Brian Motley

English

Research Papers in Economics

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August 6, 1982 
Contemporaneous Reserve Accounting 
In October, 1979, the Federal Reserve 
switched from a policy of controlling the 
money stock by managing the federal funds 
rate to a procedure which focuses on the 
provision of reserves to the banking system. 
It was anticipated that this change in operat-
ing procedures would enable the System to 
control the stock of money more precisely 
and that part of  the cost of doing this would 
be somewhat greater volatility in short term 
interest rates. 
Annual monetary growth has been lowered 
by around 1 %-2 percentage points since the 
late seventies but the weekly and monthly 
numbers unexpectedly have become more 
volatile. Several economists have argued that 
this greater volatility has increased uncer-
tainty in the financial markets and been one 
of  the factors keeping short-term interest rates 
high. They argue that a further change in the 
System's operating procedures-namely a 
sh ift from lagged to contemporaneous re-
serve accounting-is required to eliminate 
short-run monetary instability. The Board of 
Governors announced recently that it plans 
to make this shift. 
Reserve Accounting 
Banks and other depository institutions issu-
ing transactions accounts are required to hold 
reserves equal to certain proportions of their 
deposit liabilities. Before 1968, banks were 
required to meet their reserve requirement~ 
contemporaneously. The amount of reserves 
a bank was required to hold in a given state-
ment week was related to its deposit totals in 
that same week. From the individual bank's 
point of view, the difficulty with such a sys-
tem is that, because its deposits vary daily, it 
does not know precisely how many reserves 
itwill be required to hold duringagiven week 
until the final day of  the week. Hence it must 
forecast its deposittotals-at least, forthe last 
day or so of  the week-in order to determine 
its required reserves. Since both its deposits 
and its reserves are subject to unexpected 
shocks, this is like trying to hit a moving target 
(its required reserves) with a shaky rifle (its 
actual reserves). 
In 1968, this moving  target was replaced by a 
fi xed one when the Federa I Reserve moved to 
a system of lagged reserve requirements 
(LRR). Under LRR a bank's required reserves 
in the current week depend onits deposit 
liabilities two weeks ago. Although its actual 
reserves sti" are subject to unforeseen shocks, 
the target it is striving to hit is predetermined. 
Monetary control under LRR 
For monetary control purposes, lagged re-
serve accounting imposes certain limitations 
on the Fed. The most important of  these limi-
tations is that, during a given week, the Fed is 
obligated to provide as many reserves as the 
banking system requires. This is because re-
. quired reserves are a predetermined amount: 
neither a single bank nor the banking system 
as a whole can alter required reserves be-
cause these depend on deposit totals two 
weeks ago. If the Fed were to supply less 
or more reserves than the banking system 
required, interest rates would vary sharply 
as banks found themselves with deficient or 
surplus reserves and unable in the aggregate 
to do anything about it. 
There are two categories of reserves -non-
borrowed reserves and borrowed reserves. 
Although the Fed cannot control total re-
serves in the current week, it can adjust the 
proportions which are in non-borrowed or 
borrowed form. Indeed, manipulation of the 
non-borrowed/borrowed "split" has been 
the principal monetary control instrument 
since 1979. 
Suppose the Fed wants to restrain monetary 
growth. It can do this by reducing non-
borrowed reserves by selling securities. With 
no change in required reserves in the current 
week, banks bid up the federal funds rate as 
they seek to meettheir requirements. This rise Opinions cxprt's'·;ec!  in Ihi'; nc'\vsletter do not 
nece~;sarilv reflect the  vii."vv~~ of [hp lnanclgC'lTicill 
of the Federal Reserv(' Bank of San  Franci(:.co, 
or of the Board of Covernors of the Federal 
Reserve Svs\em. 
in the funds rate induces banks to borrow at 
the discount window so that the share of 
borrowed reserves in the total increases. The 
increased cost of  federal funds in turn induces 
banks to raise both their prime lending rates 
and their offering rates on certificates of de-
posit and non-deposit liabilities. This rise in 
rates leads the public to take fewer bank loans 
and to switch out of transaction deposits into 
other bank liabilities. Both of these changes 
show up in reduced monetary growth. How-
ever, because the banking system is not 
forced to reduce transaction deposits in the 
current week-since the Fed can raise the 
