks. The large
deposit balances demanded by high reserve requirements reduce the risk of daylight and
overnight overdrafts. Meeting a very high reserve requirement may involve more than
enough cash to cover operational needs. A low reserve requirement, on the other hand,
can make a required reserve balance objective redundant. Maintaining an operational
balance sufficient to ensure against overdrafts may involve more than enough cash to
meet reserve requirements.
The growing significance of banks' operational demands for base money relative
to the demands imposed by reserve requirements is consistent with the downward trend of
required reserve ratios from their peak levels shortly after World War 11, before banks
were allowed to use vault cash to satisfy requirements. Requirements today are both
lower and less complex than in days past (table 1). In 1995, the required reserve ratio
was zero on all of a bank's liabilities except transactions deposits in excess of $4.2
million, was only 3 percent on the next $50 million of transactions deposits, and only 10
percent on amounts above $54.2 m i l l i ~ n . ~
Even among large depository institutions (the 7,500 that report data to the Fed
weekly), 68 percent either operated below the $4.2 million floor or met their entire
requirement with the cash they held at teller stations, in automated teller machines, and in
their vaults (table 2). Another 20 percent had such low reserve requirements that they
contracted to hold clearing balances in addition to the vault cash and deposits they needed
to meet reserve requirements. Only about 900 banks, representing just 12 percent of
those reporting weekly (but 38 percent of deposits at large banks), actually seemed to be
constrained by reserve requirements. This relatively small group of banks met
These dollar amounts are not fixed. Law requires that both the zero and the 3 percent ceilings be adjusted
annually by 80 percent of the prior year percentage increase in total reservable liabilities of all depository
institutions.
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requirements with vault cash and required reserve deposit balances, without apparent
need for additional operating balances.
Monetary-Base Data
Basic Data
Contractual clearing balances are reducing the precision of
monetary-base data. Published Federal Reserve estimates of the monetary base do not
distinguish entirely between reserves, both total and excess, and clearing balances. This
occurs because the deviation of any bank's clearing balance from the contractual level,
whether above or below it, is included in excess reserves, rather than added to or
subtracted from contractual clearing
balance^.^
Measured excess reserves today might better be called "odds and ends."
Conceptually, under current reserve accounting regulations and in the absence of a
contractual clearing balance, the excess reserves of a single bank might be thought of as
wasted balances, that is, balances in-excess of the sum of the amounts used to meet the
current period requirement, to carry forward to meet next period's requirement, and to
carry back to offset a reserve deficiency in the previous period. In fact, however, not only
do excess reserves include wasted reserves, but also the amount of balances some banks
carried back to the last period, net of the amount that other banks carried forward from
the last period, plus the amount of balances some banks carried forward to the next
period, net of the amount that other banks carried back from the next period.
In addition to the inclusion of balances used to meet requirements by carryover,
measured excess reserves also include some nonreserve factors. This occurs because of
the inclusion of the aggregate difference between each bank's actual and contractual
clearing balance. Some of these difference are within the plus or minus 2 percent range
that is a bank's allowable, penalty-free band for maintenance of its clearing balance.
While allowable as a clearing balance, this difference is included in aggregate excess
reserves. A difference larger than plus or minus 2 percent is not allowable, being
'
Banks contract to hold a specific amount of clearing balances over and above their required reserves
during a reserve maintenance period. The reserve-accounting system defines required reserve balances as
the difference between required reserves and predetermined applied vault cash. Actual reserve balances are
defined as total balances (from the Reserve Banks' balance sheet), minus contractual clearing balances.
Excess reserves are derived as the difference between actual and required reserve balances.
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non-interest-bearing if positive, and penalized if negative. While not allowable, all such
excesses and deficiencies of actual from contractual clearing balances are included in
measured excess reserves.
Constructing more precise aggregate data series would not involve any change in
the micro data gathered from banks. These already allow the Reserve Banks to make an
exact calculation of each depositing bank's average position over a maintenance period,
-
to administer reserve requirements, calculate earnings credits, and, when necessary,
assess penalties. The total amount allocated between reserve and clearing balances
includes each bank's total position during a maintenance period, consisting of applied
vault cash plus deposit balance at the Reserve ~ a n k It. ~also includes all deficiencies or
surpluses in surrounding periods that are carried forward or back one period to offset
excesses or deficiencies in a bank's reserve position.
