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INTERMEDIATE MACROECONOMICS

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INTERMEDIATE MACROECONOMICS Powered By Docstoc
					Money and Banking
              Spring 2007
         Martin Andreas Wurm

   University of Wisconsin - Milwaukee

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Money Creation

Required Reading: Mishkin, Chapter 15


                                        2
Money Creation
    1. Overview

        As previously discussed money supply directly affects interest
         rates and, thus, the cost of borrowing.

             Due to the connection between interest rates, investment and
              saving, the money supply can act as an important gauge for
              the economy (see e.g. the IS-LM model).

             However, money supply also affects inflation and we observe
              a certain trade-off between short-run output growth and
              medium-run inflation

                                                                             3
Money Creation
    1. Overview

        In the following, we will discuss the mechanism through which
         the actual money supply is set.

             The players in the process of money creation are the central
              bank, commercial banks as well as their depositors and
              borrowers

             The natural starting point for the discussion of money supply
              is a central bank’s balance sheet


                                                                              4
Money Creation
    2. A central bank’s balance sheet

         The Fed’s balance sheet e.g. is roughly organized as follows:


         Assets                                                          Liabilities
         • <Other Items in the balance   • <Other Items in the balance
            sheet (e.g. Gold) >             sheet >


         • Government Securities         • Currency in Circulation
         • Discount Loans                • Reserves




                                                                                       5
Money Creation
    2. A central bank’s balance sheet

        1. Liabilities

             The mentioned liabilities – currency in circulation and reserves – are
              also referred to as monetary liabilities.

             Both are an important determinants of the monetary supply. If either
              one of them increases, the supply of money increases also, et v.v.

             Together with the monetary liabilities of a country’s treasury (which,
              if at all, consists primarily of coins in developed nations), currency
              in circulation and reserves build the monetary base.



                                                                                     6
Money Creation
    2. A central bank’s balance sheet

        1.1. Currency in Circulation

             While currency (in particular banknotes) is technically a
              liability for a central bank, it can only be exchanged for the
              same currency at a central bank in most countries today.

             In history currency used to be backed by real values such as
              Gold. Today the only reason why people accept these central
              bank “IOUs” in the first place is because they believe that
              they are accepted as means of payment.


                                                                               7
Money Creation
    2. A central bank’s balance sheet

        1.2. Reserves

             Commercial bank-owned reserves are liabilities for a central
              bank, since a central bank is required to pay these on demand
              to commercial banks

             As we have seen, these reserves consist of required and
              excess reserves and as we will see, an increase in reserves
              leads to an increase in the money supply. Reserves pay no
              interest to the banks in the U.S.


                                                                              8
Money Creation
    2. A central bank’s balance sheet

        2. Assets

             Assets are important for two reasons:

             First, changes in a central bank’s assets lead to changes in
              reserves and, thus, changes in money supply
             Second, central banks earn interest on their assets, through
              which they fund themselves. Any earnings in excess of their
              cost of operation is usually transferred to the national
              treasuries.

                                                                             9
Money Creation
    2. A central bank’s balance sheet

        2. 1. Government securities

             Central banks do not hold common stock or risky assets.
              Instead the hold government bonds usually in form of short
              run (3 month) bonds.

             Other than risk considerations central banks are usually
              expected not to buy extensive government debt as this results
              in inflationary pressures.



                                                                           10
Money Creation
    2. A central bank’s balance sheet

        2. 2. Discount loans

             If central banks provide loans to the banking sector they show
              up as assets on their balance sheet.

             In the U.S. the Fed earns the discount rate as return on these
              loans from commercial banks.




                                                                               11
Money Creation
    3. Control of the monetary base

        A central bank cannot control the entire supply of money to an economy.
         However, it can control the monetary base.

             The monetary base B (also: high-powered money) can be written as:


                                       BCR
             Where C indicates currency and R indicates reserves.

             A central bank has a variety of options to change the monetary base,
              which will be discussed in the following using a simplified balance
              sheet for the central bank and its trading partners.

                                                                                 12
Money Creation
    3. 1. Open market operations

        The primary tool of monetary policy are open market operations:

             The purchase of a bond through a central bank is an open market
              purchase and the sale of a bond is an open market sale.

