If the Fed lends five banks a total of 100 million but...

If the Fed lends five banks a total of $\$ 100$ million but depositors withdraw $\$ 50$ million and hold it as currency, what happens to reserves and the monetary base? Use T-accounts to explain your answer.

Key Concepts

Monetary Base

The monetary base, often referred to as high-powered money, consists of bank reserves held at the central bank plus currency held by the public. It is directly controlled by central bank operations. When the Fed lends money to banks, it increases their reserves, thereby expanding the monetary base. If some of these reserves are subsequently converted to currency through withdrawals, the composition of the monetary base changes, but its overall size remains affected solely by the initial action of the central bank.

Bank Reserves

Bank reserves are deposits that commercial banks hold at the central bank and serve as a cushion to settle interbank payments and meet regulatory requirements. When the Fed lends money to banks, their reserve balances increase. However, if depositors withdraw funds, those reserves are reduced because funds are transferred into physical currency holdings. This change in the balance between reserves and currency does not affect the total monetary base, but it does impact the banks’ immediate liquidity position.

Central Bank Lending and T?Accounts

Central bank lending is a mechanism by which the central bank extends credit to commercial banks, usually by creating reserves on its balance sheet as evidenced by T?accounts. T?accounts help illustrate how assets and liabilities shift—when the Fed issues a loan, bank reserves (an asset) increase and the Fed’s liabilities also increase by a corresponding amount. If depositors withdraw funds, this transaction shifts funds from bank reserves to physical currency, with corresponding adjustments on the balance sheets of both the banks and the central bank, while the aggregate monetary base remains determined by the central bank’s initial credit creation.

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