Allocating positions between reserve and clearing balances must begin with an
assumption about priority. That is, if a bank's total position is inadequate after adjusting
for carryover, should the bank be penalized for a reserve deficiency or for a clearingbalance deficiency? Current Reserve Bank practice gives first priority to meeting reserve
requirements, so that deficiencies are first attributed to clearing balances. No deficiency
in a reserve position can occur as long as a bank maintains the least portion of a clearingbalance contract.
In the alternative case, where a bank's total position exceeds its required reserves,
that required amount can be included in the reserves component of the base. The excess
of a bank's position above required reserves, up to the interest-bearing maximum of
102 percent of its contractual clearing balance, can be included in the clearing-balance
component of the base. When a bank's position exceeds required reserves plus
102 percent of its contractual clearing balance, however, another priority assumption
must be invoked. The redundant balance could be included in the bank's reserve position
(especially for banks without contractual clearing balances), or in its clearing balance
-
-
-
' I pass over the distinction between the source base (current-period Reserve Bank assets minus
nonmonetary liabilities and capital) and the use base (essentially, current-period currency in the hands of the
nonbank public, surplus vault cash, bank deposits at the Reserve Banks, plus applied vault cash). For a
detailed examination of the construction of the St. Louis and Board measures, see Garfinkel and Thornton
(1991).
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(especially for banks without a required reserve), or prorated between the two.g Or,
instead of making an arbitrary allocation, the redundant position might be aggregated and
reported as surplus balances, analogous to the current treatment of surplus vault cash.
Reserve Adjustments The Board of Governors' monetary base data series, which
is not break-adjusted, includes actual clearing balances, although these are not identified
separately. The Board's break-adjusted base series includes an estimate of how much
lower the monetary base would have been, had today's low reserve requirements been in
force in the past. However, clearing balances are excluded from the break-adjusted
measure. This does not seem appropriate. Some of the impact on reserve demand of the
secular decline in reserve requirements to today's low level has been offset by an
increased demand for clearing balances to meet operational needs that formerly were met
with reserve deposits. The Board's procedure makes the break adjustment too large when
comparing present values of the adjusted base with values at dates prior to the
introduction of current clearing-balance arrangements.
The Federal Reserve Bank of St. Louis excludes contractual clearing balances
from its unadjusted ("source") base, as well as from the adjusted base. The difference
between the adjusted and unadjusted series--the reserve adjustment magnitude--includes
the difference between the current level of required reserves and what the current level
would have been, had the reserve requirements of a past base period been in force. This
adjustment also is not entirely appropriate. It is too large, failing to account for the fact
that today's required reserve should include an allowance for clearing balances that have
been substituted for reserve deposits.
In both cases, adjustments to the raw monetary base may do a fine job of
indicating what required reserves would have been in the past, had today's reserve
requirements been in place (Board), or what today's required reserve would be today, had
past reserve requirements been.in place (St. Louis). However, these adjustments seem
less and less likely to produce an adjusted monetary base that is a consistent time-series
The staff of the Board of Governors regularly prepares a report for internal use that uses these definitions
and then prorates each bank's redundant position between reserve balances and clearing balances on the
basis of the relative amounts of each deposit required.
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indicator of the money-supply impulse, or thrust of policy. Yet this impulse or thrust is
the defining reason for measuring the monetary base. At one time, the impact of
changing a reserve ratio might have been limited to changes in the reserve constraint on
the expansion of reservable deposits. Increasingly, however, the reserve requirement is
not the operative constraint on the expansion of deposits.
Defining the Monetary Base
The possibility that reserve requirements are not a significant constraint for most
of the country's large banks suggests the nature of the immediate problem with empirical
representations of the monetary base: The base is intended to gauge the money-supply
impulse, which comes from the supply of base money relative to its demand. It matters
not whether demand is created by regulation through reserve requirements, or through
business needs for operational balances--only that there be a demand.
Measures of adjusted monetary base are designed to combine readings of two
policy tools into a single money-supply indicator. A cut in a required reserve ratio can be
thought of as reducing the immediate need for reserve assets (or, in Karl Brunner's
phrase, "liberating" reserve deposits). The extra reserve deposits would have to be
soaked up to avoid the money-supply stimulus of this liberation.
