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$1.4 Trillion on the Sidelines.

In Money Supply on April 29, 2011 by CQCA

The Federal Reserve requires U.S. depository institutions to hold reserves in an account at the Federal Reserve. It depends on the type of account, but the majority of deposits require a 10% reserve requirement. This means that for every ten Dollars a bank has deposited in it, it must keep one Dollar at the Federal Reserve. As far back as 1959, the banking system kept its reserves close to the absolute minimum requirement. Put another way, until 2008, required reserves made up about 98% of total reserves held at the Federal Reserve. After 2008, the curve essentially flipped, shown below. This means that banks were voluntarily putting so much money into their accounts at the Federal Reserve, the amount of require reserves dropped to only 5% of total reserves.

Bank reserves are not included in the money supply, but they are related. In fact, the total scope of the increase in bank reserves can best be shown by comparing it to the money supply.

The above chart shows the ratio between bank reserves and the money supply. In March, 2008, the ratio of the M2 money supply to bank reserves was 1 to 176.9. By March, 2011, the ratio had dropped to one-sixth, the lowest amount on record. This means that in March, 2008, bank reserves would have had to have been multiplied by 176.9 to equal the M2 money supply. In March, 2008, only three years later, bank reserves only had to be multiplied by 6.3 to equal the M2 money supply.

Bank reserves are counted separately from the money supply measures. However, eventually that money will make it into the money supply in the form of loans. Once this happens, the multiplier effect will eventually pan out. If the current reserve requirement remains at 10%, then the money held in reserve by the banks now could possibly multiply into a number 10 times the original amount. $1.4 trillion times 10 equals $14 trillion. The current M2 money supply measure stands at about $8.4 trillion, meaning the impact of bank reserves multiplying, alone, could cause the U.S. money supply to increase by up to 166%.

The good news is that the high amount of bank reserves mean our deposits are the safest they have ever been. The bad news is that the Dollars we hold will be worthless.

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