Why Government Expenditures and Taxes Increase and Decrease Bank Reserves and Derivatively the Money Supply But May Be Countered By the Fed
03 December 2016 | Pago Pago, American Samoa
Title 26 § 7809 of the US Code provides that on the deposit of revenue collections " . . . the gross amount of all taxes and revenues received under the provisions of this title, and collections of whatever nature received or collected by authority of any internal revenue law, shall be paid daily into the Treasury of the United States . . . But this isn't done.
As shown on people's tax return checks, they are not endorsed by the Treasury at all, but by a district Federal Reserve Bank, all of which hold the government's revenues, not the Treasury and the external banking system as is implied. This is key. The Fed is the collection agent for the Treasury and holds the Treasury's deposits. This means government expenditures add reserves to the banking system and derivatively, increase the money supply, and government taxes and bond sales do the opposite.
The counter to this position is that the Fed creates and destroys reserves every day, generally through the Federal Funds market.
It pegs the FF rate and operates to maintain that peg by putting reserves into the banking system or taking them out of the systems by bond purchases and sales respectively. If government expenditures add too many reserves to the system, the Fed will take reserves out of the system to maintain the peg. Similarly, if taxes and new bond sales by the government pull too many reserves out of the system and cause the FF rate to rise above the peg, the Fed will sell bonds to pull reserves out of the system.
The Fed's goal is to hold the FF target rate peg. It will accomplish this by draining or creating reserves. The Fed's trading desk contacts member banks, as well as the US Treasury, every morning, to help decide if reserves need to be added or reduced for that day.
But the point is that by the Treasury holding its deposits at the Fed instead of in the conventional banking system, its expenditures and receipts add and take away reserves from the banking system. To be sure, if they are in large enough sums, the Fed may act to counter them in order to maintain its peg on the FF rate, but that does not mean government receipts and expenditures do not decrease and increase reserves, respectively.
This is a far cry from the government keeping its deposits and receipts in the external banking system outside of the Fed as most suppose and the statute arguably requires so its receipts and expenditures do not change reserves and derivatively the money supply