Federal funds, often referred to as “good money,” are available the same day they are deposited, facilitating immediate transactions. This contrasts with clearinghouse funds, which can take multiple days to clear.
Federal Funds
Federal funds are reserves held at Federal Reserve Banks that depository institutions trade among each other, typically overnight, to maintain their reserve requirements. These funds are considered “good money” because they are available for transactions on the same day they are deposited.
Characteristics of Federal Funds
- Immediate Availability: Transactions using federal funds settle on the same day.
- Short-term Lending: Mostly used for overnight lending between banks.
- Reserve Balances: Aid in managing the federal reserve requirements.
Clearinghouse Funds
Clearinghouse funds, on the other hand, represent funds that go through a clearing process, often managed by a clearinghouse association or central clearing facility. These can include transactions that take a specified amount of time, usually one to three days, to clear completely.
Characteristics of Clearinghouse Funds
- Clearing Time: Takes one to three days to become available.
- Settlement of Transactions: Ensures that transactions are settled properly, which includes a float.
- Interbank Transfers: Used frequently in interbank transfers and large financial transactions.
Special Considerations
- One-day Float: A temporary discrepancy where funds are credited in one account but debited in another, leading to a brief period of dual availability.
- Three-day Clearance: Some transactions involving clearinghouse funds typically take up to three days to be fully processed and settled.
Gresham’s Law
Gresham’s Law states that “bad money drives out good money,” implying that money with higher intrinsic value tends to be hoarded and replaced in circulation by money with lower intrinsic value.
Historical Context
Gresham’s Law is named after Sir Thomas Gresham, a financial agent of Queen Elizabeth I. The theory was formally articulated in the 16th century, although the phenomenon it describes has been observed throughout history.
- Example: During periods of coin debasement, precious metal coins were hoarded, while coins with lesser value circulated more widely.
Applicability
In modern terms, this law can be observed in situations where currencies of different intrinsic values coexist, often affecting currency circulation and economic behaviors.
Related Terminology
- Float: The period between the initiation and settlement of a transaction.
- Clearinghouse: An intermediary that facilitates the exchange and settlement of payments, securities, or derivatives transactions.
FAQs
Q1: Why are federal funds considered “good money?” A1: Federal funds are considered “good money” due to their same-day availability for transactions, ensuring immediate settlement.
Q2: What is the significance of the clearinghouse in banking? A2: Clearinghouses provide a centralized mechanism for processing and settling large volumes of transactions efficiently, reducing risks associated with counterparty defaults.
Q3: How does Gresham’s Law apply today? A3: Gresham’s Law applies when newer, less valuable forms of currency or assets replace older, more valuable ones in common circulation, often seen in scenarios of inflation or currency redenomination.
References
- Federal Reserve Bank. “Understanding the Federal Funds Market.”
- Mishkin, Frederic S. “The Economics of Money, Banking, and Financial Markets.”
- Mankiw, N. Gregory. “Principles of Economics.”
Summary
Federal funds, known as “good money” in banking, are those that clear the same day and facilitate immediate transactions. In contrast, clearinghouse funds take one to three days to process. Gresham’s Law highlights the tendency for money of higher intrinsic value to be hoarded, allowing money of lower intrinsic value to prevail in the market. Understanding these terms and their implications is essential for efficient financial and banking operations.
