Clearing a Check

The process begins with Anna, who has a $100 demand deposit account (DDA) with Bank X. Anna writes a check for $5, which she gives to Nathan. At the same time, she records the amount in her checkbook to show a new balance of $95. (Note that only the accounts affected by the $5 check are shown in this figure.)

District Federal Reserve System Bank

MBR Bank Y $>0 15


DDA $>00 105

Nathan deposits the check.

Bank Y





Nathan, who banks at Bank Y, now has the check. If he decides to cash it, he will have $5 in currency in addition to his DDA of $100. If he decides to make a deposit, his DDA will rise to $105. Either way, Bank Y ends up with the check written by Anna.

Because the check is drawn on Bank X, Bank Y gets payment for it by sending the check to the district Federal Reserve Bank. The Fed then processes the check by transferring $5 from Bank X's MBR account to Bank Y's MBR account. The Fed then sends Anna's check to Bank X.

Bank Y

MBR $>0 15

Nathan's DDA $100 105

Bank Y sends the check to the Fed district bank for payment.



Did you know?

extend truth-in-lending disclosures to millions of individuals who purchase or borrow from corporations, retail stores, automobile dealers, banks, and lending institutions.

If you buy furniture or a car on credit, for example, you will discover that the seller must explain several items before you make the purchase. These items include the size of the down payment, the number and size of the monthly payments, and the total amount of interest over the life of the loan.

Today's currency, the paper component of the money supply, is made up of Federal Reserve notes-fiat paper money issued by Federal Reserve banks and printed at the Bureau of Engraving and Printing. This currency, issued in amounts of $1, $2, $5, $10, $20, $50, and $100, is distributed to the Fed district banks for storage.

The Bureau of the Mint produces coins-metallic forms of money-such as pennies, nickels, dimes, quarters, and the new Sacagawea dollar coin. After the coins are minted, they are shipped to the Fed district banks for storage. When member banks need additional coins or currency, they contact the Fed to fulfill their needs.

When banks come across coins or currency that are mutilated or cannot be used for other reasons, they return it to the Fed for replacement. The Fed then destroys the old money so that it cannot be put back into circulation.

Commercial Banks Commercial banks are the largest financial institutions in the country and are the main sources for exchanging money. The first commercial bank in the United States was founded in 1782 in Philadelphia. Today, commercial banks hold about two-thirds of the nation's money deposits.

One of the Fed's important functions involves the financial services it provides to the federal government and its agencies. For example, the Fed conducts nationwide auctions of Treasury bills, bonds, and notes. It also issues, services, and redeems these securities on behalf of the Treasury. In the process, it maintains the equivalent of numerous demand deposit accounts for the Treasury and clears all checks drawn on those accounts. Other accounts are used to process the tens of millions of dollars of U.S. savings bonds that are sold and redeemed annually.

The Fed also maintains accounts for the IRS, which holds federal taxes paid by individuals and businesses. In fact, any check written to the United States Treasury is deposited in the Fed. Any federal agency check, such as a monthly Social Security payment, comes from accounts held at the Fed. In essence, the Fed serves as the federal government's bank.

Section 1 Assessment

Checking for Understanding

1. Main Idea What is the purpose of the Federal Reserve?

2. Key Terms Define member bank, bank holding company, Regulation Z, currency, coins.

3. Describe the structure of the Fed.

4. List eight areas in which the Fed has responsibility.

Applying Economic Concepts

5. Truth-in-Lending Laws Visit any local store that sells goods on credit—appliances, cars, or furniture, for example. Ask the owner or manager about the type of information that the store is required to disclose when the sale is made. Obtain copies of the disclosure forms and share them with your classmates.

-CrilkaJ Thinking

6. Synthesizing Information One of the responsibilities of the Fed is to approve or disapprove mergers between state member banks. Explain how the mergers of two such banks would be classified according to the discussion of mergers in Chapter 3.

. Practice and assess key social studies skills with the Glencoe Skillbuilder Interactive Workbook, Level 2.

