Module 8
Central Bank Balance Sheet and Money Supply Assignment
a. The Central Bank’s Balance Sheet
As the government’s banker and the bankers’ banker, the central bank engages
in numerous financial transactions. It supplies currency, provides deposit accounts to
the government and commercial banks, makes loans, and buys and sells securities and
foreign currency. All these activities cause changes in the central bank’s balance sheet.
Because the balance sheet is the foundation of any financial institution, understanding
the day-to-day operation of a central bank must start with an understanding of its
assets and liabilities and how they change. 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. The Federal Reserve and the European Central
Bank both do so weekly; you can find the information on their websites. (To get a
sense of the changing scale and composition of the Fed’s balance sheet, see Applying
the Concept on page&452.) Publication is a critical part of the transparency that makes
monetary policy effective. The actual published data are complicated and include
items we don’t need to worry about here. Instead, we’ll focus on a strippeddown
version of the balance sheet, one that has been reduced to the most important
components.
Imagine you are poring over the intricate balance sheet of a central bank. As
you study the document, you notice that it's meticulously divided, not just into the
familiar columns of assets on the left and liabilities on the right, but into distinct
categories as well. This organization is no mere coincidence—it reflects the central
bank’s multifaceted roles and responsibilities.
At the top of the balance sheet, you find the first category: the central bank's
activities as the government's bank. Here, the entries reveal the various assets and
liabilities the central bank manages on behalf of the government. This section is like a
financial panorama, showcasing the central bank’s crucial functions in this capacity.
As you delve into the assets, you see government securities—bonds and other
debt instruments issued by the government and held by the central bank. These
securities form a significant part of the central bank's assets, representing the money
the government owes to the central bank.
Next, you notice the central bank's gold reserves. These glittering assets are a
testament to the nation's wealth and stability, providing a tangible foundation for the
currency. Gold has always been a symbol of economic strength, and here it stands
proudly on the balance sheet.
Another intriguing entry is the foreign exchange reserves. These are holdings
of foreign currencies, and they play a pivotal role in maintaining the country's
exchange rate and managing external debt. The central bank uses these reserves to
intervene in the foreign exchange market, ensuring the stability of the national
currency.
On the liabilities side, you find the government’s deposit accounts. These
accounts hold the government’s funds, ready to be deployed for various public
expenditures. When the government collects taxes or issues bonds, the money flows
into these accounts. Conversely, when the government spends on infrastructure,
defense, or social programs, the money flows out.
Below the government’s bank section, you discover another category: the
central bank's role as the bankers’ bank. This part of the balance sheet sheds light on
how the central bank supports the commercial banking system, ensuring its smooth
operation.
Here, among the assets, you spot loans to commercial banks. These loans are
extended to banks in need of liquidity, helping them manage short-term funding needs
and stabilize the financial system. The central bank acts as a lender of last resort,
providing a safety net for the banking sector.
You also see securities purchased under repurchase agreements, known as
repos. In these transactions, the central bank buys securities from commercial banks
with an agreement to sell them back later. This process injects liquidity into the
banking system, aiding in the smooth functioning of financial markets.
On the liabilities side, you find the commercial banks’ reserve accounts. These
accounts are the mandatory reserves that commercial banks must hold with the central
bank. These reserves are crucial for the implementation of monetary policy, as they
influence the amount of money banks can lend to businesses and consumers.
Another key liability is the currency in circulation. This entry represents the
physical money—coins and banknotes—that is used by the public. The central bank is
responsible for issuing and managing this currency, ensuring there is enough to meet
the demands of the economy.
As you continue to explore the balance sheet, you gain a deeper appreciation
of the central bank's dual role. It's not just a distant institution setting interest rates and
controlling inflation; it is the government’s trusted financial advisor and the guardian
of the banking system’s stability. Each entry on the balance sheet tells a story of
economic stewardship, a narrative of balancing growth and stability in an ever-
changing financial landscape.
By understanding these entries, you unlock the secrets of the central bank’s
operations and its pivotal role in the economy. From managing government funds to
ensuring the health of commercial banks, the central bank stands as a pillar of
financial strength, guiding the nation through the complex world of modern finance.
Foreign exchange reserves are the central bank’s and government’s balances of
foreign currency. These are held in the form of bonds issued by foreign governments.
For example, the Fed holds euro-denominated bonds issued by the German
government as well as yen-denominated bonds issued by the Japanese government.
These reserves are used in foreign exchange interventions, when officials attempt to
change the market values of various currencies. Loans are usually extended to
commercial banks. But, in 2008 and 2009, as part of its extraordinary response to the
financial crisis, the Fed made substantial loans to nonbanks as well. There are several
kinds of loans, and their importance varies depending on how the central bank
operates. Discount loans are the loans the Fed makes when commercial banks need
short-term cash. Discount loans usually are in the millions of dollars, but the volume
temporarily surged in 2008 to beyond $400 billion as the Fed battled the liquidity
crisis.
Securities are the primary assets of most central banks. Traditionally, the Fed
exclusively held Treasury securities, mostly short maturity. However, during the
2007– 2009 financial crisis, the central bank chose to acquire a variety of riskier
assets, including more than $1 trillion of mortgage-backed securities (MBS, page&52),
making MBS temporarily the largest component of Federal Reserve assets. Later, the
central bank sharply boosted purchases of medium- and long-term Treasury
instruments, restoring U.S. government debt to the top rank. The quantity of securities
that the Fed holds is controlled through purchases and sales known as open market
operations. It is important to emphasize that independent central banks, not fiscal
authorities, determine the quantity and mix of securities they purchase.
Prior to the financial crisis of 2007–2009, the Fed controlled the federal funds
rate and the availability of money and credit by adjusting its holdings of liquid
securities, primarily short-term Treasury bills. Foreign exchange reserves play only a
small role in Fed policy, and (aside from crises) loans are almost always modest. At
other central banks, this ranking of assets often differs. For example, the ECB’s
primary assets prior to the euro-area crisis were collateralized loans (repos) to the
banks, rather than securities, but that ranking has reversed in recent years as the ECB
expanded its securities holdings rapidly.2 In many trade-dependent economies, the
primary focus is often on the level of foreign exchange reserves.
