Week 11 Lecture on Money Supply Process (PDF)

Week 11 Money supply process BANK2011 Banking and the Financial System The University of Sydney Page 1  Learning Objectives 1. Describe the central bank’s balance sheet and the monetary base 2. Explain how the central bank’s balance sheet changes 3. Cal...

Week 11 Money supply process BANK2011 Banking and the Financial System The University of Sydney Page 1  Learning Objectives 1. Describe the central bank’s balance sheet and the monetary base 2. Explain how the central bank’s balance sheet changes 3. Calculate the deposit expansion multiplier 4. Analyse the link between the monetary base and the money supply The University of Sydney Page 2  The Central Bank’s Balance Sheet – There are numerous financial transactions leading to changes in the central bank’s balance sheet. – The structure of the balance sheet gives us a window through which we can study how the institution operates. – Central banks publish their balance sheets regularly. – Publication is a critical part of the transparency that makes monetary policy effective. The University of Sydney Page 3  The Central Bank’s Balance Sheet The University of Sydney Page 4  The Monetary Base – Together, currency in the hands of the public and reserves in the banking system make up the monetary base. – This is the privately held liabilities of the central bank. – It is also called high-powered money. – The central bank can control the size of the monetary base. – When the monetary base increases by a dollar, the quantity of money typically rises by several dollars. The University of Sydney Page 5  Open Market Operations – When the Fed buys or sells securities in financial markets, it engages in open market operations. – To see how the process works, we can track the purchase of $1 billion in U.S. Treasury bonds from a commercial bank. The University of Sydney Page 6  Open Market Operations – The Fed transfers $1 billion into the reserve account of the seller, called a T- account. – The Fed’s assets and liabilities both go up $1 billion, increasing the monetary base by the same amount. – Both the $1 billion in securities and in reserves are banking system assets. The University of Sydney Page 7  Open Market Operations – Notice that the reserves are an asset to the banking system but a liability to the Fed. – This is similar to the balance in your bank account is your asset, but it is your bank’s liability. – If the Fed sells a U.S. Treasury bond through an open market sale, the impact on everyone’s balance sheet is reversed. The University of Sydney Page 8  The Deposit Expansion Multiplier – Central bank liabilities form the base on which the supplies of money and credit are built. – This is why they are called the monetary base. – The central bank controls the monetary base. – Our primary interest, however, is in the broader measures of money which are multiples of the monetary base. – M1. – M2. The University of Sydney Page 9  The Deposit Expansion Multiplier – M1 and M2 are the money we think of as available for transactions. – What is the relationship between the central bank’s liabilities and these broader measures of money? – How do reserves become bank deposits? – This happens in a process called multiple deposit creation. The University of Sydney Page 10  Deposit Creation at a Single Bank – We have an open market purchase in which the Fed buys $100,000 worth of securities from a bank called First Bank. – The bank’s total assets are unchanged. – $100,000 shifts out of securities into reserves. – Reserves typically bear a lower interest rate, so if the bank does nothing, its revenues will fall and so will profits. – Remember these are excess reserves. The University of Sydney Page 11  Deposit Creation at a Single Bank – So now First Bank loans out the reserves to a customer, Office Builders Inc. (OBI). – OBI’s chequing account is credited with $100,000. – OBI writes cheques totalling $100,000. – As the cheques are paid, OBI’s chequing account balance falls, and – First Bank’s reserve account balance falls. – The loan replaces the securities as an asset on First Bank’s balance sheet. The University of Sydney Page 12  Deposit Creation in a Single Bank The University of Sydney Page 13  Deposit Expansion in a System of Banks – All the cheques that OBI wrote end up in someone else’s bank account. – Only the Fed can create and destroy the monetary base. – But the nonbank