Paul Bernd Spahn, Goethe-Universität Frankfurt/Main1 Lecture 8 DETERMINANTS OF THE MONEY SUPPLY, AND THE TOOLS OF CENTRAL BANKS (2)

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 1

Lecture 8

DETERMINANTS OF THE MONEY SUPPLY, AND THE TOOLS OF CENTRAL BANKS (2)


ESCB monetary policy instruments

• In order to achieve its objectives, the ESCB has at its disposal a set of monetary policy instruments.

• The ESCB

– conducts open market operations, – offers standing facilities and– requires credit institutions to hold minimum

reserves on accounts with the ESCB.


Money supply process

• In order to understand the money supply process, we have to come back to the ECB’s balance sheet and the monetary base (or high-powered money).

• The assets of the CB constitute the sources of the base.

• The liabilities of the CB constitute the uses of the base.


Schematic central bank balance

Assets Liabilities

Bank notes

Gold and SDR

Forex

Securities

Bank lending

Bank reserves


Bundesbank, Balance sheet 2001

Gold 35.0 Banknotes 76.5Foreign exchange*) 71.8 Bank reserves 57.5Bank lending ECB claims 30.9 Main refinancing 80.5 Revaluation 41.7 Long-term lending 41.1 Reserve fund 5.4 Marginal refinancing 1.4 Other liabilities 11.7Loans to government 4.4 Capital 5.1Other assets 5.8 Profits 11.2TOTAL 240.0 TOTAL 240.0*) Including claims on the ECB.

31st of December, in bill. €


The control of the monetary base

• The quantity-oriented approach to monetary policy purports that the central bank can control the monetary base.

• It is basically effected via open market operations with commercial banks.

• The ECB can control OMOs more effectively than foreign reserves, but she can also use interventions in forex markets to change the monetary base.


Controlling the money supply

• Under fixed exchange rates controlling the money supply is more difficult.

• In this case the central bank has to “sterilize” inflows or outflows of foreign exchange.

• It renders interest rates endogenous, i.e. they vary in response to sterilizing interventions.

• Forex interventions will be discussed later.


Forex inflows with sterilization

Assets Liabilities

Base money remains fixed

Gold

Forex

Securities


Forex inflows with sterilization

Assets Liabilities

Base money remains fixed

Gold

Forex

Securities


OMOs

• Among the OMOs, the main refinancing operations (MROs) are the most important, playing a pivotal role in steering liquidity and signaling the stance of monetary policy.

• Three quarters of liquidity is provided by MROs.

• MROs were conducted as fixed rate and variable rate tenders with a minimum bid rate.

• The MROs are regular, liquidity providing, reverse transactions, conducted as standard tenders, with a weekly frequency and normally a maturity of two weeks.


Longer-term refinancing (LTROs)

• Longer-term refinancing operations (LTROs) are carried out through monthly standard tenders and have a maturity of three months.

• LTROs are regular open market operations executed by the Eurosystem also in the form of a reverse transaction.

• On average over the year, LTROs provided about one quarter of the total refinancing of banks.


Reserve requirements of banks

• The Eurosystem requires banks to hold minimum reserves equal to 2% of certain short-term liabilities. It is part of base money.

• The purpose is the stabilization of short-term interest rates and the enlargement of the structural liquidity deficit of banks.

• Reserve requirements bear interest, and must only be fulfilled on average over a one-month reserve maintenance period.

• It has a significant smoothing effect on the behavior of short-term interest rates.


Short-term liquidity policy

• The monetary base is also affected when a central bank makes a discount loan to a bank. The ECB does not use this instrument however.

• There are two standing facilities offered by the Eurosystem– the marginal lending facility and – the deposit facility,

• These instruments provide and absorb overnight liquidity, signal the stance of monetary policy and set an upper and lower limit for the overnight market interest rate.


The use of the standing facility


Key ECB interest rates

• The key ECB interest rates are at present

– the minimum bid rate on the main refinancing operations,

– the interest rate on the marginal lending facility

– and the interest rate on the deposit facility.


ECB interest rates

EONIA (euro overnight index average):


Interest rate policy in Europe and the US


The notion: quantity of money

• In addition to the central bank, commercial banks do also supply credit money.

• We assume that there is a fixed relationshipbetween central bank money (base money) and credit money.

• Then the quantity of money M equalsM = m B = multiplier base money.

• We assume the ECB controls B, then she also controls M.


Money creation through bank credit

• Credit money is created (destroyed) if the sum of demand deposits of non-banks at commercial banks increases (declines)

• In the case of a credit to a customer by a bank, the bank creates „book money“.

• As this credit is redeemed, money is destroyed.


Money creation by a commercial bank

Example: A commercial bank receives a cash deposit of € 1 Mill. and uses it for a loan to a firm of € 1 Mill..

Cash deposit + € 1 mill. Loan + € 1 mill.

Liability + € 1 mill.

Bank

Firm

A

L

L

A

Outlays + € 1 mill.

Demand deposit + €1 mill.Loan + € 1 mill.

Liability + € 1 mill. Outlays etc.

Demand deposit etc.


Money creation by banks: is it limited?

Yes, money creation by banks is not infinite!

• Central banks require commercial banks to maintain minimum reserves to be held on accounts of the central bank.

• These reserve requirements are calculated as a percentage of demand, savings and time deposits.

• Demand deposits represent a claim on central bank money, which commercial banks cannot create themselves.


Multiple money creation: An example

• Mr. K. puts € 10,000 into his acount at A-Bank.

• The central bank requires minimum reserves of 20% of the deposit (=1/5).

• There remains an excess reserve of € 8,000.

• A-Bank grants a loan to Mr. L. for the purchase of a car. The amount of the loan can only be € 8,000.


Example, continued

• Mr. L. transfers this amount to an account of the car dealer at B-Bank.

• At B-Bank it creates excess reserves of €8,000 minus €1,600 minimum reserves required (= € 6,400).

• These excess reserves can be used for a loan, etc.....


Example, continued

• It is best to imagine this process in terms of “rounds” of credit creation:

Round Deposit Minimum reserve Excess reserve=credit creation

1(primary impulse)

10000 2000 8000

2 8000 1600 6400

3 6400 1280 5120

4 5120 1024 4096

etc.


The money creation multiplier

• The money creation multiplier is obtained as a result of an infinite geometric series.

• In the example:

10,000 + 8,000 + 6,400+..... = 50,000

• From an initial excess reserves of € 10,000 an an additional credit volume of 40000 € can be derived.


By subtracting R2 from R1

it is obtained:[1 - (1-) ] Cr =

[{1-}1 - {1-}+1] ER

Cr = {1-} ER =

Cr=ER ({1-} / )

or in this case: ({1-.2} / .2 ) = 4

The credit multiplier


Critique of the simple model

• Supply of credit must meet a demand!

• Banks do not extend their lending to the maximum because of insolvency risks.

• Lending is limited by capital adequacy ratios (Basel I and II).

• But there are refinancing possibilities– through the ESCB, and– through the interbank market.


An example: The Eurodollar market

• The Eurodollar market (better: xeno market) is an off-shore market for the US dollar (more generally: any hard currency).

• It is characterized by the absence of mandatory reserve requirements for commercial banks.

• The experience has shown that this market had avoided “credit explosion”.

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Paul Bernd Spahn, Goethe-Universität Frankfurt/Main1 Lecture 8 DETERMINANTS OF THE MONEY SUPPLY, AND THE TOOLS OF CENTRAL BANKS (2)