Turning to the liabilities side of the central bank’s balance sheet, we see three
major entries: currency, the government’s deposit account, and the deposit accounts of
the commercial banks. Again, these can be divided into two groups based on their
purpose. The first two items allow the central bank to perform its role as the
government’s bank, while the third allows it to fulfill its role as the bankers’ bank.
Let’s look at each in turn, again using the example of the United States to illustrate
some important details.
Government’s account. Governments need a bank account just like the rest of
us. They must have a place to deposit their income and a way to pay for the things
they buy. The central bank provides the government with an account into which the
government deposits funds (primarily tax revenues) and from which the government
writes checks and makes electronic payments. By shifting funds between its accounts
at commercial banks and the Fed, the Treasury usually keeps its account balance at
the Fed fairly constant. However, to improve the Fed’s ability to purchase assets
during the financial crisis, the Treasury temporarily increased its central bank
deposits, which peaked at more than $500 billion in November 2008. Commercial
bank accounts (reserves). Commercial bank reserves are the sum of two parts:
deposits at the central bank plus the cash in the bank’s own vault. The first of these
functions like the commercial bank’s checking account. In the same way that you can
take cash out of a commercial bank, the bank can withdraw its deposits at the central
bank. And just as you can instruct your bank to transfer some part of your account
balance to someone else, a commercial bank can transfer a portion of its deposit
account balance to another bank. Vault cash is part of reserves; it is not part of item 1,
which includes only cash held by the nonbank public. Because a bank’s vault cash is
available to meet depositors’ withdrawal demands, it serves the insurance function for
which reserves are designed.
Reserves, which play a crucial role in the financial system, are assets held by
the commercial banking system and simultaneously represent liabilities for the central
bank. These reserves are a pivotal component in the functioning of monetary policy
and the banking sector. They serve as a buffer to ensure liquidity and stability within
the financial system, enabling banks to meet their obligations and support economic
activity.
During and after financial crises, such as the global financial crisis of 2008,
central banks like the Federal Reserve (Fed) in the United States and the European
Central Bank (ECB) in the Eurozone implemented a series of extraordinary policy
measures. These measures included quantitative easing and other forms of monetary
stimulus aimed at stabilizing the financial system, ensuring the flow of credit, and
fostering economic recovery.
Quantitative easing involved the large-scale purchase of government securities
and other financial assets by central banks. This action significantly increased the
reserves held by commercial banks, as the central banks credited their accounts in
exchange for these assets. Consequently, the balance sheets of the Fed and the ECB
expanded substantially, with reserves becoming the largest liability on their books by
2019.
The increase in reserves had several implications. For one, it provided banks
with a greater cushion of liquidity, enhancing their ability to lend and manage short-
term funding pressures. It also influenced the interest rates in the economy, as the
abundance of reserves affected the supply and demand dynamics in the interbank
lending market.
Moreover, the high level of reserves underscored the central banks'
commitment to maintaining financial stability and supporting economic growth. It
reflected their readiness to intervene in the markets as needed to prevent systemic
failures and to promote a resilient financial system.
As of 2019, the vast amounts of reserves held by commercial banks indicated
the lasting impact of the policy actions taken during the crisis period. These reserves
remained a critical element in the central banks' toolkits, providing them with the
flexibility to manage future economic challenges and to implement monetary policy
effectively. The interconnectedness of the commercial banking system and central
banks, epitomized by the reserves, continues to play a fundamental role in ensuring
the smooth functioning of the global financial system
Of all central bank liabilities, bank reserves are the most important in
determining the quantity of money and credit in the economy, and for this reason, they
play a central role in monetary policy operations. Increases normally lead to a rise in
deposits and to growth in the availability of money and credit; decreases do the
opposite. Originally, the government required banks to hold a certain level of reserves
to ensure banks’ safety and soundness. However, as a result of financial innovations
that reduce the demand for checkable deposits, required reserves declined well below
the level of overall reserves that banks wish to hold. Indeed, today’s bankers hold
excess reserves both as insurance against unexpected outflows and for use in
conducting their day-today business.
Buried in the mountain of paper that every central bank publishes is a
statement of the bank’s own financial condition. This balance sheet contains what is
probably the most important information that any central bank makes public. Every
responsible central bank in the world discloses its financial position regularly, most of
them every week. In the same way that shareholders require a periodic accounting of
the activities of the companies they own, we are all entitled to the information on our
central bank’s balance sheet. Without public disclosure of the level and change in the
size of foreign exchange reserves and currency holdings, it is impossible for us to tell
whether the&policymakers are doing their job properly. Publication of the balance
sheet is an essential aspect of central bank transparency. Delays, like those during the
Mexican debt crisis of 1994–1995, are a clear sign of impending disaster. Another
sign of trouble is misrepresentation of the central bank’s financial position. A
particularly egregious case of lying by a central bank occurred in the Philippines in
1986, when then-President Ferdinand Marcos was desperate to remain in power.
It has come to light that Ferdinand Marcos, in a bid to secure electoral victory,
ordered the central bank to engage in the massive and clandestine printing of
currency. This drastic measure was intended to generate a substantial amount of
money that could be distributed to voters, effectively attempting to buy enough
individual votes to sway the election outcome in his favor.
The process of printing such vast amounts of currency was not just a logistical
challenge but also a highly secretive operation. The central bank, under immense
pressure from Marcos, meticulously concealed the extent of this monetary expansion.
This concealment was crucial to prevent any immediate economic repercussions and
to avoid alarming both domestic and international observers who closely monitored
the country's monetary policy and economic stability.
The central bank's role in this scheme was multifaceted. It had to ensure that
the newly printed currency entered the economy in a manner that did not immediately
trigger hyperinflation or draw suspicion. This involved sophisticated planning and
coordination with various government agencies and political operatives who would be
responsible for distributing the funds in a way that appeared legitimate or, at the very
least, difficult to trace back to the central bank's activities.
Despite these efforts to maintain secrecy, the sudden influx of money into the
economy inevitably caused inflationary pressures. Prices of goods and services began
to rise as the increased money supply chased the same amount of goods. However, the
full extent of the inflation was somewhat delayed, as the central bank likely took
measures to stagger the release of funds to mitigate the immediate impact.