             In principle, a central bank can purchase/sell bonds from the banking
              sector or from the non-bank public.




                                                                                 13
Money Creation
    3. 1. Open market operations

        1. Open market purchase from a bank.

             A central bank can e.g. buy a bond (let’s say worth a $1,000) directly
              from a commercial bank in exchange for reserves

             For the bank this indicates an increase in their reserves of $1,000
              matched by a decrease of their securities of $1,000

             For the central bank securities increase by $1,000 and so do its
              reserve liabilities.



                                                                                    14
Money Creation
    3. 1. Open market operations

         1. Open market purchase from a bank.

         Assets                       Central Bank         Liabilities
         • Government Securities   + $1,000   • Reserves        + $1,000




         Assets                    Commercial Bank         Liabilities
         • Reserves                + $1,000
         • Government Securities   - $,1000


                                                                           15
Money Creation
    3. 1. Open market operations

        2. Open market purchase from the non-bank public

             A central bank can e.g. buy a bond (again worth a $1,000)
              alternatively from other partners (such as traders) in exchange for
              let’s say a check, which this partner deposits into his banks checking
              account.

             Three parties’ balance sheets are affected in this instance, the central
              bank’s, the private bank’s and the private trading partner’s.



                                                                                     16
Money Creation
    3. 1. Open market operations

         2. Open market purchase from the non-bank public

         First, the trading partner’s securities decrease by $1,000 while it’s
          checkable deposits increase by $1,000. Note that the checking
          account is an asset for the private trader

         Assets                           Trader              Liabilities
         • Checkable Deposits      + $1,000
         • Government Securities   - $,1000




                                                                              17
Money Creation
    3. 1. Open market operations

         2. Open market purchase from the non-bank public

         Second, the private bank processes the central bank’s check with
          the central bank increasing the private bank’s reserves, while at
          the same time its checkable deposit liabilities increase by $1,000

         Assets               Commercial Bank                         Liabilities
         • Reserves          + $1,000       • Government Securities        + $,1000




                                                                                      18
Money Creation
    3. 1. Open market operations

         2. Open market purchase from the non-bank public

         Finally, the central bank’s securities and reserve liabilities
          increase by $1,000 just as before.


         Assets                       Central Bank             Liabilities
         • Government Securities   + $,1000   • Reserves           + $1,000




                                                                              19
Money Creation
    3. 1. Open market operations

        2. Open market purchase from the non-bank public

             The net effect of both of these procedures on the monetary base is the
              same:

                         B  C  R  0  $1, 000
             No additional currency has been issued, but reserves have increased
              by $1,000 in both instances.




                                                                                  20
Money Creation
    3. 1. Open market operations

        2. Open market purchase from the non-bank public

        A central bank technically could also buy securities from the
         private public in exchange for currency.

        In this instances, reserves would be unaffected, but the currency in
         circulation would increase. This procedure is depicted below




                                                                           21
Money Creation
    3. 1. Open market operations

         2. Open market purchase from the non-bank public

         Assets                       Central Bank                         Liabilities
         • Government Securities   + $1,000    • Currency in circulation        + $1,000




         Assets                           Trader                           Liabilities
         • Currency                + $1,000
         • Government Securities   - $,1000


                                                                                           22
Money Creation
    3. 1. Open market operations

        2. Open market purchase from the non-bank public

             The net effect of both of this strategy on the monetary base is given
              by:
                         B  C  R  $1, 000  0
             Reserves remain unchanged, while currency in circulation increases
              by $1,000

             Independently of which strategy is used, the monetary base increases
              by $1,000.


                                                                                      23
Money Creation
    3. 1. Open market operations

        3. An open market sale

             Open market sales can use the same three channels and are the exact
              reverse of each procedure.

             Open market sales always decrease the monetary base.

             Hard to predict in the case of sales and purchases is the effect on
              reserves, since a buyer or seller of securities might decide to use
              either currency or checkable accounts in the transaction.

                                                                                    24
Money Creation
    3. 1. Open market operations

        4. Shifts between currency and checkable deposits

             Independently of whether a seller (buyer) of a bond is initially
              compensated (initially pays) using cash or holdings in her/his
              checkable account, she/he can always shift funds from one asset to
              another.

