Money and Banking

1
Money and Banking

• Spring 2007
• Martin Andreas Wurm
• University of Wisconsin - Milwaukee

2
Money Creation

• Required Reading Mishkin, Chapter 15

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Money Creation

• 1. Overview
• As previously discussed money supply directly
  affects interest rates and, thus, the cost of
  borrowing.
• Due to the connection between interest rates,
  investment and saving, the money supply can act
  as an important gauge for the economy (see e.g.
  the IS-LM model).
• However, money supply also affects inflation and
  we observe a certain trade-off between short-run
  output growth and medium-run inflation

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Money Creation

• 1. Overview
• In the following, we will discuss the mechanism
  through which the actual money supply is set.
• The players in the process of money creation are
  the central bank, commercial banks as well as
  their depositors and borrowers
• The natural starting point for the discussion of
  money supply is a central banks balance sheet

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Money Creation

• 2. A central banks balance sheet
• The Feds balance sheet e.g. is roughly
  organized as follows

Assets
Liabilities

• ltOther Items in the balance sheet (e.g.
  Gold) gt
• Government Securities
• Discount Loans

• ltOther Items in the balance sheet gt
• Currency in Circulation
• Reserves

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Money Creation

• 2. A central banks balance sheet
• 1. Liabilities
• The mentioned liabilities currency in
  circulation and reserves are also referred to
  as monetary liabilities.
• Both are an important determinants of the
  monetary supply. If either one of them increases,
  the supply of money increases also, et v.v.
• Together with the monetary liabilities of a
  countrys treasury (which, if at all, consists
  primarily of coins in developed nations),
  currency in circulation and reserves build the
  monetary base.

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Money Creation

• 2. A central banks balance sheet
• 1.1. Currency in Circulation
• While currency (in particular banknotes) is
  technically a liability for a central bank, it
  can only be exchanged for the same currency at a
  central bank in most countries today.
• In history currency used to be backed by real
  values such as Gold. Today the only reason why
  people accept these central bank IOUs in the
  first place is because they believe that they are
  accepted as means of payment.

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Money Creation

• 2. A central banks balance sheet
• 1.2. Reserves
• Commercial bank-owned reserves are liabilities
  for a central bank, since a central bank is
  required to pay these on demand to commercial
  banks
• As we have seen, these reserves consist of
  required and excess reserves and as we will see,
  an increase in reserves leads to an increase in
  the money supply. Reserves pay no interest to the
  banks in the U.S.

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Money Creation

• 2. A central banks balance sheet
• 2. Assets
• Assets are important for two reasons
• First, changes in a central banks assets lead to
  changes in reserves and, thus, changes in money
  supply
• Second, central banks earn interest on their
  assets, through which they fund themselves. Any
  earnings in excess of their cost of operation is
  usually transferred to the national treasuries.

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Money Creation

• 2. A central banks balance sheet
• 2. 1. Government securities
• Central banks do not hold common stock or risky
  assets. Instead the hold government bonds usually
  in form of short run (3 month) bonds.
• Other than risk considerations central banks are
  usually expected not to buy extensive government
  debt as this results in inflationary pressures.

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Money Creation

• 2. A central banks balance sheet
• 2. 2. Discount loans
• If central banks provide loans to the banking
  sector they show up as assets on their balance
  sheet.
• In the U.S. the Fed earns the discount rate as
  return on these loans from commercial banks.

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Money Creation

• 3. Control of the monetary base
• A central bank cannot control the entire supply
  of money to an economy. However, it can control
  the monetary base.
• The monetary base B (also high-powered money)
  can be written as
• Where C indicates currency and R indicates
  reserves.
• A central bank has a variety of options to change
  the monetary base, which will be discussed in the
  following using a simplified balance sheet for
  the central bank and its trading partners.

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Money Creation

• 3. 1. Open market operations
• The primary tool of monetary policy are open
  market operations
• The purchase of a bond through a central bank is
  an open market purchase and the sale of a bond is
  an open market sale.
• In principle, a central bank can purchase/sell
  bonds from the banking sector or from the
  non-bank public.

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Money Creation

• 3. 1. Open market operations
• 1. Open market purchase from a bank.
• A central bank can e.g. buy a bond (lets say
  worth a 1,000) directly from a commercial bank
  in exchange for reserves
• For the bank this indicates an increase in their
  reserves of 1,000 matched by a decrease of their
  securities of 1,000
• For the central bank securities increase by
  1,000 and so do its reserve liabilities.

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Money Creation

• 3. 1. Open market operations
• 1. Open market purchase from a bank.

Central Bank
Assets
Liabilities

• Government Securities 1,000

• Reserves
  1,000

Commercial Bank
Assets
Liabilities

• Reserves 1,000
• Government Securities - ,1000

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Money Creation

• 3. 1. Open market operations
• 2. Open market purchase from the non-bank public
• A central bank can e.g. buy a bond (again worth a
  1,000) alternatively from other partners (such
  as traders) in exchange for lets say a check,
  which this partner deposits into his banks
  checking account.
• Three parties balance sheets are affected in
  this instance, the central banks, the private
  banks and the private trading partners.