Additionally, the central bank may have engaged in other forms of monetary
manipulation to disguise the effects of the increased money supply. These could have
included interventions in foreign exchange markets to stabilize the currency or
adjustments in interest rates to control inflationary expectations among the public and
investors.
The aftermath of this elaborate scheme left the economy in a precarious state.
Once the election was over, and regardless of the outcome, the excessive money
supply had to be dealt with. This likely led to long-term economic challenges,
including higher inflation, reduced confidence in the currency, and potential
difficulties in managing the country's monetary policy going forward.
Furthermore, the revelation of such a scheme would have significant political
and social repercussions. It would erode trust in both the government and the central
bank, leading to increased scrutiny and calls for accountability. Internationally, it
could damage the country's reputation, affecting foreign investment and relations with
other nations and international financial institutions.
In summary, Marcos's decision to print enormous amounts of currency to buy
votes involved a complex and covert operation by the central bank to conceal the true
scale of monetary expansion. While it might have offered a temporary political
advantage, the long-term economic and reputational damage underscored the high
risks associated with such an audacious and unethical maneuver.
Together, currency in the hands of the public and reserves in the banking
system—the privately held liabilities of the central bank—make up the monetary
base, also called high-powered money. As we will see in the next section, the central
bank can control the size of the monetary base, the base on which all other forms of
money stand. (The term high-powered comes from the fact that the quantity of money
and credit in the economy is a multiple of currency plus banking system reserves.
When the monetary base increases by a dollar, the quantity of money typically rises
by several dollars. To get some sense of the relationship between the monetary base
and the quantity of money, we can look at a few numbers. In January 2019, the U.S.
monetary base was $3.34 trillion. At the same time, M1 was $3.74 trillion and M2
was $14.47 trillion. So M1 was was barely 12 percent larger than the monetary base,
while M2 was more than four times greater than the monetary base return to these
relationships and learn how the financial crisis of 2007–2009 altered them. But first,
let’s see how the central bank adjusts its balance sheet and changes the size of the
monetary base.
b. Changing the Size and Composition of the Balance Sheet
Unlike you and me, the central bank controls the size of its balance sheet. That
is, policymakers can enlarge or reduce their assets and liabilities at will, without
asking anyone. We can’t do that. To see the point, think about a simple transaction
you engage in regularly, like buying $50 worth of groceries. When you arrive at the
checkout counter, you have to pay for your purchases. Let’s say you do it with a
check. When the supermarket deposits your check in the bank, your $50 moves
through the payments system. It is credited to the supermarket’s account and,
eventually, debited from yours. As long as you started with at least $50 in your
checking account, the process works smoothly. The grocery store’s bank account is
$50 larger and yours is $50 smaller. Now think about a standard transaction in which
the central bank buys a $1 million government security. What’s the difference
between this purchase and yours at the grocery store? First, there is its size. The
central bank’s transaction is 20,000 times as big as yours. But that’s not all. To see
another important difference, let’s look at the mechanics of the security purchase. To
pay for the bond, the central bank writes a $1&million check payable to the bond
dealer who sells the bond. (In real life, the transaction is done electronically.) After
the check is deposited, the dealer’s commercial bank account is credited $1 million.
The commercial bank then sends the check back to the central bank. When it gets
there, something unusual happens. Remember, at the end of your check’s journey,
your bank debited your checking account $50. But when the central bank’s $1 million
check is returned, the central bank credits the reserve account of the bank presenting it
$1 million.
The ability of a central bank to expand its balance sheet through various
monetary policy tools, such as purchasing assets like government bonds, illustrates its
pivotal role in influencing economic conditions. Let's delve deeper into how this
process works and its broader implications.
When a central bank, like the Federal Reserve in the United States or the
European Central Bank (ECB), decides to purchase assets such as government bonds
or mortgage-backed securities, it does so with the aim of injecting liquidity into the
financial system. This action increases the reserves held by commercial banks,
effectively adding to their capacity to lend and stimulating economic activity.
The mechanism behind this operation involves the central bank creating new
money electronically to pay for the assets it acquires. This newly created money is
then credited to the reserves of the commercial banks that sold the assets to the central
bank. As a result, the central bank's balance sheet expands, with the asset purchased
(e.g., government bonds) on one side and the corresponding increase in reserves on
the liabilities side.
Importantly, this process highlights the central bank's ability to influence
interest rates and overall monetary conditions in the economy. By purchasing assets,
the central bank can lower long-term interest rates, thereby encouraging borrowing
and investment. This is particularly effective during times of economic downturn or
when conventional monetary policy tools, such as adjusting short-term interest rates,
are constrained.
The size of a central bank's balance sheet is not inherently limited; it can
theoretically expand as much as necessary to achieve its policy objectives. However,
the implications of such expansion are carefully monitored. For instance, a
significantly enlarged balance sheet could lead to concerns about inflationary
pressures or financial stability if not managed prudently.
Moreover, the central bank's ability to create liabilities (such as reserves in the
banking system) to finance its asset purchases underscores its unique role in the
economy. This power is balanced by the need for transparency, accountability, and
clear communication to maintain confidence in its operations and to ensure that its
actions support long-term economic stability and growth.
The flexibility of a central bank's balance sheet expansion extends beyond
traditional asset purchases. In recent years, central banks have employed
unconventional measures like quantitative easing (QE), which involves large-scale
purchases of various assets beyond government bonds. These measures aim to address
specific economic challenges, such as deflationary pressures or financial market
disruptions.
In conclusion, while central banks have the authority to expand their balance
sheets through asset purchases and the creation of liabilities, the implications of such
actions are significant and require careful consideration. The ability to influence
economic conditions through these monetary policy tools underscores the central
bank's critical role in maintaining price stability, supporting growth, and safeguarding
financial stability in the broader economy.
Turning to the specifics of this process, we’ll look at four types of
transactions: (1)&an open market operation, in which the central bank buys or sells a
security; (2)&a foreign exchange intervention, in which the central bank buys or sells
foreign currency reserves; (3)&the extension of a discount loan to a commercial bank
by the central bank; and (4)&the decision by an individual to withdraw cash from the
bank. Each of these has an impact on both the central bank’s balance sheet and the
banking system’s balance sheet. Open market operations, foreign exchange
interventions, and discount loans all affect the size of the central bank’s balance sheet
and change the size of the monetary base. Cash withdrawals by the public are
different. They shift components of the monetary base, changing the composition of
the central bank’s balance sheet but leaving its size unaffected. To figure out the
impact of each of these four transactions on the central bank’s balance sheet, we need
to remember one simple rule: When the value of an asset on the balance sheet
increases, either the value of another asset decreases so that the net change is zero or
the value of a liability rises by the same amount. What’s true for assets is also true for
liabilities. An increase in a liability is balanced either by a decrease in another liability
or by an increase in an asset.