             In this case the system’s reserve holdings are affected. Assume for
              example that a seller of a bond is initially compensated with
              currency, but then deposits these $1,000 in her/his checkable deposit.


                                                                                   25
Money Creation
    3. 1. Open market operations

         4. Shifts between currency and checkable deposits

         Assets                        Trader                          Liabilities
         • Checkable Deposits   + $1,000
         • Currency             - $1,000




         Assets                 Commercial Bank                        Liabilities
         • Reserves             + $1,000        • Checkable Deposits        + $,1000



                                                                                       26
Money Creation
    3. 1. Open market operations

        4. Shifts between currency and checkable deposits

             Similarly if a seller of a bond is compensated in checkable deposits
              and then withdraws money from the private bank, overall reserves
              will decrease.

             Thus, while the overall size of the monetary base does not change, its
              composition depends also on the public’s withdrawal behavior.




                                                                                     27
Money Creation
    3. 2. Discount Loans

        Other than open market operations a central bank’s lending to the private
         banking sector affects the monetary base. In the U.S. this lending is
         processed through the discount window.

        Usually if a discount loan is provided to a bank, the Fed increases that
         private bank’s reserves (increasing the monetary base). As a matter of fact,
         discount loans are often granted so that banks can meet their reserve
         requirements over night.

        If a discount loan is paid back, the monetary base decreases
         correspondingly.


                                                                                  28
Money Creation
    3.2. Discount loans

       Assets                Central Bank               Liabilities
       • Discount Loans   + $1,000    • Reserves              + $1,000




       Assets             Commercial Bank               Liabilities
       • Reserves         + $1,000   • Discount Loans   + $1,000




                                                                         29
Money Creation
    3. 3. Other factors affecting the monetary base

        A central bank does not necessarily have full control over the monetary
         base:

             In the U.S. so-called floats (i.e. temporary increases in reserves in the
              process of check-clearing at the Fed) and Treasury deposits at the Fed
              (i.e. shifts of treasury funds from commercial banks to deposits at the
              Fed which decrease the monetary base) are not fully under control of
              the Fed

             Further certain foreign exchange interventions can affect the
              monetary base as well.

                                                                                    30
Money Creation
    4. Multiple Deposit Creation – the role of private banks

        For every unit of base money a central bank supplies to the private
         banking sector, the creation of checkable deposits on behalf of these banks
         multiplies this amount further increasing larger definitions of the money
         supply such as M2 or M3. This process is known as multiple deposit
         creation.

        Let’s first start with the central bank a single private bank. How does
         money creation on behalf of private banks work?




                                                                                   31
Money Creation
    4. Multiple Deposit Creation – the role of private banks

         1. Since checkable deposits are unaffected by this transaction, required
          reserves do not increase and the bank has an additional $1,000 dollars at
          its disposal, which it has no interest in keeping, since it provides no return.

         2. Let’s, thus , assume, the bank lends these funds out to the private sector
          and deposits this loan in the borrower’s checking account:

         Assets                    Commercial Bank A                  Liabilities
         • Reserves                + $1,000    • Checkable Deposits     + $1,000
         • Government Securities   - $,1000
         • Loans                   + $,1000


                                                                                      32
Money Creation
    4. Multiple Deposit Creation – the role of private banks

        3. Since checkable deposits can be used as means of transactions, the
         creation of checkable deposits has added to the money supply as defined
         in M2 and M3 – in addition to the increase in the monetary base.

        Why is the initial infusion of reserves needed for the bank to be able to
         give out such a loan?

        At the current state, the bank in our example still has excess reserves of
         $1,000 at its disposal. However, these reserves are not going to stay with
         the bank for long: The borrower will either withdraw them or write checks
         against them to pay off whatever he originally obtained the loan for. Thus,
         a bank cannot give out loans fully safely in excess of their free reserves.

                                                                                     33
Money Creation
    4. Multiple Deposit Creation – the role of private banks

        4. Checkable deposits can be traded against deposits within a bank but at
         larger they are traded against checkable deposits in other banks, so that
         this is a good point to introduce another bank.