Profiles lJNf


Enormous Power:

Alan Greenspan

In some ways, Alan Greenspan is like many other people in government today-a longtime public servant, a respected administrator, and a fiscally conservative theorist with a Ph.D. in economics. What sets him apart, however, is that he is widely regarded as being the second most powerful person in America, after the president.

Greenspan is chairman of the Federal Reserve System's Board of Governors. As such, his views on the economy are closely monitored by almost everyone in the business community.


In late 1996, when stocks were setting record highs during a bull market, Greenspan asked publicly if prices weren't being propelled by the "irrational exuberance" of investors. The reaction to his remarks was almost instantaneous: investors, fearing that the Fed chairman was about to implement restrictive monetary policies that would drive stock prices down, began to sell. Within hours, stock exchanges around the world lost 2 percent of their value, and the



Dow-Jones Industrial Average fell 145 points. Such is the power of Greenspan.


Greenspan is a longtime conservative. Early in his career, he was even a staunch advocate of the gold standard, which he saw as a way to assure monetary stability and fiscal responsibility by government. In his career he has worked as an economic consultant to private industry and served on a number of corporate and industry boards. Greenspan served from 1974 to 1977 as chair of the president's Council on Economic Advisors during the Ford administration. From 1981 to 1983, he chaired the National Commission on Social Security Reform, leading to the reform of the nation's Social Security system.

Greenspan joined the Fed in 1987 and was appointed chair of the Fed's Board of Governors by Presidents Reagan, Bush, and Clinton. Greenspan continues to be a strong supporter of the free market and an opponent of government intervention in the economy. As the second most powerful person in America, people will continue to scrutinize his every statement.

Examining the Profile

1. Synthesizing Information Explain how Greenspan's position as chairman of the Federal Reserve System's Board of Governors makes him extremely influential.

2. Evaluating Information Do you think Greenspan has too much power? Explain your answer.


Stmt y tfirV/t'

Main Idea

Federal Reserve actions intended to stabilize the economy make up what is called monetary policy.

Reading Strategy

Graphic Organizer As you read the section, complete a graphic organizer similar to the one below.

Key Terms monetary policy, fractional reserve system, legal reserves, reserve requirement, excess reserves, liabilities, assets, balance sheet, net worth, liquidity, savings account, time deposit, member bank reserve, easy money policy, tight money policy, open market operations, discount rate, margin requirement, moral suasion, selective credit controls


After studying this section, you will be able to:

1. Describe the use of fractional reserves.

2. Understand the tools used to conduct monetary policy.

Applying Economic Concepts

Fractional Bank Reserves Did you know that most of our money supply exists in the form of intangible computer entries? Read to find out how the fractional reserve system works.


Is the Fed Ready to Hike Rates?

NEW YORK (CNNfa)-If recent reports of unex-eS^gth in the nations economy are any mdr-L Federal Reserve is likely to raise mterest

cation, rates sooner rather than later, analysts said Wednesday

A rise in short-term rates would follow three rate cuts by the Fed late last year that were intended to insu-

cation, rates sooner rather than later, analysts said Wednesday

A rise in short-term rates would follow three rate cuts by the Fed late last year that were intended to insu-

Interest rates on the risei

late the United States frl economic problems to Asia and^elsewhere J* 1st falll Asia's economic woes had spread to La to te^a £ much of Europe and looked poised to hrt th"^gS i- acton, cuttog ratesthr^ times, and theU cuts worked. By = the U* economy was back on track . . . [But now], . officials are likely to raise rates. . . .

One of the Federal Reserve System's most important responsibilities is that of monetary policy. Monetary policy is the expansion or contraction of the money supply in order to influence the cost and the availability of credit. The Fed, as you read in the cover story, does not hesitate to change interest rates whenever the economy's health is threatened.

Monetary policy is a structured process. In order to understand it better, it helps to understand the fractional reserve system that our banking system is based on.

Fractional Bank Reserves

■M The United States has a fractional reserve M^Ut system, which requires banks and other depository institutions to keep a fraction of their deposits in the form of legal reserves. Legal reserves consist of coins and currency that depository institutions hold in their vaults, plus deposits with Federal Reserve district banks. Under this system, banks are subject to a reserve requirement, a rule stating that a percentage of every deposit be set aside as legal reserves.