public determines how much of it ends up as reserves in the banking system and how much in currency. The University of Sydney Page 14  Deposit Expansion in a System of Banks – We start with the following assumptions: – Banks hold no excess reserves. – The reserve requirement ratio is 10%. – Currency holding does not change when deposits and loans change. – When a borrower writes a cheque, none of the recipients of the funds deposit them back in the bank that initially made the loan. The University of Sydney Page 15  Deposit Expansion in a System of Banks – OBI pays $100,000 to American Steel. – American Steel deposits $100,000 into Second Bank. – Second Bank’s reserve account at the Fed is credited with $100,000. – Second Bank will make a loan of its now excess reserves minus the 10% they are required to hold. – The new loan is deposited into Third Bank and the process continues. The University of Sydney Page 16  Deposit Expansion in a System of Banks The University of Sydney Page 17  Deposit Expansion in a System of Banks – At this point, a $100,000 open market purchase has created: – $100,000 + $90,000 + $81,000 = $271,000 – All in new combined loans at First Bank, Second Bank, and Third Bank. The University of Sydney Page 18 The University of Sydney Page 19  Deposit Expansion in a System of Banks The University of Sydney Page 20  Deposit Expansion in a System of Banks – We can derive a formula for the deposit expansion multiplier. – That is the increase in commercial bank deposits following a one-dollar open market purchase. – This continues to assume there are no excess reserves and no changes in the amount of currency held by the nonbank public. The University of Sydney Page 21  Deposit Expansion in a System of Banks – Let’s begin by assuming there is only one bank and everyone must use it. – The level of reserves, then, is just the required reserve ratio rD times its deposits. – If required reserves are RR and deposits are D, then the level of reserves can be expressed as: RR = rDD. The University of Sydney Page 22  Deposit Expansion in a System of Banks – Any change in deposits creates a corresponding change in reserves: ∆RR = rD∆D – The change in deposits is: 1 D = RR rD – For each dollar increase in reserves, deposits increase by (1/rD). The University of Sydney Page 23  Deposit Expansion in a System of Banks – This is the simple deposit expansion multiplier. – For example: rD = 0.10 RR = $100, 000 1 D = ($100, 000) 0.10 D = $1, 000, 000 – An open market sale will decrease deposits in the same way. The University of Sydney Page 24  The Monetary Base and the Money Supply – The simple deposit expansion multiplier is too simple. – In deriving it, we ignored a few details: 1. We assumed banks lend out all their excess reserves, but banks do hold some of their excess reserves. 2. We ignored the fact that the nonbank public holds cash. As people’s account balances rise, they tend to hold more cash. – Both of these affect the relationship among reserves, the monetary base, and the money supply. The University of Sydney Page 25  Deposit Expansion With Excess Reserves and Cash Withdrawals – Assume: – Chequing account holders withdraw 5% of cash. – Banks hold excess reserves of 5% of deposits. – From our previous example, if American Steel takes some of the $100,000 in cash and Second Bank wishes to hold excess reserves, then the next loan cannot be $90,000. The University of Sydney Page 26  Deposit Expansion With Excess Reserves and Cash Withdrawals – American Steel holds the 5% in cash leaving $95,000 in chequing account. – Second Bank holds 5% excess reserves, so they are left with $80,750 to loan out. – Remember they hold 10% as required by the Fed and 5% excess reserves for a total of 15%. – Deposit expansion becomes smaller if we take excess reserves and cash withdrawals into account. The University of Sydney Page 27  Deposit Expansion With Excess Reserves and Cash Withdrawals The University of Sydney Page 28  The Arithmetic of the Money Multiplier – The money multiplier shows how the quantity of money is related to the monetary base. – If we label the quantity of money M and the monetary base MB, the money multiplier m is defined as: M = m × MB The University of Sydney Page 29  The Arithmetic of the Money Multiplier – We will start with the following relationships: – Money equals currency, C, plus chequable deposits, D, – The monetary base MB equals