cost but cannot reduce the quantity of  total 
reserves in the current week-this effect on 
money growth occurs only with a lag. 
Several economists-mostly monetarists-
have argued that the limitations imposed by 
the LRR system are largely responsible for the 
fluctuations in monetary growth which have 
been observed in the last three years. Their 
argument runs as follows. Suppose the stock 
of transactions deposits rises in the current 
week either because banks are making more 
loans or because the public is shifting funds 
into transactions accounts from other bank 
liabilities. Because of LRR, this increase in 
money has no effect on the demand for re-
serves this week and hence no immediate 
impact on the federal funds rate. As a result, 
there is no immediate tendency for the in-
crease in money to be reversed. 
Two weeks hence required reserves will be 
higher and hence the Fed is obligated to in-
crease total reserves. If  the Trading Desk does 
not increase non-borrowed reserves, these 
additional reserves will be supplied through 
the discount window as the funds rate is 
driven up. This increase in the funds rate will 
drive loans and transaction deposits down-
ward again -as banks raise their prime lend-
ing rates and their offering rates on certificates 
of deposit-but this reversal will not occur at 
once. It may take several months before 
money is brought back on track. The reversal 
cou Id be hastened if  the Fed were actively to 
reduce unborrowed reserves, but it will do so 
2 
only if it regards the surge in money as perma-
nent. Monetarists argue that this cautious con-
trol has produced cycles in monetary growth 
which are about four months in length. 
Contemporaneous accounting 
The cure for this problem, say the monetar-
ists,  is a return to contemporaneous' reserve 
accounting (eRR). And, after studying the 
issue, the Board of Governors announced 
recently that it has decided in principle to do 
just that. The new system-which will not  . 
come into use u  nti I m id-1983 at the earl iest-
will not be quite like the pre-1968 regime. 
The principal differences are that the ac-
cou  nti ng period wi  II be extended from one to 
two weeks, the contemporaneous require-
ment will apply only to transactions ac-
counts, and the system will not be a perfectly 
contemporaneous one. There will be a two-
day lag with reserves over two-week periods 
ending on Wednesdays being based on de-
posit totals for two-week periods ending 
on Mondays. 
Under eRR required reserves in a given state-
ment period will no longer be predetermined. 
If banks take actions which alter total depos-
its, this will change required reserves con-
temporaneously. Hence the Fed wi  II not be 
obligated to supply a quantity of reserves 
equal to a predetermined required amount. 
Instead it will be able to offset changes in 
borrowing at the discount window by equal 
changes in non-borrowed reserves to keep 
total reserves unchanged. Thus, with contem-
poraneous accounting, the Fed will in prin-
ciple be able to control total reserves, rather 
than only the non-borrowed/borrowed 
reserves split. At present, however, although 
the System has decided to move to contem-
poraneous accounting, it has not yet decided 
whether  to adopt total reserves as its short-run 
operati ng target rather than the non-borrow-
ed reserves target currently in use. 
Monetarists argue that the switch to eRR will 
enable the Fed to move to a regime of con-
trolling total reserves. This will permit closer 
short-run monetary control since the "multi-plier" relationship between the stock of 
money and total reserves can be predicted 
with greater precision than that between 
money and non-borrowed reserves. This is 
because borrowings at the discount window 
are volatile and difficult to forecast in the 
short run. Hence, argue monetarists, the Fed 
should switch from a non-borrowed to a total 
reserves target when it adopts contempora-
neous accounting. 
This monetarist argument for total reserves 
targeting raises two important and as yet un-
answered questions. The first relates to how 
banks will react to the introduction of CRR. 
Since reserve management will become 
somewhat more difficult-because, once 
again, the target as well as the rifle will be 
uncertain-banks may choose, as they did 
before 1968, to hold more excess reserves or 
may become less inhibited from having re-
serve deficiencies. This would weaken the 
link between total reserves and money and 
offset some of  the improved monetary contro  I 
expected to result from total reserves target-
ing. For example, if  banks react to an increase 
in total reserves by simply adding to their 
excess reserves, there is no effect on the stock 
of money. 
The second question relates to the difficu  Ity 