Historically, the Federal Reserve could use open-market sales of securities to
absorb reserves liberated by cutting reserve requirements. The concept of an adjusted
monetary base was designed for this situation. The adjustment is intended to purify a
monetary-base time series from the effect of the hypothetical open-market operations that
would have sterilized the money supply of the effects of changes in required reserve
ratios.
Of course, if there were no money-supply "kick" from changing reserve
requirements, then the base adjustment would be inappropriate. And that is where the
American banking system has been headed. If reducing reserve requirements induces
banks to contract for larger clearing balances, then those extra clearing balances soak up
some or all of the "kick" to the money supply. Reducing the required reserve ratio
doesn't reduce the demand for balances; it merely changes their classification from
"reserve" to "clearing." Under these circumstances, adjusting the monetary base for
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"cumulated reserve liberations" will not provide a better gauge of a money-supply
impulse.
A perpetual downward trend in required reserve ratios almost guarantees that this
second method of soaking up liberated reserves will be employed. Only if banks have
absolutely no need for operating balances could an adjusted monetary base continue to be
a useful gauge of the money-supply impulse as the downward trend of reserve
requirements continues. If there is a positive demand for operating balances, however,
reserve requirements eventually will become low enough to be irrelevant. With 88
percent of large banks targeting reserve positions larger than the regulatory requirement,
arrival at that point seems imminent.
It is easier to indicate the potential error in these adjusted base measures than it is
to suggest a specific, immediate remedy. Unfortunately, factoring clearing balances into
a break- or reserve-adjustment magnitude will not be as straightforward as applying
today's reserve ratio to yesterday's reservable deposits, or yesterday's reserve ratio to
today's reservable deposits. The required ratio of reserve assets to reservable deposits
remains constant until an administrative change is announced. The desired ratio of
contractual clearing balance to deposits is a behavioral variable. It will evolve over time,
much as do the currencyldeposit and transaction/nontransactiondeposit ratios, and is
likely to vary with the level of the funds rate.''
Conclusion
The monetary base is defined as the money-supply impulse originating from the
stock of central-bank money. Deregulation poses a problem for this definition if it
eliminates the demand for central-bank money. Likewise, the definition remains useful as
long as there remains a demand for central-bank money with sufficient interest and
income elasticities to make central bank monetary policy an "important" influence on all
other market outcomes in the economy.
Currency in the hands of the public represents the lion's share of the monetary
base. This demand is not in obvious peril from deregulation. True, demand for currency
l o This is to be expected. A balance that earns just enough to pay service charges at low interest rates will
earn too much at higher rates.
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should continue to suffer competitive erosion from the substitution of checks and ACH,
credit, debit, and ATM cards, and (it is predicted) from cybermonies and smart cards.
However, more immediately, currency demand has been vastly inflated by foreign users.
This is not a definitional problem, but an analytic challenge to distinguish the domestic
from the foreign money-supply impulse of the monetary base.
Banks7demand for central-bank money, on the other hand, has eroded
substantially because of deregulation in the form of lower reserve requirements.
Moderating this decline, demands for vault cash and for clearing balances have emerged
as important sources of banks' demands for central-bank money. These demands for
central-bank money should not dry up as long as banks and the central bank dominate the
payments mechanism, for it is the payments function that creates the demand.
Deregulation may not affect the definition of the monetary base, but it already has
exposed deficiencies in current measures of the monetary base. Linkages between
demand for base money and broader monetary aggregates can be less rigid. Perhaps the
base will be more closely linked to the flow of economic activity, but that is sheer
speculation. In any case, the determinants of money multipliers and income multipliers
should be expected to change.
In the future, measuring a money-supply impulse from changes in the stock of
central-bank money is likely to involve more sophisticated models than the somewhat
mechanical reserve-adjustment and break-adjustment magnitudes devised in the past.
Both of the available measures employ exaggerated adjustments for changes in reserve
requirements. Unfortunately, however, the raw data are collected and presented in an
outdated classification framework that precludes the ready estimation of better models.
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References
Anderson, Leonall C., and Jerry L. Jordan, "The Monetary Base--Explanation and
Analytical Use," Federal Reserve Bank of St. Louis, Review, vol. 50, no. 8 (August
1968).