        Let’s assume that the borrower who obtained his loan from bank A in the
         above example buys a machine and transfers these funds from the
         checking account in bank A to the sellers account in Bank B.

        Let’s for simplicity assume, that Bank B beforehand had no excess
         reserves and is obliged to hold 10% (i.e. $100) of each dollar its checkable
         deposits.

                                                                                   34
Money Creation
    4. Multiple Deposit Creation – the role of private banks

         Assets                Commercial Bank B                  Liabilities
         • Reserves            + $1,000    • Checkable Deposits     + $1,000




         Bank B – apparently has no incentive to hold reserves in addition
          to the required reserves. Thus, it can loan out $900 to borrowers
          and put them into their checkable deposits:

         Assets                Commercial Bank B                  Liabilities
         • Required Reserves   + $1,000    • Checkable Deposits     + $1,900
         • Loans                + $900
                                                                                35
Money Creation
    4. Multiple Deposit Creation – the role of private banks

        As in the case of bank A borrowers will make use of the funds the obtain
         from these loans and the corresponding funds ($900) will be withdrawn
         from bank B. Let’s say these end up in the checking deposits of bank C

         Again bank C is required to hold 10% of these $900 (i.e. $90) as required
         reserves. The remaining $810 can again be given out as loan to somebody,
         etc.

        These process could go on (mathematically forever). The below table
         summarizes this procedure of “multiple deposit creation” for an initial
         infusion of $1,000 worth of reserves and a required reserve ratio of 10%.

                                                                                 36
Money Creation
    4. Multiple Deposit Creation – the role of private banks

          Bank        Increase in   Increase in   Increase in
                      Deposits      Loans         Reserves
          A           0             $1,000        0
          B           $1,000        $900          $100
          C           $900          $810          $90
          D           $810          $729          $81
          E           $729          %656.1        $72.9
          …           …             …             …
          Total       $10,000       $10,000       $1,000



                                                                37
Money Creation
    4. Multiple Deposit Creation – the role of private banks

        Thus, an in initial increase in bank reserves leads to a much higher
         increase in deposits, since banks only have to hold a certain fraction of
         their checkable deposits as reserve requirements (note that this effect is
         independent of whether a bank makes a loan or buys a security)

        This phenomenon is called the simple deposit multiplier, which is given
         by:
                                         1
                                     D  R
                                         r
        Where D stands for deposits, R stands for reserves and r is the reserve
         requirement ratio.
                                                                                      38
Money Creation
    4. Multiple Deposit Creation – the role of private banks

        In our example the change in reserves – sparked by the central banks open
         market purchase – was $1,000.

        The required reserve ratio was equal to 10%, so that deposits increased by
         a factor of 10, or by $10,000:

                                       1
                            $10,000      $1,000
                                      0.1


                                                                                 39
Money Creation
    4. Multiple Deposit Creation – the role of private banks

        Proof of the simple deposit multiplier (a more formal proof can be
         obtained from the limiting behavior of a so-called geometric series):

        We assumed that banks hold no excess reserves, so that the total amount1
         of required reserves RR will be equal to the actual reserves R held by
         banks:
                                  RR=R                                       <1.>

        We further know, that the amount of required reserves is the fraction of
         total checkable deposits in the banking system:

                                   RR=r*D                                  <2.>

                                                                                    40
Money Creation
    4. Multiple Deposit Creation – the role of private banks

        By substitution of <2.> in <1.>, it follows that:

                                       r*D  R
                                          1
                                       D R
                                          r
        Now, if we assume r to be a constant, we can express changes in both sides
         by (this is technically equal to the total differential of this equation):

                                             1
                                         D  R                           q.e.d.
                                             r


                                                                                41
Money Creation
    5. Critique of this simple model

        The simple model suggests that a central bank is in perfect control over the
         money supply through open market policy, discount loans and reserve
         requirements.
             However, the actual procedure is less mechanical than suggested by the
              model. If at any point proceeds from loans or securities are kept in cash
              instead of being deposited or if excess reserves are not fully used to
              buy loans or securities, the process stops, which makes the multiplier
              much less predictable
        Both are plausible scenarios and a central bank, hence, is not the only player
         in determing the actual money supply. Banks, borrower’s and depositors
         behavior matter as well - as we will see in the following


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