of predicting required reserves. Under total 
reserves targeting, the Desk must predict the 
total demand for reserves, given its target for 
money. This total demand depends critically 
on the legal reserve requirements. At present, 
different classes of transactions accounts 
have different requirements so that the de-
mand for reserves depends on the distribution 
of deposits among these classes. An unex-
pected shift in this distribution will alter the 
demand for reserves -and hence produce a 
change in the funds rate-even though 
money remains on target. Because such shifts 
are difficult to predict, it is widely believed 
that total reserves targeting would increase 
interest rate volatility and possibly reduce 
short-run monetary control. This is not a long-
term objection to total reserves targeting. 
When the Monetary Control Act of 1980 is 
3 
fully phased in, most transactions accounts 
will bear the same reserve requirements, 
making it feasible to make accurate predic-
tions of required reserves and so to move to 
total reserves targeting. 
The monetary control mechanism will adjust 
to shocks more rapidly under CRR whether or 
not the Fed adopts total reserves targeting. If 
banks create more deposits, requ ired reserves 
increase immediately, putting upward pres-
sure on the federal funds rate immediately 
rather than with a two-week lag. Hence  there 
will be less tendency for money to drift away 
from target because banks begin their adjust-
ments sooner. However, this advantage 
depends on the Fed's willingness to allow 
interest rates to fluctuate. If the Desk sought 
to "manage" the funds rate, the greater pre-
cision of control promised byCRR would fail 
to materialize. 
Several writers have argued that the shift to 
CRR will reduce the amount of interest rate 
fluctuations. Under LRR, the banking system 
can obtain additional reserves at the discount 
window but cannot reduce its required re-
serves. Under CRR, it has an additional 
option-reducing loans or issuing more CDs 
-which lowers deposits and hence reduces 
required reserves. It is argued that this new 
option will mean thatthe impact on interest 
rates will be smaller. This argument depends 
on the assumption thatthe Desk will continue 
to target u  nborrowed reserves. If  the Fed sh ifts 
to a total reserves control procedure, the 
banking system as a whole wi  II no longer be 
able to increase total reserves by borrowing at 
the window. Empirical studies by the Federal 
Reserve suggest that with existing reserve 
requirementsvolatility would be increased 
with a total reserves target, though it would 
be reduced under a non-borrowed reserves 
target. However, such studies necessarily 
assume that the behavior of the banks and  . 
the public will not be dramatically different 
under the new procedures. Although this 
seems a plausible assumption, only actual 
experience can provide a firm answer to 
this question. 
Brian Motley 
~ 
~ BANKI NG DATA-TWELFTH FEDERAL RESERVE DISTRICT 
(Dollar amounts in millions) 
Selected Assets and Liabilities 
Large Commercial· Banks 
Loans (gross, adjusted) and investments* 
Loans (gross, adjusted) - total# 
Commercial and industrial 
Real estate 
Loans to individuals 
Securities loans 
U.S. Treasury securities* 
Other securities* 
Demand deposits - total # 
Demand deposits - adjusted 
Savings deposits -total 
Time deposits - total# 
Individuals, part. & corp. 
(Large negotiable CD's) 
Weekly Averages 
of Daily Figures 
Member Bank Reserve Position 
Excess Reserves (  +  )/Deficiency (  - ) 
Borrowings 
Net free reserves (  +  )/Net borrowed( -) 
* Excludes traqing account securities. 
#  Includes items not shown separately. 
Amount 
Outstanding 
7/21/82 
160,373 
140,062 
44,045 
57,101 
23,395 
2,726 
6,630 
13,681 
138,823 
26,873 
30,505 
99,238 
89,648 
37,840 
Weekended 
7/21/82 
10 
7 
3 
Change 
from 
7/14/82 
491 
583 
148 
44 
4 
480 
15 
- 107 
-1,040 
-1,319 
- 119 
1,897 
1,794 
1,404 
-
-
-
Weekended 
7/14/82 
55 
10 
45 
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Change from 
year ago 
Dollar  Percent 
9,860  6.6 
10,699  8.3 
5,044  12.9 
3,593  6.7 
561  2.5 
1,341  96.8 
411  6.6 
1,250  8.4 
338  0.9 
973  - 3.5 
183  0.6 
16,135  19.4 
15,060  20.2 
4,359  13.0 
Comparable 
year-ago period 
13 
72 
59 
Editorial comments may be addressed to the editor (William Burke) or to the author ....  Free copies of this 
and other Federal Reserve publications can be obtained by calling or writing the Public Infonnation Section, 
Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 544-2184. 

Contemporaneous reserve accounting

http://www.frbsf.org/publications/economics/letter/1982/el82-32.pdf

Contemporaneous reserve accounting

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Research Papers in Economics