currency plus reserves in the banking system R, and – Reserves equal required reserves RR plus excess reserves ER. M=C+D MB = C + R R = RR + ER The University of Sydney Page 30  The Arithmetic of the Money Multiplier – We know that banks’ holdings of required reserves depends on the required reserve ratio rD. – The amount of excess reserves a bank holds depends on the costs and benefits of holding them. – The higher the interest rate on loans, the lower banks’ excess reserves, and – The greater banks’ concern over the possibility of deposit withdrawals, the higher their excess reserves. The University of Sydney Page 31  The Arithmetic of the Money Multiplier – Labelling the excess reserve-to-deposit ratio {ER/D}, we can rewrite the reserve equation as: R = RR + ER = rDD + {ER/D}D = (rD + {ER/D})D – Banks hold reserves as a proportion of their deposits. The University of Sydney Page 32  The Arithmetic of the Money Multiplier – The currency-to-deposit ratio, {C/D}, is the fraction of deposits that people hold as currency. C = {C/D}D – The decision of how much currency to hold depends on the costs and benefits as well. – The cost of currency is the interest it would earn on deposit. – The benefit is its lower risk and greater liquidity. The University of Sydney Page 33  The Arithmetic of the Money Multiplier – Putting this all together, we can see to following. MB = C + R = {C/D}D + (rD + {ER/D})D = ({C/D} + rD + {ER/D})D – The monetary base has three uses: – Required reserves – Excess Reserves – Cash in the hands of the nonbank public The University of Sydney Page 34  The Arithmetic of the Money Multiplier – We can do the same with the equation for money. M=C+D = {C/D}D + D = ({C/D} + 1)D The University of Sydney Page 35  The Arithmetic of the Money Multiplier – We can use the equation for MB to solve for deposits: 1 D= × MB {C / D } + rD + {ER / D } – And substituting D into the money equation: {C / D } + 1 M=  MB {C / D } + rD + {ER / D } The University of Sydney Page 36  The Arithmetic of the Money Multiplier – The quantity of money in the economy depends on: 1. The monetary base, which is controlled by Fed, 2. The reserve requirement, 3. The banks’ desire to hold excess reserves, and 4. The nonbank public’s demand for currency. The University of Sydney Page 37  The Arithmetic of the Money Multiplier – What is the impact of each of these? 1. If the monetary base increases, the quantity of money increases. 2. An increase in either the reserve requirement or banks’ excess reserve holdings reduces money. 3. When an individual withdraws cash, he or she increases the currency in the public and decreases reserves. The decline in reserves creates a multiple deposit contraction. The money supply contracts. The University of Sydney Page 38  Factors Affecting the Quantity of Money The University of Sydney Page 39  The Limits on the Central Bank’s Ability to Control the Quantity of Money – The various factors affecting the quantity of money change over time. – Market interest rates affect the cost of holding both excess reserves and currency. – As interest rates increase, we expect to see {ER/D} and {C/D} fall. This increases the money multiplier and the quantity of money. The University of Sydney Page 40  The Limits on the Central Bank’s Ability to Control the Quantity of Money – If these changes in the money multiplier were predictable, the central bank might choose to exploit this link in its policymaking. – Although this made sense in the U.S. in the 1930s, it no longer does. – For emerging economies it might. – In countries like the U.S., Europe, and Japan, the link has become too weak and unpredictable to be exploited. The University of Sydney Page 41  The Limits on the Central Bank’s Ability to Control the Quantity of Money – The money multiplier is just too variable. – The relationship between the monetary base and the quantity of money is not something that a central bank can exploit for short-run policy purposes. – Interest rates have become the monetary policy tool of choice. – In a financial crisis, other balance-sheet tools help address liquidity needs and market disruptions more directly. The University of Sydney Page 42  The Limits on the Central Bank’s Ability to Control the Quantity of Money The University of Sydney Page 43  Homework problems – CS chapter 17 – Problems 3, 5, 7, 9, 11, 14, 15, 18 – Data exploration problems 2-4 The University of Sydney Page 44