To illustrate, the banking system today operates with a 12 percent reserve requirement against demand deposit accounts. That means that whenever someone deposits $100 to open a checking account, $12 must be set aside as vault cash or kept as a deposit at the Fed. The other $88 is called excess reserves-legal reserves in excess of the reserve requirement. The excess reserves are the funds the bank can lend to others who may want a loan.

How Banks Operate

To understand how a bank operates, it helps to examine the bank's liabilities and assets. Its liabilities are the debts and obligations to others. Its assets are the properties, possessions, and claims on others. Liabilities and assets generally are put together in the form of a balance sheet-a condensed statement showing all assets and liabilities at a given time. The balance sheet also reflects net worth-the excess of assets over liabilities, which is a measure of the value of a business.

Organizing a Bank

Suppose someone obtains a charter to start the hypothetical State Bank of Highland Heights. The bank is organized as a corporation, and the owners supply $20 so that the bank can obtain buildings and furniture before it opens for business. In return for this investment, the owners receive stock, which shows as net worth or equity. Panel A in Figure 15.3 shows how the balance sheet of the bank might look as soon as it is organized.

The balance sheet shows the assets on the left and the liabilities and net worth on the right. To see why net worth is placed on the right side of the balance sheet, rearrange the definition of net worth from Assets - Liabilities = Net Worth to

Assets = Liabilities + Net Worth

The balance sheet in the figure is sometimes called a T-account because of its appearance, separating the assets from the liabilities and net worth the same way the equal sign does in the above equation. The T-account also works like an equal sign in that the entries on the left must always be equal to the entries on the right.

Accepting Deposits

Suppose that now a customer walks in and opens a checking account with $100 in currency. This transaction, shown in Panel B of Figure 15.3, is reflected on the balance sheet in two ways.

First, to indicate that the money is owed to the depositor, the $100 checking account (or demand deposit) is carried as a liability. Second, to indicate that the cash is the property of the bank, it also appears as an asset on the balance sheet. Actually, the $100 appears in two places on the asset side-$90 appears as cash, and $10 appears as required reserves. The size of the reserve is determined by the reserve requirement, which is assumed to be 10 percent in this example. If the requirement was 15 percent, $15 would be set aside.

Making Loans

Now that the bank has some cash on hand, it can make loans. Specifically, it is free to loan out $90 of excess reserves, the cash and currency not needed to fulfill the reserve requirement.

If another person enters the bank and borrows an amount equal to the excess reserves, the $90 is moved from the cash line to the loans, or accounts receivable, line in the balance sheet. These changes appear in Panel C. Note that there is no change in total assets, only in their distribu-tion-a change from a noninterest-earning asset (cash) to an interest-earning one (a consumer loan).

If the bank charged 12 percent interest on the new loan, it would earn 12 percent of $90, or

Student Web Activity Visit the Economics: Principles and Practices Web site at and click on Chapter 15—Student Web Activities for an activity on the Fed's monetary policy.

eco r


Figure 15.3



$10.80 each year. This income, along with income earned on other loans, would then be used to pay its officers and employees; its utility bills, taxes, other business expenses; and its stock dividends.

Reaching Maturity

In time, the bank would grow and prosper, diversifying its assets and liabilities in the process. Most of the bank's deposits would eventually return to the community in the form of loans, and some of those loans would return to the bank in the form of new deposits.

The bank might even use some of its excess reserves to buy federal, state, or local bonds and other securities. The bonds and securities are helpful for two reasons. They earn interest and, therefore, are more attractive than cash. They also have a high degree of liquidity-the potential to be converted into cash in a very short time. Liquidity adds to the bank's ability to serve its customers. When the demand for loans increases, the bank can sell its bonds and then lend the cash to customers.

The bank also might try to attract additional funds by introducing different kinds of products. One product is a certificate of deposit, a receipt showing that an investor has made an interest-bearing loan to a bank. Most banks also offer savings accounts and time deposits, interest-bearing deposits that cannot be withdrawn by check. The two accounts are similar, except that prior notice must be given to withdraw time deposits, while no prior notice is needed to withdraw savings.

Unless costs are extremely high, the bank should be able to make a



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