The Federal Reserve System consists of the Board of Governors in
Washington, D.C., and twelve regional Reserve Banks located across major cities in
the United States. Each Reserve Bank operates somewhat autonomously but under the
overarching policies and objectives set by the Board of Governors. Notably, the
Federal Reserve Bank of New York plays a crucial role in executing the Fed's
monetary policy decisions, particularly in managing securities and foreign exchange
transactions.
he transparency and effectiveness of these transactions are crucial for
maintaining confidence in the Federal Reserve's policies and operations. Clear
communication and accountability mechanisms ensure that the Fed's actions align
with its mandate and are understood by market participants, policymakers, and the
public. The Fed's institutional structure, with its decentralized regional banks and
centralized decision-making at the Board of Governors, enhances its ability to respond
to diverse economic conditions across different regions of the United States.
In conclusion, the Federal Reserve's institutional structure and its management
of various transactions, including securities, foreign exchange, and discount loans,
illustrate its pivotal role in shaping monetary policy and maintaining financial
stability. Understanding these operations provides a deeper appreciation of how
central banks influence economic outcomes and navigate challenges in the global
financial system.
When the Federal Reserve buys or sells securities in financial markets, it
engages in open market operations. These open market purchases and sales have a
straightforward impact on the Fed’s balance sheet. To see how the process works, take
the common case in which the Federal Reserve Bank of New York purchases $1
billion in U.S. Treasury bonds from a commercial bank.4 To pay for the bonds, the
Fed transfers $1&billion into the reserve account of the seller. The exchange is done
electronically. This is called a T-account. The left side shows the change in assets and
the right side gives the change in liabilities. What is the impact of the Fed’s open
market purchase on the banking system’s balance sheet? The Fed exchanged $1
billion in securities for $1 billion in reserves, both of which are banking system assets.
What happens if the U.S. Treasury instructs the Federal Reserve to buy $1
billion worth of euros? The answer is that the Federal Reserve Bank of New York
buys German government bonds, denominated in euros, from the foreign exchange
departments of large commercial banks and pays for them with dollars.6 Like an open
market bond purchase, this transaction is done electronically and the $1 billion
payment is credited directly to the reserve account of the bank from which the bonds
were bought. The impact on the Fed’s balance sheet is almost identical to that of the
open market operation.
The Federal Reserve does not force commercial banks to borrow money; the
banks ask for loans. To get one, a borrowing bank must provide collateral.7 While this
usually takes the form of U.S. Treasury bonds, the Fed has always been willing to
accept a broad range of securities and loans as the collateral for lending to banks.
During the crisis, when discount loans surged, this willingness facilitated lending. Not
surprisingly, when the Fed makes such a loan, it changes the balance sheet of both
institutions. For the borrowing bank, the loan is a liability that is matched by an
offsetting increase in the level of its reserve account. For the Fed, the loan is an& asset
that is created in exchange for a credit to the borrower’s reserve account. In summary,
open market purchases, an increase in foreign exchange reserves, and the extension of
discount loans all increase the reserves available to the banking system, expanding the
monetary base. We turn now to a different type of transaction, one that affects only the
composition—not the size—of the monetary base.
The Federal Reserve can always shift its holdings of various assets, selling
U.S. Treasury bonds and using the proceeds to buy Japanese yen, or engaging in an
offsetting sale of a U.S. Treasury security after a bank takes out a discount loan. But
the same is not true of its liabilities. Because the Fed stands ready to exchange
reserves for currency on demand, it does not control the mix between the two. The
nonbank public—the people who hold the cash—controls that. You may be surprised
to learn that when you take cash from an ATM, you are changing the Federal
Reserve’s balance sheet. The reason is that vault cash is part of reserves, while the
currency holdings of the nonbank public—your cash and ours—are not. By moving
your own assets out of your bank and into currency, you force a shift from reserves to
currency on the Fed’s balance sheet. The transaction is complicated, involving the
nonbank public (you and me), the banking system, and the central bank, so
understanding it means looking at three balance sheets.
Consider an example in which you withdraw $100 from your checking
account. This transaction changes the composition of the asset side of your balance
sheet. (Because there is no change in your liabilities, the changes in the asset side of
your balance sheet must sum to zero.) But that isn’t all. By taking $100 out of the
cash machine, you had an impact on your bank’s balance sheet as well. Remember,
cash inside the bank—vault cash—counts as reserves, so by withdrawing cash from
your bank, you decreased the banking system’s reserves. The change in the banking
system’s T-account.
It's a fundamental aspect of banking operations that when you withdraw
money from your bank account, the bank's balance sheet undergoes a contraction.
This process reveals a crucial mechanism in the financial system where individual
actions impact broader economic dynamics. When you make a withdrawal, the
amount of cash held by the bank decreases, directly reducing its assets. Consequently,
the bank's liabilities, which include your deposited funds, also decrease by the amount
withdrawn. This withdrawal doesn't just affect one bank in isolation; rather, it has
ripple effects throughout the banking system.
As banks adjust to withdrawals, they may need to rebalance their reserves or
seek additional funding to maintain liquidity requirements. This interplay between
individual actions and systemic adjustments highlights the interconnectedness of
financial institutions. Moreover, it underscores how changes in bank balance sheets
can influence overall economic activity, including lending capacities and monetary
policy effectiveness.
Understanding these dynamics is essential for grasping broader economic
concepts such as money supply, liquidity management, and the role of banks in the
economy. Each withdrawal or deposit represents a shift in the delicate balance of
assets and liabilities within the banking sector, shaping the financial landscape we
interact with daily. Thus, the act of withdrawing cash from your account not only
impacts your immediate financial position but also plays a part in shaping the broader
economic environment.
