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Money _ Central Banks


									Central Bank Balance Sheet and
  the Money Supply Process
          Chapter 17
        Banking Regulation
• Many central banks require banks to keep
  some fixed fraction of checking deposits
  as deposits at central bank.
• Required reserve ratio - 0 ≤ rr < 1.
• China most prominently uses the reserve
  ratio as a measure of monetary policy.
  Reserve Ratios
  From Around
  the World.


Hong Kong 0
People’s Bank of China
Reserve Requirement
     Money Supply The stock of the medium of
      exchange supplied by the central bank.

               Types of Financial Assets

M1    Currency in Hands of the Public [C] + Demand
      Deposits [D]

M2    M1 + Savings Deposits + “Small” Time Deposits +
      [Liquid Money Market Instruments inc/ “Small” NCD’s]

M3    M2 + LTD [“Large” Time Deposits and NCD’s]
          The Monetary Base
• The monetary base, also called “high powered
  money” consists of:
        C    Currency in the Hands of the Public
       +R     + Reserves of the Banking System
      =MB                      = Monetary Base

 • Monetary base is typically the monetary
 liabilities of the central bank .
Money Supply vs. Monetary Base

 Monetary       Money            Money
            *                =   Supply
 Base           Multiplier
           Balance Sheets
• Central banks like all banks have balance
  sheets with assets and liabilities.
• Hong Kong has some unique monetary
  institutions which may be most usefully
  examined in the contrast with US central
  bank (which is examined closely in the
Balance Sheets of U.S. Federal Reserve

               Billion US$, 12-2004, Federal Reserve
               Annual Report
     Central Bank Balance Sheet
• Government Securities: A large number of
  central banks (but not HK) hold domestic
  currency government bonds as main holdings of
  central bank.
  – These are used to conduct monetary policy
• Foreign Reserves: Central banks typically hold
  some foreign currency assets. Foreign reserves
  are also held by Treasury/Finance Ministry.
    Central Bank Balance Sheet
           Assets (cont.)
• Loans: Central banks also conduct
  monetary policy by lending reserves to
• Miscellaneous:
  – Float: Checks in the process of the payment
  – Gold Reserves, Stocks Etc.
           Structure of Assets: HK
Interest Paid to                                                Land Fund
Fiscal Reserve                Exchange Fund Assets
                                                               (since 1999)

                   Backing Portfolio          Investment Portfolio
                      (Invested                    (Invested
                     for Liquidity)               for Return)

                                           Domestic       Foreign
                    US Treasuries          Equities      Securities
Foreign vs. Domestic Currency
    Central Bank Balance Sheet
• Deposits of the Government: Central Bank
  manages some of government wealth.
  – In 1997, holdings of the Land Fund were
    deposited with HKMA along with HK’s Fiscal
       Central Bank Balance Sheet
           Monetary Liabilities

• Currency: Paper Money is typically issued by
  central bank. Coins are sometimes (as in HK)
     • Currency Held by Non Bank Public [C]
     • Currency Held by Banks aka “Vault Cash”:
       includes money ATM machines.
• Deposits of Banks: Banks keep accounts at the        [R]
  central bank to facilitate payments and meet
  regulatory requirements.
    An average of 4.6% of currency in circulation in
    USA is vault cash. In HK, 7.5%
Balance Sheet of Exchange Fund

          Billion HK$, 12-2004, HKMA Annual Report
HK$ Money Categories
  Source: HKMA
Hong Kong’s Unique Monetary
 “Guide to Hong Kong Monetary and Banking
            Terms” by HKMA.see
• Hong Kong’s central bank does not print money.
• Bank of China, HSBC, and Standard Chartered
  print banknotes but…
   – the banks can only issue paper notes if they
     buy licenses from the central bank with US$
     at a rate of $1 per HK$7.8 printed.
• The Licenses are called Certificates of
  Indebtedness Certificates issued by the
  Financial Secretary to be held by note-
  issuing banks as cover for the banknotes
  they issue.
• CI’s appear as liabilities on HKMA balance
   Certificates of Indebtedness
increase when currency increases

   • Coins (and recent 10 Banknotes) are
     issued by the central bank unlike the
     USA where they are issued by the

