system This is the system of money and banking,
by law and subject to the control of the central bank, the Federal
Each nation has its own system, some quite different from the U.S.
system This is the system of depository institutions,
of commercial banks and thrifts (savings institutions and credit
The term bank is sometimes
used generically to refer to any
institution that is licensed to accept deposits and issue credit money
base Referred to here as base money,
issued by the Fed. Federal Reserve notes and coins comprise the
part of the monetary base. The Fed estimates that over
half of the
value of notes outstanding are used in foreign countries as transaction
money and as a store of wealth where local currencies are not stable.
and coins Federal Reserve notes in various
up to $100 are the only form of paper money now issued. They are
printed by the Treasury and sold at cost to the Fed. Coins
are minted by the Treasury and sold at face value to the Fed.
purchase notes and coins at face value from the Fed and issue them to
in exchange for debits against their deposits.
at the Fed In addition to its vault cash, a bank
deposits at the Fed as a part of its required reserves. In order
to avoid overdraft penalties, its account at the Fed must be sufficient
to cover the net withdrawal of funds due to the checking activities of
its depositors as well as its own expenditures.
money This is money created by a depository
when it credits an account with a new deposit to fund a loan.
the loan is repaid, that amount of credit money vanishes.
funds rate This is the interest rate banks charge
another on overnight loans of reserves that they hold at the Fed.
Since the Fed does not pay interest on reserves, banks with excess
normally seek to lend them to banks needing reserves. This is an
active market in which the interest rate varies with supply and
banks These comprise the major part of the banking
system. They should not be confused with investment banks and
companies. The latter may neither accept deposits nor create
They can only lend their own money or borrowed money.
rate Banks lend at different interest rates
upon the amount and duration of the loan, and the creditworthiness of
borrower. Their lowest rate, known as the prime rate, is
for major companies who are regular borrowers. The prime rate is
normally based on a markup from the Fed funds rate which in turn sets
cost that banks must pay to borrow funds.
A bank's equity, also known as its capital, is the difference
what it owns and what it owes, in other words assets minus
A bank's capital grows with retained earnings. If its total
exceed its total assets, the bank is insolvent. Do not confuse
total market value of a bank's outstanding shares, which is sometimes
to as its market capitalization, with the bank's capital.
ratio This is the ratio of a bank's capital to its
risk-weighted assets. The Fed requires a minimum capital ratio
4% to 8%, depending upon the type and quality of its assets. When
a bank issues a loan, its assets increase but not its capital since its
liabilities increase equally by the deposit created to fund the loan. However
interest earned on loans, together with fees and income from its other
investments, increase both its capital and assets.
ratio This is the ratio of a bank's reserves to the
amount of its demand deposits, i.e. its checking deposits. The
sets the required minimum ratio, currently 10%. Even with no
minimum ratio, banks would have to maintain sufficient reserves to
checks written by depositors and to provide cash on demand.
market operations The Open Market Desk of the New
Federal Reserve Bank has the task of controlling the reserves in the
system as required to hold the Fed funds rate on target.
does so mainly through repurchase agreements with authorized
The Fed buys or sells Treasury securities with a promise to reverse the
transaction at a later date. Commonly known as repos,
these are basically short-term collateralized loans at a negotiated
system reserves This is the total reserves held by
all depository institutions. A bank must hold its reserves on
at the Fed and as vault cash. Banks cannot create reserves
amount of reserves fluctuates for a number of reasons, including cash
or withdrawals by bank customers. The Fed must constantly monitor
and adjust reserves to keep the Fed funds rate on target.
rate The Open Market Committee of the Federal
(FOMC) sets the target rate for Fed funds, its primary monetary policy
tool. That is its only effective means for controlling the demand
for credit, and thus the rate of growth of the money supply.
window This is the facility through which the Fed lends
to healthy banks. The rate of interest on the loan is known as
rate. It is set 100 basis points above the target Fed funds
Banks use the discount window sparingly because they can usually borrow
at a lower rate in the money market.
securities This refers to Treasury bills, notes,
bonds sold to the public to cover deficit spending, i.e. spending not
by tax revenues. The term T-bond is
used generically to refer to all three types of Treasury
the debt The Fed occasionally purchases T-bonds
for its own portfolio to meet the growing demand for cash and for
system reserves. This is done as needed to reduce the number and
size of repos arising from its open market operations. It pays
its purchases by simply crediting the seller's bank with a new deposit
in its account at the Fed.
money The Treasury only sells securities to the Fed
to roll over maturing securities in the Fed's portfolio.
it would be creating new money rather than recycling existing money
obvious inflationary implications. That is sometimes referred to
as printing money.
Until this date, the Fed bought whatever securities the Treasury could
not sell to the public at a pegged interest rate. The Accord
the inflationary pressure resulting from the creation of excessive
system reserves. Henceforth the Fed assumed full control of
policy, independent of the executive branch.
balances The Treasury maintains accounts, i.e.
balances, with the Fed and with commercial banks. Incoming funds
are deposited in banks and transferred as needed to the Fed account
which all of its payments are made.
debt owed to the public This refers to the Treasury
debt on which real interest payments are made, as distinct from the
debt which includes what it owes to government trust funds. The
involves intra-government interest payments, an essentially meaningless
over T-bonds For the Treasury, this means selling
T-bonds to cover the principal due on the maturing T-bonds. For
holders, it means using the proceeds from a maturing bond to buy a new
owners Less than 10 percent of the debt is held by
individual U.S. owners. Most Treasury securities are held by
e.g. commercial banks, insurance companies, corporations, pension
mutual funds, foundations, security dealers, and state local
governments, and foreign central banks.
As of 2006, about 50 percent of the bonds were owned by foreign