Reserves held at the Federal Reserve somehow act as money — so goes popular assumption. When the Fed adds dollars to bank reserves, it simultaneously adds an equal number of dollars to the quantity of money. For a long time, empirical evidence seemed to confirm that theory.
Around 1973 evidence began to appear that contradicted this popular assumption. Since that time, the money supply has grown much more rapidly than have bank reserves.
In 2008 the assumed connection between bank reserves and the quantity of money completely broke down. The quantity of bank reserves skyrocketed while the money supply chugged along at about the same historical rate.
This contradiction exposed a critical question. Where did the error exist? — In the data? Or in the theory?
The error existed in the theory, for the theory started with a couple of false premises:
- dollars = dollars
- dollars always play the role of money
When a person selects one dollar bill over another from their wallet, they provide evidence that they do not value two, seemingly identical, dollars the same. People frequently confuse the idea of fungibility with that of equal value. Fungibility means that in a practical application, two nearly identical commodities can substitute for each other. On the other hand, no two individual commodities have equal value, for the simple fact that no two items are identical in all respects, and no individual will value them the same.
Every dollar is different from every other dollar. They have different serial numbers; some are new and crisp, and others not; some dollars exist as Federal Reserve notes; some dollars exist as coins; some dollars even exist as negotiable checks. Thus, the idea that every dollar equals every other dollar either physically or in value proves false.
Every dollar does not play the role of money. The dollars with which you pay for your latte act as money. Any dollar you use in any exchange acts as money. Some dollars, however, do not act as money.
I once ate in a restaurant in which the walls were covered with dollar bills. People had written on those bills, laminated them, and hung them on the walls. These dollars did not act as money.
Dollars held in the accounts of banks at the Federal Reserve also do not act as money. For dollars to act as money, the public must be allowed to own and use those dollars for indirect exchange. The public cannot hold (or have a claim on) dollars held as bank reserves. We cannot, therefore, consider bank reserves as a form of money.
The Role of Bank Reserves
Bank reserves do not act as a form of money. They never have. When people used gold as a form of money, and banks had 100% reserves, banks would hold gold to back the claims represented by banknotes or checks. While held as reserves, gold no longer played the role of money. Only after the holders of banknotes and checks exercise their claim on gold (at which time the holders’ claim on the gold would be canceled), with the gold returned to its former role as money. Gold and banknotes/checks would never play the role of money simultaneously.
In the modern banking system, in which we have fractional reserve banking and reserves created by the Federal Reserve, this relationship has not changed. Bank reserves still do not play a role as money. They act more like a control mechanism on the ability of banks to create money.
In an hypothetical situation in which banks must hold a reserve equal to 50% of their deposit liabilities, a bank with $1,000 in reserves (1,000 reserve dollars) could create 2,000 money dollars (I use the phrase money dollars to distinguish them from dollars held as bank reserves – reserve dollars). If the Federal Reserve created another thousand dollars in reserves, to pay for assets they acquired from the bank, the bank would have no obligation to create another 2,000 money dollars. Thus, the Fed could not “pump” money into the economy.
Historically, because of the relatively low level of bank reserves, when the Fed increased the quantity of reserves, banks would have sufficient demand for money that they would buy an adequate number of notes to use their moneymaking capability fully. With the massive run-up in bank reserves during the financial crisis in 2008, banks no longer had access to a sufficient number of quality notes for which to use their total moneymaking capacity.
The premise that the Federal Reserve adds directly to the money supply when it increases bank reserves contained flaws from the beginning. Bank reserves have never acted as a form of money.
When the Federal Reserve increases the amount of bank reserves (under a fractional reserve banking system), banks are not obligated to use their total moneymaking capacity.
Thus, when we understand the distinction between dollars held as bank reserves (reserve dollars) and dollars held by the public for indirect exchange (money dollars), we have a more accurate premise from which to develop a theory about the relationship between bank reserves and the money supply. It makes sense for bank reserves and the money supply to grow and contract at somewhat different rates.