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Money Creation

• 3. 1. Open market operations
• 2. Open market purchase from the non-bank public
• First, the trading partners securities decrease
  by 1,000 while its checkable deposits increase
  by 1,000. Note that the checking account is an
  asset for the private trader

Trader
Assets
Liabilities

• Checkable Deposits 1,000
• Government Securities - ,1000

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Money Creation

• 3. 1. Open market operations
• 2. Open market purchase from the non-bank public
• Second, the private bank processes the central
  banks check with the central bank increasing the
  private banks reserves, while at the same time
  its checkable deposit liabilities increase by
  1,000

Commercial Bank
Assets
Liabilities

• Government Securities ,1000

• Reserves 1,000

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Money Creation

• 3. 1. Open market operations
• 2. Open market purchase from the non-bank public
• Finally, the central banks securities and
  reserve liabilities increase by 1,000 just as
  before.

Central Bank
Assets
Liabilities

• Government Securities ,1000

• Reserves
  1,000

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Money Creation

• 3. 1. Open market operations
• 2. Open market purchase from the non-bank public
• The net effect of both of these procedures on the
  monetary base is the same
• No additional currency has been issued, but
  reserves have increased by 1,000 in both
  instances.

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Money Creation

• 3. 1. Open market operations
• 2. Open market purchase from the non-bank public
• A central bank technically could also buy
  securities from the private public in exchange
  for currency.
• In this instances, reserves would be unaffected,
  but the currency in circulation would increase.
  This procedure is depicted below

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Money Creation

• 3. 1. Open market operations
• 2. Open market purchase from the non-bank public

Central Bank
Assets
Liabilities

• Government Securities 1,000

• Currency in circulation
  1,000

Trader
Assets
Liabilities

• Currency 1,000
• Government Securities - ,1000

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Money Creation

• 3. 1. Open market operations
• 2. Open market purchase from the non-bank public
• The net effect of both of this strategy on the
  monetary base is given by
• Reserves remain unchanged, while currency in
  circulation increases by 1,000
• Independently of which strategy is used, the
  monetary base increases by 1,000.

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Money Creation

• 3. 1. Open market operations
• 3. An open market sale
• Open market sales can use the same three channels
  and are the exact reverse of each procedure.
• Open market sales always decrease the monetary
  base.
• Hard to predict in the case of sales and
  purchases is the effect on reserves, since a
  buyer or seller of securities might decide to use
  either currency or checkable accounts in the
  transaction.

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Money Creation

• 3. 1. Open market operations
• 4. Shifts between currency and checkable deposits
• Independently of whether a seller (buyer) of a
  bond is initially compensated (initially pays)
  using cash or holdings in her/his checkable
  account, she/he can always shift funds from one
  asset to another.
• In this case the systems reserve holdings are
  affected. Assume for example that a seller of a
  bond is initially compensated with currency, but
  then deposits these 1,000 in her/his checkable
  deposit.

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Money Creation

• 3. 1. Open market operations
• 4. Shifts between currency and checkable deposits

Trader
Assets
Liabilities

• Checkable Deposits 1,000
• Currency -
  1,000

Commercial Bank
Assets
Liabilities

• Reserves 1,000

• Checkable Deposits ,1000

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Money Creation

• 3. 1. Open market operations
• 4. Shifts between currency and checkable deposits
• Similarly if a seller of a bond is compensated in
  checkable deposits and then withdraws money from
  the private bank, overall reserves will decrease.
• Thus, while the overall size of the monetary base
  does not change, its composition depends also on
  the publics withdrawal behavior.

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Money Creation

• 3. 2. Discount Loans
• Other than open market operations a central
  banks lending to the private banking sector
  affects the monetary base. In the U.S. this
  lending is processed through the discount window.
• Usually if a discount loan is provided to a bank,
  the Fed increases that private banks reserves
  (increasing the monetary base). As a matter of
  fact, discount loans are often granted so that
  banks can meet their reserve requirements over
  night.
• If a discount loan is paid back, the monetary
  base decreases correspondingly.

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Money Creation

• 3.2. Discount loans

Central Bank
Assets
Liabilities

• Discount Loans 1,000

• Reserves
  1,000

Commercial Bank
Assets
Liabilities

• Reserves 1,000

• Discount Loans 1,000

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Money Creation

• 3. 3. Other factors affecting the monetary base
• A central bank does not necessarily have full
  control over the monetary base
• In the U.S. so-called floats (i.e. temporary
  increases in reserves in the process of
  check-clearing at the Fed) and Treasury deposits
  at the Fed (i.e. shifts of treasury funds from
  commercial banks to deposits at the Fed which
  decrease the monetary base) are not fully under
  control of the Fed
• Further certain foreign exchange interventions
  can affect the monetary base as well.