Definitions here are from the “Guide to Hong Kong Monetary and Banking
  Terms” by HKMA.see
   Reserves: Clearing Balances
• The reserve requirement in HK is zero.
  Banks must only have enough reserves to
  meet all of their payment obligations.
• Clearing Account: The accounts
  maintained with the HKMA for settling inter-
  bank balances and payments between
  banks and the HKMA.
  – Aggregate Balances: The sum of balances
    maintained by banks in clearing accounts at the
    central bank.
Reserves: Exchange Fund Bills
• Exchange Fund Bills and Notes Debt
  Instruments issued by the HKMA for the
  account of the Exchange Fund.
• Since 1990, the Exchange Fund has sold
  short-term bonds (stretching the maturity
  structure as time goes on ).
• Exchange Fund bonds are listed on HKEX
  and traded in secondary markets.
Should government debt be part of
       the monetary base?
• Exchange Fund Paper can be held by anyone,
  but large share is owned by local banks.
  Therefore, they can be thought of as being
  mostly secondary reserves of banks.
• ExFund paper is held primarily for HK$ liquidity
  management purposes.
• These instruments are fully backed by Foreign
  Reserves. The HKMA has undertaken that new
  Exchange Fund paper will only be issued when
  there is an inflow of funds.
Hong Kong Exchange Fund Bills
 HKMA & Fed: Similarities & Differences
            Assets                Base
Same                              Central Bank
Different   •Fed assets are       • HK liabilities
            primarily Treasury    include interest
            securities            paying tradable
            •HKMA assets are      securities primarily
            primarily foreign     held by banks
            currency securities   •Fed Liabilities
                                  don’t pay interest.
                                  Ex Fund bonds do.
    HKMA & Fed Similarities & Differences
            (Monetary Base)

            Currency             Reserve Accounts

Same        Large part of        Banks keep funds at
            monetary base.       central bank
Different   • Fed prints US      • US Reserve accounts
            currency             are required by
            •3 private banks     regulation.
            purchase licenses    •HK Clearing balances
            to print currency.   are only necessary for
Changing the Monetary Base
  4 Ways Central Banks Change
         Monetary Base
1. Open Market Operation – Sell/Purchase
   Government Securities
2. Discount Window – Bank borrows funds
   from Central Bank
3. Foreign Exchange Intervention
4. Printing Currency
• T-Accounts are a handy tool for examining
  the effects that any transaction has on
  balance sheets.
• A bank transaction will change both
  liabilities and assets (and possibly net
  worth). The total change in liabilities plus
  net worth must always equal the total
  change in assets.
             Open Market Purchase:
          The Fed Purchases $100 of T-Bills from Bank A

• Fed credits the reserve   Fed Balance Sheet
  accounts of Bank A which Assets             Liabilities
  increases its liabilities
  and takes possession of   +100 T-Bills      + 100 Reserves
  an equal value of
  securities as assets.

                                 Bank A Balance Sheet
• Bank A gets an extra            Assets                Liabilities
  amount of reserves and
                                  +100 Reserves
  loses an equal amount of
  securities.                     -100 T-Bills
              Exchange Rate
•   The exchange rate between any
    currency and the US dollar can be
    written in two ways.
    1. S: # of Currency Units per dollar (e.g.
       7.8HK$ per US$)
    2. Ex: # of Dollars per Currency Unit (e.g.
•   For most currencies (exceptions € & £),
    the former definition prevails.
           Currency Market Intervention
Central Bank buys 100/S foreign currency from Bank.
• Central Bank          Central Bank Balance Sheet
  credits Bank A
  reserves with 100      Assets                         Liabilities
  of domestic            +100 Foreign Reserves*         + 100 Reserves
• This will increase
  Central Banks            *100/S when measured in foreign currency
  asset holdings of
                       Bank A Balance Sheet
  foreign reserves
  of 100/S.                Assets                        Liabilities
• Bank A has 100
  extra in reserve         +100 Reserves
  assets but loses         -100 Foreign Currency*
  100/S in foreign
           Discount Loans :
        The Fed Lends $100 to Bank A
                       Fed Balance Sheet

Reserves are         Assets            Liabilities
divided into         +100 Loan         + 100 Reserves
reserves and
nonborrowed            Bank A Balance Sheet
reserves.             Assets               Liabilities
                      +100 Reserves        + 100 Loan
 Convertibility Undertaking: Currency
• Currency Board “When the three NIBs issue
  banknotes, they are required to submit US dollars
  (at HK$7.80=US$1) to the HKMA for the account of
  the Exchange Fund in return for Certificates of
  Indebtedness (which are required by law as
  backing for the banknotes issued).”