Finally, there is the Federal Reserve. Remember, the Fed controls the size of
its own balance sheet, so your transactions can’t affect that. But what you can do is
change the composition of the Fed’s liabilities. By withdrawing cash, you changed the
amount of currency outstanding—a change that shows up on the Fed’s balance sheet
as a shift from reserves to currency. Note that the monetary base hasn’t changed.
Remember that the monetary base equals currency plus reserves, and one went up
while the other went down. But the relative size of each component of the monetary
base has changed.
It is worth noting that there are countries where the process works differently
when a central bank wishes to control its country’s exchange rate rather than the
domestic interest rate, one way to do so is to stand ready to buy and sell foreign
currency. In such cases, foreign exchange intervention is not truly under the central
bank’s control. Instead, the private sector decides when the purchases and sales are
made and how large they are. That is essentially what the Bank of Thailand was doing
in 1997, and when it started to run out of foreign currency reserves, the system
collapsed.
c. The Deposit Expansion Multiplier
Central bank liabilities form the base on which the supplies of money and
credit are built; that is why they are called the monetary base. The central bank
controls the monetary base, causing it to expand and contract. But most of us don’t
focus much attention on the monetary base. Our primary interest is in the broader
measures of money, M1 and M2, which are mostly liabilities of private banks. Recall
from that M1 is currency plus demand deposits and M2 adds time deposits to M1.
This is the money we think of as available for transactions.
The relationship between the central bank's liabilities and broader measures of
money, such as the money supply, is crucial to understanding how monetary policy
influences the economy. Central banks issue liabilities primarily in the form of
currency in circulation and reserves held by commercial banks. These liabilities serve
as the foundation upon which the broader monetary aggregates, like M1 and M2, are
built.
Reserves held by commercial banks at the central bank play a pivotal role in
the creation of bank deposits. When the central bank conducts open market
operations, buys government securities, or engages in other monetary policy tools, it
injects reserves into the banking system. These reserves provide the basis for
commercial banks to extend loans and create deposits through a process known as
multiple deposit creation or the money multiplier effect.
Here's how it works: When a commercial bank receives reserves from the
central bank, it can use a portion of these reserves to lend to individuals and
businesses. As loans are extended, new deposits are created in the accounts of
borrowers. These deposits are essentially new money in the economy, representing an
expansion of the money supply beyond the initial injection of reserves by the central
bank.
The process of reserves becoming bank deposits is facilitated by the fractional
reserve banking system, where banks are required to hold only a fraction of their
deposits as reserves. This allows them to lend out the majority of their deposits,
thereby multiplying the initial reserves injected into the system. As loans are repaid or
new deposits are made, the cycle can continue, further influencing the overall money
supply and economic activity.
Understanding this mechanism is central to comprehending how changes in
central bank policies, such as interest rate adjustments or quantitative easing
programs, impact the availability of credit and the overall health of the economy. By
influencing the level of reserves and the cost of borrowing, central banks aim to
achieve their monetary policy objectives, such as price stability and sustainable
economic growth.
In summary, the creation of bank deposits from reserves, known as multiple
deposit creation, illustrates the intricate relationship between central bank liabilities
and the broader measures of money. It demonstrates how monetary policy actions
affect the money supply and economic activity, highlighting the pivotal role of
commercial banks in the financial system and the transmission of monetary policy
throughout the economy.
To see how deposits are created, let’s start with an open market purchase in
which the Federal Reserve buys $100,000 worth of securities from a bank called First
Bank. While First Bank may have its own reasons for selling the securities, we are
assuming that the Fed initiated the transaction. So if First Bank doesn’t sell the
securities, some other bank will. The Fed’s purchase leaves the bank’s total assets
unchanged, but it shifts $100,000 out of securities and into reserves, increasing
reserves by the amount of the open market purchase. What does First Bank do in
response to this change in the composition of its assets? The bank’s management must
do something. After all, it just sold a U.S. Treasury bond to the Fed and received
reserves that typically bear a lower interest rate in exchange. If it does nothing, the
bank’s revenue will fall, and so will its profits. With liabilities unchanged, the increase
in First Bank’s reserves doesn’t affect the quantity of reserves the bank is required to
hold, so it counts as an increase in excess reserves.
Banks hold reserves for two primary reasons: regulatory requirements and
operational needs. Regulatory requirements dictate the minimum level of reserves that
banks must hold as a percentage of their deposits, which is often set by central banks
or banking regulators. These requirements are designed to ensure financial stability
and the ability of banks to meet their obligations to depositors.
Operational needs refer to the reserves that banks hold to facilitate their daily
transactions and operations. These reserves are essential for processing payments,
clearing transactions, and managing liquidity within the banking system. Banks must
maintain a sufficient level of reserves to handle fluctuations in deposit inflows and
outflows and to comply with regulatory requirements.
The profitability of managing increased reserves depends on various factors,
including prevailing interest rates, market conditions, and the bank's risk appetite.
Banks must assess opportunities to deploy reserves effectively to optimize returns
while managing risks associated with investments and lending activities.
Moreover, the strategic deployment of reserves contributes to the broader
functioning of monetary policy transmission. Changes in reserves influence interest
rates, credit availability, and overall economic activity, aligning with central bank
objectives such as price stability and sustainable economic growth.
In conclusion, the management of reserves by banks involves balancing
regulatory requirements, operational needs, and profitability considerations. The
strategic deployment of increased reserves from securities sales underscores banks'
role in the financial system and their contribution to economic stability and growth
through lending, investment, and interbank operations.
First Bank’s loan and OBI’s expenditures can’t be the end of the story because
the suppliers and employees paid by OBI took their checks to the bank and deposited
them. As the checks made their way through the payments system, First Bank’s
reserves were transferred to the reserve accounts of the suppliers’ and employees’
banks. Only the Fed (the central bank) can create and destroy the monetary base. The
nonbank public determines how much of it ends up as reserves in the banking system
and how much is in currency; all the banks can do is move the reserves they have
around among themselves. So, assuming cash holdings don’t change following an
open market purchase, the reserves created by the Fed must end up somewhere. Let’s
follow them to see where they go. We’ll start by making four assumptions that allow
us to focus on the essential parts of the story: (1) banks hold no excess reserves; (2)
the reserve requirement is 10 percent of checking account deposits; (3) when the level
of checking account deposits and loans changes, the quantity of currency held by the
nonbank public does not; and (4)& when a borrower writes a check, none of the
recipients of the funds deposit them&back in the bank that initially made the loan.