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Money Creation

• 4. Multiple Deposit Creation the role of
  private banks
• For every unit of base money a central bank
  supplies to the private banking sector, the
  creation of checkable deposits on behalf of these
  banks multiplies this amount further increasing
  larger definitions of the money supply such as M2
  or M3. This process is known as multiple deposit
  creation.
• Lets first start with the central bank a single
  private bank. How does money creation on behalf
  of private banks work?

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Money Creation

• 4. Multiple Deposit Creation the role of
  private banks
• 1. Since checkable deposits are unaffected by
  this transaction, required reserves do not
  increase and the bank has an additional 1,000
  dollars at its disposal, which it has no interest
  in keeping, since it provides no return.
• 2. Lets, thus , assume, the bank lends these
  funds out to the private sector and deposits this
  loan in the borrowers checking account

Commercial Bank A
Assets
Liabilities

• Reserves 1,000
• Government Securities - ,1000
• Loans ,1000

• Checkable Deposits 1,000

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Money Creation

• 4. Multiple Deposit Creation the role of
  private banks
• 3. Since checkable deposits can be used as means
  of transactions, the creation of checkable
  deposits has added to the money supply as defined
  in M2 and M3 in addition to the increase in the
  monetary base.
• Why is the initial infusion of reserves needed
  for the bank to be able to give out such a loan?
• At the current state, the bank in our example
  still has excess reserves of 1,000 at its
  disposal. However, these reserves are not going
  to stay with the bank for long The borrower will
  either withdraw them or write checks against them
  to pay off whatever he originally obtained the
  loan for. Thus, a bank cannot give out loans
  fully safely in excess of their free reserves.

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Money Creation

• 4. Multiple Deposit Creation the role of
  private banks
• 4. Checkable deposits can be traded against
  deposits within a bank but at larger they are
  traded against checkable deposits in other banks,
  so that this is a good point to introduce another
  bank.
• Lets assume that the borrower who obtained his
  loan from bank A in the above example buys a
  machine and transfers these funds from the
  checking account in bank A to the sellers account
  in Bank B.
• Lets for simplicity assume, that Bank B
  beforehand had no excess reserves and is obliged
  to hold 10 (i.e. 100) of each dollar its
  checkable deposits.

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Money Creation

• 4. Multiple Deposit Creation the role of
  private banks
• Bank B apparently has no incentive to hold
  reserves in addition to the required reserves.
  Thus, it can loan out 900 to borrowers and put
  them into their checkable deposits

Commercial Bank B
Assets
Liabilities

• Reserves 1,000

• Checkable Deposits 1,000

Commercial Bank B
Assets
Liabilities

• Required Reserves 1,000
• Loans 900

• Checkable Deposits 1,900

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Money Creation

• 4. Multiple Deposit Creation the role of
  private banks
• As in the case of bank A borrowers will make use
  of the funds the obtain from these loans and the
  corresponding funds (900) will be withdrawn from
  bank B. Lets say these end up in the checking
  deposits of bank C
• Again bank C is required to hold 10 of these
  900 (i.e. 90) as required reserves. The
  remaining 810 can again be given out as loan to
  somebody, etc.
• These process could go on (mathematically
  forever). The below table summarizes this
  procedure of multiple deposit creation for an
  initial infusion of 1,000 worth of reserves and
  a required reserve ratio of 10.

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Money Creation

• 4. Multiple Deposit Creation the role of
  private banks

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Money Creation

• 4. Multiple Deposit Creation the role of
  private banks
• Thus, an in initial increase in bank reserves
  leads to a much higher increase in deposits,
  since banks only have to hold a certain fraction
  of their checkable deposits as reserve
  requirements (note that this effect is
  independent of whether a bank makes a loan or
  buys a security)
• This phenomenon is called the simple deposit
  multiplier, which is given by
• Where D stands for deposits, R stands for
  reserves and r is the reserve requirement ratio.

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Money Creation

• 4. Multiple Deposit Creation the role of
  private banks
• In our example the change in reserves sparked
  by the central banks open market purchase was
  1,000.
• The required reserve ratio was equal to 10, so
  that deposits increased by a factor of 10, or by
  10,000

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Money Creation

• 4. Multiple Deposit Creation the role of
  private banks
• Proof of the simple deposit multiplier (a more
  formal proof can be obtained from the limiting
  behavior of a so-called geometric series)
• We assumed that banks hold no excess reserves, so
  that the total amount1 of required reserves RR
  will be equal to the actual reserves R held by
  banks
• RRR lt1.gt
• We further know, that the amount of required
  reserves is the fraction of total checkable
  deposits in the banking system
• RRrD lt2.gt

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Money Creation

• 4. Multiple Deposit Creation the role of
  private banks
• By substitution of lt2.gt in lt1.gt, it follows that
• Now, if we assume r to be a constant, we can
  express changes in both sides by (this is
  technically equal to the total differential of
  this equation)
• q.e.d.

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Money Creation

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