HKMA      A           L
+100 FC Reserves      +100 CI’s

      NIB       A            L
      +100 CI’s              -100 Deposit
      -100 FC Reserves       +100 Cash      2
      Clearing Accounts Reserves
• 1996-2005 The HKMA has an undertaking to
  convert Hong Kong dollars in clearing accounts
  into US dollars at rate of HK$7.8 to US$1
  – When the exchange rate depreciates to $7.8, the
    HKMA allows licensed banks to trade clearing
    balances for US dollars.

• May 2005 Under the strong-side Convertibility
  Undertaking, the HKMA undertakes to buy US
  dollars from licensed banks at 7.75. Under the
  weak-side Convertibility Undertaking, the HKMA
  undertakes to sell US dollars at 7.85.
   – Within the Convertibility Zone between 7.75 and 7.85,
     the HKMA may choose to conduct market operations
Convertibility        HKMA

Undertaking &         Assets           Liabilities
                       + 100 Foreign            + 100
                           Currency          Reserves
• Bank A converts        (US$12.82)
  US$12.82 into HK$
The Money Supply Process
     Fractional Reserve Banking
• Banks keep only a fraction of any deposits
  they receive on hand in the form of vault.
  The rest is used to acquire other assets,
  especially loans.
• Reserves- Deposit Ratio:
The fraction of deposits kept as reserves is
  the Reserves-Deposit Ratio.
  – D = Demand Deposits (we can think of this as
    equivalent to checking accounts).
            Liquidity Portfolio
• Savers keep some of their asset portfolio in
  liquid assets.
• We can divide up liquid assets into currency and
• Currency-Deposit Ratio:
  – Bank deposits and currency are both assets which
    will be part of the portfolios of savers.
     Monetary Base & Money Supply
• A given increase in the monetary base
  creates money on a greater than 1 for 1
• Each $1 of reserves can be used to
  back up more than $1 of deposits which
  will exist as the stock of money.
• Money supply consists of currency in
  circulation plus some level of bank
                  M1 = C + D
OMO & Multiple Deposit Expansion
• The simplest way to see how fractional
  reserve banking causes multiple money
  expansion is to assume           .        .
• In our example, we will assume        .
      Central bank open market purchase
    increases Bank A’s reserves by $100K.
                           Bank A
1. Bank A increases                    Assets Liabilities
2. Bank makes loan to           +100 Reserves
   real estate developer      1
   by crediting bank               -100 T-Bills
   account.                     2   +100 Loan + 100 Deposits
3. Developer writes a         3 -100 Reserves -100 Deposits
   check to pay a
   construction company
   for services.           Bank B
                            Assets              Liabilities

• Construction Company      +100 Reserves       +100 Deposits
  deposits check with
  Bank B
Money Circulates through fractional
        reserve banking
                              Bank B
• Bank B maintains 10% of
                               Assets           Liabilities
  new deposits as reserves.
• They loan 90 to a            +100 Reserves    +100 Deposits
  department store. Bank B
  puts 90 into the department  +90 Loans        +90 Deposits
  stores checking account.
                                                -90 Deposits
• The department store writes -90 Reserves
  a check to a clothes
  manufacturer for inventory. Bank C
• The clothes manufacturer    Assets           Liabilities
  deposits the check at Bank
                              +90 Reserves     +90 Deposits
 • Bank C maintains 10% of new deposits as reserves. They loan
   81 to a car dealer. Bank C puts 81 into the car dealers checking
   account. The department store writes a check to a car
         Bank C

         Assets                  Liabilities
         +90 Reserves            +90 Deposits
         +81 Loans               +81 Demand Deposits
         -81 Reserves             -81 Demand Deposits

Bank D      Assets                   Liabilities
            +81 Reserves             +81 Demand Deposits
                                Bank D

Assets            Liabilities

+81 Reserves      + 81 Deposits
+72.90 Loans      +72.90 Deposits
-72.90 Reserves    -72.90 Deposits