Now, let’s say that OBI uses the $100,000 loan to pay for steel girders from American
Steel Co.
American Steel, a manufacturing company, initiates a transaction by
depositing $100,000 into its checking account at Second Bank. This deposit increases
American Steel's balance in its checking account, reflecting an increase in its liquidity.
Simultaneously, Second Bank records this deposit as a liability owed to
American Steel. This transaction adds to Second Bank's overall deposit liabilities,
which are part of its broader financial obligations to its depositors.
Meanwhile, OBI, another entity, issues a check for $100,000, drawn on its
account held at Second Bank. When this check is presented for payment, Second
Bank processes it through its clearing system. The check is then sent to the Federal
Reserve Bank for clearance.
Upon clearance, the Federal Reserve Bank credits Second Bank's reserve
account with $100,000. This credit represents an increase in Second Bank's reserve
balance held at the Federal Reserve Bank, which is a crucial component of Second
Bank's ability to meet its reserve requirements and facilitate interbank transactions.
In summary, the initial deposit by American Steel and the subsequent check
clearance involving OBI illustrate the interconnected nature of banking operations.
These transactions impact both individual bank accounts and the broader financial
infrastructure managed by entities like Second Bank and the Federal Reserve Bank.
The additional $100,000 in American Steel’s checking account is costly for
Second Bank to service. American Steel will want to receive interest on its idle
balance as well as access to it for payments. And the reserves Second Bank just
received usually pay less interest than a loan. In the same way that First Bank lent out
its new reserves following the Fed’s open market purchase, Second Bank will make a
loan after American Steel has made its deposit. How large will the loan be? Because
the reserve requirement is 10 percent, Second Bank must hold an additional $10,000
in reserves against the new $100,000 deposit. Individual banks can’t make loans that
exceed their excess reserves, so the largest loan Second Bank can make is $90,000—
and that’s what it does. (Remember, we’re assuming banks hold no excess reserves.)
If the borrower immediately uses the $90,000 loan. This new loan, and the reserves
that go with it, must go somewhere, too.
Deposit and Reserves: When American Steel deposits $100,000 into its
checking account at Third Bank, this amount increases Third Bank's liabilities
(deposits) by $100,000. Simultaneously, Third Bank must hold a fraction of this
deposit as reserves, typically set by central bank regulations. For instance, if the
reserve requirement is 10%, Third Bank would need to hold $10,000 in reserves and
can lend out the remaining $90,000.
Lending Process: With $90,000 now available for lending, Third Bank
evaluates creditworthy borrowers and extends loans based on their creditworthiness
and the bank's lending criteria. These loans could be in the form of business loans,
mortgages, or other types of credit facilities, depending on customer demand and the
bank's strategic goals.
Impact on Economy: By making loans, Third Bank injects money into the
economy. Borrowers use the loaned funds for various purposes, such as expanding
businesses, purchasing homes, or making investments. This lending activity
stimulates economic growth by increasing spending and investment, thereby
supporting job creation and overall economic activity
Interest and Profit: Third Bank earns interest income from the loans it extends.
The interest rate charged on loans typically exceeds the interest paid on deposits,
allowing the bank to earn a profit margin. This profit contributes to the bank's
sustainability and ability to provide banking services to customers.
Risk Management: Banks carefully manage risks associated with lending,
including credit risk (the risk that borrowers may default on their loans) and interest
rate risk (the risk that changes in interest rates may affect the profitability of loans).
Effective risk management practices are crucial for maintaining financial stability and
safeguarding depositors' funds.
At this point, a $100,000 open market purchase has created $100,000 +
$90,000 = $190,000 in new checking account deposits at Second Bank and Third
Bank and $100,000 + $90,000 + $81,000 = $271,000 in new combined loans at First
Bank, Second Bank, and Third Bank. But the process doesn’t stop there. The $81,000
loan from Third Bank is deposited into Fourth Bank, where it creates an additional
$81,000 in checking account deposits. Fourth Bank then makes a loan that is 90
percent of $81,000, or $72,900, and the $72,900 is deposited. With a bit of algebra,
we can derive a formula for the deposit expansion multiplier—the increase in
commercial bank deposits following a one-dollar open market purchase, (assuming
there are no excess reserves in the banking system and no changes in the amount of
currency held by the nonbank public). There’s an easy way and a hard way to figure
out the size of the deposit expansion multiplier. Let’s start with the easy way. Imagine
that the entire banking system is composed of a single bank—call it the Monopoly
Bank.
In a hypothetical scenario where an entire country's banking system revolves
around a single entity, such as the Monopoly Bank, several unique dynamics come
into play. Firstly, with all financial transactions occurring within the confines of this
singular institution, every payment from one individual to another simply entails a
transfer between accounts held at the Monopoly Bank. This centralized structure
grants the bank unparalleled control and insight into the flow of money throughout the
economy.
Due to the monopoly status of the bank, its managers possess an extraordinary
level of market power and influence. Unlike in a diversified banking system where
competition can constrain lending practices, the Monopoly Bank operates without fear
of losing reserves when issuing loans. This is because any reserves that might
ostensibly be depleted through lending are essentially recycled within the same
closed-loop system. Thus, the traditional concerns over reserve adequacy and liquidity
management, which typically govern banking decisions in more competitive
environments, are markedly attenuated.
Moreover, the absence of competitive pressures can potentially alter the risk
appetite of the Monopoly Bank. In a competitive banking sector, institutions often
strive to balance risk and return to maintain market share and profitability. However,
in a monopoly scenario, the incentives to rigorously assess risk may be diminished, as
the bank faces limited external scrutiny and market discipline. This could lead to a
scenario where lending decisions are made with less stringent criteria, potentially
increasing the overall risk profile of the bank's loan portfolio.
Furthermore, the role of the Monopoly Bank extends beyond traditional
banking functions. With its central position in the financial landscape, the bank may
also wield significant influence over broader economic policies and outcomes. Its
lending practices, for instance, could impact the availability of credit, interest rates,
and ultimately economic growth and stability.
