The Fed can control all three of these items as a means of implementing monetary policy. It controls the printing of paper bills (Federal Reserve notes), which is the primary component of currency in circulation and vault cash (U.S. Treasury coins are the other component). The Fed can specify exactly how many ones, fives, tens, twenties, fifties, and hundreds to print. If it does not authorize the printing, then the printing does not happen.

Even more important, the Fed has extensive control over Federal Reserve deposits. The Fed can change the total amount of Federal Reserve deposits of commercial banks through open market operations--the buying and selling of U.S. Treasury securities. Buying securities expands Federal Reserve deposits and selling securities reduces Federal Reserve deposits.

Three Blocks in the Base

• Currency in Circulation: This is the paper bills and metal coins that is held by the nonbank public, that is, in circulation throughout the economy. It includes Federal Reserve notes (paper bills) and U.S. Treasury coins (metal coins). The nonbank public consists of consumers, businesses (other than banks), and government agencies (other than the Fed or the Treasury Department). This is the currency that can be used to purchase goods, make payments, and complete transactions.


• Vault Cash: This is the paper bills and metal coins that is kept in the bank, that is, in the vault. This cash is used, quite literally, to "cash" checks and otherwise to satisfy currency withdrawal demands of depositors. Note that vault cash is not part of the official M1 money supply because it is held by banks (not the nonbank public) and thus it is not in circulation.


• Federal Reserve Deposits: This is deposits that banks keep with the Federal Reserve System to clear checks and assist in other banking activities. The Federal Reserve System provides banks with a range of banking services, including loans and deposits. Banks are not only required to keep deposits as a means of joining the Federal Reserve System, these deposits are used to process checks through the banking system.

Monetary Policy

• During a business-cycle contraction, the Fed implements expansionary monetary policy, which involves an increase in the money supply and usually a reduction in interest rates.


• During a business-cycle expansion that generates excessive inflation, the Fed implements contractionary monetary policy, which involves a decrease in the money supply and usually an increase in interest rates.

The Federal Reserve System, including each of the 37 Federal Reserve Banks, buy and sell Treasury securities in the course of their daily business. However, the Fed is also inclined to do extra buying or selling as a means of conducting monetary policy. When the Fed buys or sells Treasury securities, payment is ultimately made with Federal Reserve deposits. When the Fed buys, commercial banks end up with more Federal Reserve deposits. When the Fed sells, commercial banks end up with fewer Federal Reserve deposits.

As these Federal Reserve deposits change, so too does the monetary base.

Demand-Driven Currency