                                Bank E

Assets            Liabilities
+72.90 Reserves   +72.90 Deposits
+65.61 Loans      +65.61 Deposits
-65.61 Reserves    -65.61 Deposits
         Reserves       Demand
Bank B   10             100
Bank C   9              90
Bank D   8.1            81
Bank E   7.29           72.90
Bank F   65.61          65.61
Total    100            409.31

                 But the process continues…
   Deposit Expansion Multiplier
                   Figure 17.17: Multiple Deposit Creation
                             Reserves                               $100,000
          Federal                                                     Loan           Real Estate
                                                 Bank A
          Reserve                                                                    Developer
                                     $90,000                                                Payment
          Bank C                                 Bank B                             Construction
     Retains $9,000 in                                                               Company
     Retains $9,000 in
         Reserves           $90,000             Retains $10,000
                                               Retains $10,000
        Reserves           Deposit                 Reserves
                                                in in Reserves

$81,000                             $72,900
 Loan                                  Loan                                    $65,610
                                                                                Loan        and on
                         Bank D                             Bank E
    $81,000                                                                                 and on.
                    Retains $8,100 in                    Retains $7,290 in
    Deposit            Reserves           $72,900           Reserves
                        Assuming a 10 percent reserve requirement, banks hold
                   no excess reserves, and there are no changes its currency holdings.
          Money Multiplier
• The change in the money supply is a
  multiple of the change in the base

• If      , the money multiplier is 10
           Monetary Feedback
                                Central Bank


           Monetary Feedback
                                Central Bank


           Monetary Feedback
                                 Central Bank


                M1 Multiplier
• In the more general case, the M1 multiplier can
  be derived by the ratio of M1 to the monetary

• As long as the reserve ratio is less than 1, the
  money multiplier is greater than 1.
• Multiplier is decreasing in reserve-deposit ratio
  and decreasing in cash-deposit ratio.
           Monetary Feedback

Reserves                        Central Bank


M2 Multiplier
    Determinants of Reserve Ratio
1. Regulatory Requirements – Some regulatory
   regimes have minimum reserve levels.
                     Reserve Ratio =
     Required Reserves Ratio + Excess Reserves Ratio
                     (R/D) = rr + ER/D
2. Market Interest Rates – If assets are held in the form
   of reserves, banks lose opportunity to get interest
   income. The greater is the interest rate, the less
   reserves held.
3. Volatility of Deposit Outflows – If deposit outflows are
   likely to be large, banks hold more reserves.
China Monetary Policy
         Determinants of C/D
1. Wealth – Holding some cash is probably a
   necessity. Wealthier people hold less of their
   wealth in the form of cash.
2. Returns on Deposits – If the deposit interest rate
   is high, currency deposit ratio is small.
3. Risk – High default risk of bank deposits
   encourages cash holdings. Low crime risk
   encourages cash holdings.
4. Liquidity – Difficulty in using deposits in
   transactions encourages cash holdings.
5. Value of Anonymity Premium – High levels of
   black market activity/tax avoidance encourages
   cash holdings.
Japanese Banks face probability of
     default in recent years.
Money Multiplier and
 Monetary Policy
   Money as a Nominal Anchor
• One way to commit to a low inflation policy
  is to commit to low money growth a tenet
  of a school of macroeconomic analysis
  referred to as “monetarism”
• Timely reporting of the supply of money
  can help to build credibility for low inflation.
Problem: Central bank cannot control the
  money supply. Can only directly control
  the monetary base.
     US M2
•The history of
volatility of the M2
multiplier has
convinced the Fed
that it is impossible to
control the money
supply through their
control of the
monetary base.
• Over the past
  8 years, the
  M2 multiplier
  has been
  more volatile
  in HK than the
 Can the Central Bank Control the
         Money Multiplier
• The government’s main tool to control the
  multiplier is the required reserve ratio. However,
  this regulatory tool is less effective if banks
  reserve holdings exceed requirements.
• In other economies, such as the US and
  Euroland, the reserve requirement is low and the
  regulation seldom binds.
  – Technological change has allowed banks to evade
    reserve requirements.
• In many economies, including HK, Australia,
  Canada and the UK there is no reserve
 HK Dollar Peg: Fully Backed?
• The convertibility undertaking requires the
  HKMA to convert foreign currency into
  domestic currency at a rate of
• Does the monetary authority have enough
  US dollars to meet this undertaking?
HK Foreign Currency Reserves vs.
       HK Money Supply

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