However, despite these potential advantages in terms of control and influence,
a monopoly banking system also raises significant concerns. Chief among these is the
lack of competitive pressure to innovate, offer competitive interest rates, or provide
superior customer service. Without alternative banking options, consumers and
businesses may face limited choices and potentially higher costs for financial services.
In conclusion, while a monopoly banking system such as the hypothetical
Monopoly Bank offers unique advantages in terms of control and risk management, it
also presents significant challenges and risks. Balancing the benefits of centralized
control with the drawbacks of reduced competition is a critical consideration in
assessing the viability and sustainability of such a financial framework.
So for every dollar increase in reserves, deposits increase by (1/rD). This is the
simple deposit expansion multiplier. If the reserve requirement is 10 percent, as it was
in our example, then the simple deposit expansion multiplier equals (1/0.1) = 10, and
a $100,000 open market purchase generates a $1,000,000 = 10 × $100,000 increase in
the quantity of money. To see why this makes sense, note that if deposits rose by more
than $1,000,000 following the addition of $100,000 in reserves, the banking system
would violate the reserve requirement. And if deposits rose by less than 10 times the
change in reserves, some banks would be holding excess reserves, which violates one
of the assumptions we made at the outset. Notice that starting with Third Bank, each
entry in the column “Increase in Deposits” equals (1 − rD) times the entry above it,
where rD is the reserve requirement (measured as a decimal). With a reserve
requirement of 10&percent, rD = 0.10, (1 − rD) = 0.90, so each entry is 0.90 times the
one above it.
d. The Monetary Base and the Money Supply
We have made considerable headway in understanding the link between the
central bank’s balance sheet and the quantity of money in the economy. A change in
reserves precipitates a significant change in the level of loans and checkable deposits
in the banking system. But the simple deposit expansion multiplier is too simple. In
deriving it, we ignored a few important details. First, we assumed that banks lent out
the entirety of the reserves that were not required, leaving no excess reserves in the
banking system. In fact, banks do hold some excess reserves, in part to protect against
unexpected deposit outflows, but also for other reasons. Demand for excess reserves
can change dramatically and unpredictably. For example, during the financial crisis of
2007–2009, excess reserves surged as banks built a safety cushion to insure
themselves against the loss of funding liquidity and unanticipated drawdowns of
credit lines. Second, we ignored the fact that the nonbank public holds cash. As
people’s account balances rise, they have a tendency to hold more cash. From our
discussion of the central bank’s balance sheet, we know that when individuals change
their cash holdings, they change the level of reserves in the banking system. Both
these considerations affect the relationship among reserves, the monetary base, and
the quantity of money in the economy. Let’s look at the relationship in more detail.
To see how important excess reserves and cash holdings are, we can go back
through the deposit expansion story, this time taking them into account. Assume that
banks want to hold excess reserves equal to 5 percent of checking account deposits
and that the holder of a checking account withdraws 5 percent of a deposit in cash.
Recall that the reserve requirement is 10 percent. To understand the implication of
these changes, let’s go back to the example in the last section, in which the Fed
purchased $100,000 worth of securities from First Bank, which proceeded to make a
$100,000 loan to Office Builders Incorporated. OBI then used the $100,000 to
purchase steel from American Steel, which withdrew the funds from First Bank and
deposited them in a checking account in Second Bank. 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.
Assuming that American Steel removes 5 percent of its new funds in cash, that
leaves $95,000 in the checking account and $95,000 in Second Bank’s reserve
account. Because Second Bank wishes to hold excess reserves equal to 5&percent of
deposits, it will want to keep reserves of 15&percent of $95,000, or $14,250. That
means making a loan of only $80,750 Second Bank’s balance sheet looks. We can
continue as before, following the proceeds of Second Bank’s loan as it is deposited in
Third Bank. Assuming that the depositor of the loan’s proceeds wishes to hold 5
percent of the deposit in cash and that Third Bank wants to hold excess reserves equal
to 5 percent of deposits, the increase in deposits will be $80,750 minus $4,037.50
equals $76,712.50, and Third Bank will make a loan of $65,205.63, keeping reserves
of $11,506.87.
In the last section, we derived the result that a one-dollar change in reserves
created a change in deposits equal to one over the reserve requirement, or (1/rD). So,
for an rD of 10&percent, a $1 change in reserves generated a $10 change in deposits.
But now the analysis is more complicated and the deposit expansion is smaller. The
desire of banks to hold excess reserves and the desire of account holders to withdraw
cash both reduce the impact of a given change in reserves on the total deposits in the
system. The more excess reserves banks desire to hold, and the more cash the public
withdraws, the smaller the impact. In fact, these two factors operate in the same way
as an increase in the reserve requirement
To better understand the relationship between deposits and reserves, we can
derive the money multiplier, which shows how the quantity of money (checking
account deposits plus currency) is related to the monetary base (reserves in the
banking system plus currency held by the nonbank public). Keep in mind that the
monetary base is the quantity that the central bank can control. If we label the quantity
of money M and the monetary base MB, the money multiplier m is defined by the
relationship M = m × MB (4) To derive the money multiplier, we start with a few
simple relationships: money equals currency (C) plus checkable 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). Writing these
relationships as simple equations, we have M = C + D Money =
Currency&+&Checkable&deposits (5) MB = C + R
Monetary&base&=&Currency&+&Reserves (6) R = RR + ER
Reserves&=&Required&reserves&+&Excess&reserves (7) These are just accounting
definitions; the next step is to incorporate the behavior of banks and individuals.
Starting with banks, we know that their holdings of required reserves depend on the
required reserve ratio rD. But what about excess reserves? In our earlier discussion,
we assumed that banks hold excess reserves as a proportion of their deposits, and that
the amount of excess reserves a bank holds depends on the costs and benefits of
holding them. The cost of excess reserves is the interest on the loans that could be
made with them, less the interest received on reserve balances, while the benefits have
to do with safety should deposits be withdrawn suddenly. The higher the interest rate
on loans, the lower banks’ excess reserves will be; the greater banks’ concern over the
possibility of deposit withdrawals, the higher their excess reserves will be.