Board of Governors of the Federal Reserve System, "Improving the Monetary
Aggregates," Report of the Advisory Committee on Monetary Statistics. Washington,
D.C., June 1976.
,"Reserves of Depository Institutions," Report of the Advisory Committee on
Monetary Statistics. Washington, D.C., March 1995.
Boone, Henry J., "W. Randolph Burgess," The Burroughs Clearing House (October
1944).
Brunner, Karl, "A Schema for the Supply Theory of Money," International Economic
Review (January 1961).
Friedman, Milton, and Anna Jacobson Schwartz, A Monetary History of the United
States, 1867-1960. Princeton: National Bureau of Economic Research and Princeton
University Press, 1963.
Garfinkel, Michelle, and Daniel L. Thornton, "Alternative Measures of the Monetary
Base: What Are the Differences and Are They Important?," Federal Reserve Bank of St.
Louis, Review, vol. 73, no. 6 (NovemberIDecember 1991).
Gurley, John G., and Edward S. Shaw, Money in a Theory of Finance. Washington,
D.C.: The Brookings Institution, 1960.
Humphrey, Thomas M., "Derivative Deposit Theory of Banking," in Palgrave Dictionary
of Money and Finance. London: Macmillan Press, 1992.
Selgin, George A., and Lawrence H. White, "How Would the Invisible Hand Handle
Money?" Journal of Economic Literature, vol. 32 (December 1994).
Stevens, E.J., "Required Clearing Balances," Federal Reserve Bank of Cleveland, Review,
vol. 29, no. 4 (Q IV 1993a).
, "Replacing Reserve Requirements," Federal Reserve Bank of Cleveland,
Commentary (December 1,1993b).
Tobin, James, "Money, Capital and Other Stores of Value," American Economic Review,
vol. 51 (May 1961).
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Table 1
The Declining Level and Complexity of Reserve Requirements
December 31,1948
Demand Deposits
Location of
bank
December 31,1975
June 30,1995
Demand Deposits
Transactions Deposits
Amount of
Amount of
deposits:
Required
deposits:
Required
Required
reserve ratio (million)
reserve ratio
reserve ratio (million)
-------------
-------------
-------------
-------------
-------------
-------------
Central
Reserve City
26.0%
> $400
16.5%
> $54.2
10.0%
Reserve City
22.0%
> $100
13.0%
> $ 4.2
3.0%
Country
16.0%
> $ 10
12.0%
c $ 4.2
0
.................................
.................................
.................................
Time
Deposits
Time
Deposits
Time
Deposits
Size of
deposit and
maturity:
> $5 million
c 180 days
c 4 years
> 4 years
c $5 million
c 4 years
> 4 years
All banks
All banks
7.5%
6.0%
3.0%
1.0%
3.0%
1.0%
Source: Board of Governors of the Federal Reserve System.
0
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Table 2
Use of Clearing;Balances, May 1995
(percent of weekly reporting banks)
No applied
vault cash
No required
reserve
Characteristic
Applied
vault cash
exceeds
required
reserve
Required
reserve
exceeds
applied vault
cash; no
clearing
balance
Required
reserve
exceeds
applied vault
cash; with
clearing
balance
(percent of total)
Number of
banks
1.3
8.2
59.6
11.6
19.3
Reservable
deposits
1.4
4.0
20.0
37.7
36.8
Required
reserves
0.3
0
6.4
52.8
40.6
Contractual
clearing
balances
1.9
2.2
21.1
0
74.8
Reserve
deposits
0.7
0
0.001
58.3
41.0
Source: Board of Governors of the Federal Reserve System.
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Millions of dollars
450 7
Figure 1
COMPONENTS OF THE MONETARY BASE
(not seasonally adjusted, not adjusted for changes in reserve requirements;
12-month moving average)
A
Clearing balances
I
Source: Board of Governors of the Federal Reserve System
* ex*
$
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Figure 2
Millions of dollars
--
COMPONENTS OF THE MONETARY BASE, EXCLUDING CURRENCY
(not seasonally adjusted, not adjusted for changes in reserve requirements;
12-month moving average)
Source: Board of Governors of the Federal Reserve System
@FedFRASER