To see how the quantity of money in the economy changes, we can look at the
impact of each of these four elements. The first is the easiest. We know that if the
monetary base increases, holding bank and public behavior constant, the quantity of
money increases. Looking at the second and third elements—those factors affecting
reserves—we see that an increase in either the reserve requirement or banks’ excess
reserve holdings decreases the money multiplier. So for a fixed level of the monetary
base, an increase in either rD or {ER/D} reduces M. Finally, there is the currency-to-
deposit ratio. What happens when individuals increase their currency holdings at a
fixed level of the monetary base? Because {C/D} appears in both the numerator and
the denominator of the money multiplier in equation&(13), we can’t immediately tell
whether the change creates an expansion or a contraction. Fortunately, logic gives us
the answer that is correct whenever, as has usually been the case, deposits exceed total
reserves. (Reserves have surpassed checkable deposits since 2008 but remain well
below total deposits.) When an individual withdraws cash from the bank, he or she
increases currency in the hands of the public and decreases reserves, so the monetary
base is unaffected. But the decline in reserves creates a multiple deposit contraction.
(Remember, every dollar in reserves creates more than a dollar’s worth of deposits,
raising the quantity of money more than a dollar.) Because each extra dollar held in
currency raises M by only a dollar, when reserves are converted to currency, the
money supply contracts.
At this point, we might discuss why the various factors affecting the quantity
of money change over time. For example, market interest rates affect the cost of
holding both excess reserves and currency. So as interest rates increase, we would
expect to see both {ER/D} and {C/D} fall, increasing the money multiplier and the
quantity of money. If these changes in the money multiplier were predictable, a tight
link would exist between the monetary base and the quantity of money—a link the
central bank might choose to exploit in its policymaking. While such a link made
sense in a discussion of the U.S. economy in the 1930s, and might still be important in
some emerging economies, for countries with sophisticated financial systems it no
longer is. In places like the United States, Europe, and Japan, the link between the
central bank’s balance sheet and the quantity of money circulating in the economy has
become too weak and unpredictable to be exploited for policy purposes.
In addressing the dynamics of monetary policy and money supply, the
relationship between M1 and M2 aggregates plays a crucial role. M1 represents the
narrowest definition of money, encompassing currency in circulation, demand
deposits (checking accounts), and other liquid assets readily accessible for
transactions. In contrast, M2 includes M1 plus savings deposits, time deposits, and
other less liquid but still easily accessible financial assets.
When policymakers confront challenges within M1, such as fluctuations in the
money multiplier, they often look to M2 as a broader measure of monetary conditions.
This approach allows for a more comprehensive assessment of the overall liquidity
and financial stability within the economy.
Historically, the behavior of the M2 multiplier has mirrored trends seen in M1,
albeit with variations reflecting the broader inclusion of less liquid assets. For
instance, in the mid-1980s, both the M1 and M2 multipliers stood at 12, indicating
robust monetary expansion and liquidity within the financial system. However, by the
end of the 1990s, both multipliers had declined, with M2 falling to around 8. This
decline suggested a relative tightening of monetary conditions, influenced by various
economic factors and policy adjustments.
More recently, the trajectory of the M2 multiplier has continued to evolve,
reaching approximately 4 by 2019. This substantial reduction reflects ongoing
changes in consumer behavior, financial regulations, and economic policies that have
affected the velocity of money and the broader financial landscape. The decline in the
M2 multiplier indicates a potentially reduced efficiency in converting monetary
aggregates into broader economic activity, highlighting challenges for policymakers
in stimulating economic growth and managing inflationary pressures.
Moreover, the interplay between M1 and M2 multipliers underscores the
complexity of monetary policy formulation. Policymakers must not only monitor the
dynamics within M1 but also consider the broader implications captured by M2. This
broader perspective enables a more nuanced understanding of how changes in money
supply and financial conditions impact various sectors of the economy, including
consumption, investment, and overall economic stability.
Looking ahead, the task for policymakers involves balancing the management
of both M1 and M2 aggregates to ensure adequate liquidity, promote economic
growth, and maintain price stability. This requires a comprehensive approach that
incorporates empirical data, economic modeling, and strategic policy interventions
aimed at optimizing monetary conditions and fostering sustainable economic
development over the long term.
The conclusion that the relationship between the monetary base and the
quantity of money is not easily exploitable for short-run policy purposes underscores
a fundamental aspect of modern monetary policy. Central banks traditionally manage
the monetary base, which includes currency in circulation and bank reserves, as a
means to influence broader money supply aggregates such as M1 and M2. However,
the transmission mechanism from the monetary base to these broader measures of
money has proven complex and often less direct than initially theorized.
In response to these challenges, central banks have increasingly turned to
interest rates as their primary tool for conducting monetary policy. By adjusting short-
term interest rates, central banks seek to influence borrowing costs, investment
decisions, and ultimately economic activity. This approach, known as interest rate
targeting or monetary policy through the interest rate channel, has become the
cornerstone of monetary policy frameworks in many economies globally.
Furthermore, during periods of financial crisis or significant market
disruptions, central banks deploy a range of balance sheet tools to address liquidity
needs and stabilize financial markets more directly. These tools include measures such
as open market operations, where central banks buy or sell government securities to
adjust the supply of money and influence interest rates. Additionally, central banks
may engage in quantitative easing (QE), where they purchase longer-term securities
or other assets to inject liquidity into the financial system and lower long-term interest
rates.
The effectiveness of these balance sheet tools during crises underscores their
importance in complementing interest rate adjustments. By directly influencing
market conditions and alleviating liquidity constraints, central banks can support
financial stability and facilitate the flow of credit to businesses and households.
Moreover, these interventions help restore confidence in financial markets and
mitigate the adverse economic impact of severe disruptions.
Looking ahead, the evolution of monetary policy frameworks continues to be
shaped by ongoing economic developments, technological advancements, and shifts
in financial market dynamics. Central banks must remain adaptive and innovative in
their approach to addressing new challenges while preserving their ability to achieve
price stability, promote full employment, and support sustainable economic growth.
In conclusion, while the direct relationship between the monetary base and
broader money supply aggregates may be limited for short-run policy purposes,
central banks have effectively utilized interest rates as their primary tool for
influencing economic conditions. Moreover, the strategic deployment of balance sheet
tools during crises highlights the importance of a multifaceted approach to monetary
policy that can adapt to evolving economic landscapes and financial market dynamics.
