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Back to Subjects - Economics

Measuring the Money Supply

Measuring the Money Supply M1: Currency in Circulation +Demand (Checking Accounts on which checks may be drawn) Deposits+Travelers’ Checks (The most widely used and most liquid definition yet the narrowest.) Currency in Circulation (Paper and Coins): Vault Cash in Banks and Currency outside of Banks. M2: M1+ Savings (Time) Deposits+Money Market Mutual Funds (investments on liquid T-Bills and CDs) +Certificates of Deposits (CDs-large denomination saving accounts with competitive yields)+Eurodollars (US$ deposited in European Banks.) M3: M2+ large denomination savings accounts+institutional money market mutual funds. “Banking is the art of lending and getting it back.” Anonymous How banks operate in a Fractional Reserve System If banks, regulated by the CB (Central Bank), were imposed reserve requirements of 100%, they would hold all of their deposits as reserves and would loan nothing out. Deposit money would collect dust in bank vaults. In fractional banking system, banks are imposed reserve requirements as a fraction of their total deposits by the CB to be able to meet deposit withdrawals at any point in time. For instance, a bank with $100 Million worth of deposits should keep $10 Million as required reserves either in the form of vault cash or bank reserve account in the CB or both to meet a 10% reserve requirement ratio. The remaining amount of $90 Million can be invested by the bank in government bonds and loans. Sometimes, prudent banks, those concerned with loan defaults (likely to increase during recession and bad economic times), hold excess reserves over and beyond the required reserves, contracting their loan portfolio especially when staying liquid is desirable. Or Alternatively, those banks may channel a large portion of their deposits to liquid and safe assets like government bonds and T-Bills instead of loaning them to private firms. This may be understandable as loans are illiquid and there is always some risk of default on loans. Prudent banks try to limit their loan portfolio (and ration credit/ loaning out only to reputable companies rather than new and small businesses) not to take on the risk of non-performing loans/ loan losses and possibility of an erosion in their net worth. Of course, this type of bank behavior may reduce the overall profitability as loans pay out more in terms of interest returns, say, as compared to government bonds. One major rule in finance: Higher the risk, higher the expected return. An aggressive bank, on the other hand, keeps little or almost no excess reserves over and beyond the required reserves and rather than investing a sizeable part of the deposit funds in government bonds, it chooses to lend out almost all of its deposits (after satisfying the reserve requirements). Each loan carries a risk of default and sometimes, loans are simply non-performing as firms don’t make timely payments on the principal amount borrowed as well as the interest owed to the bank. If a majority of the loans made out by a bank becomes non-performing, then the bank has to consider those as losses. The value of the loan portfolio drops and those losses erode the banks’ net worth (capital placed on the bank by the shareholders/owners) as loan losses are ultimately subtracted from the net worth of the bank. When a bank has a net worth which is insufficient to cover its liabilities, then it is insolvent and goes bankrupt. It has a negative net worth when loan losses accumulated over time erodes the owners’ capital. To prevent such dire cases, the CB closely monitors (or should monitor) the activities of banks and imposes capital requirements as a % of total assets to build confidence in the banking sector. This is because higher the capital requirements, less risks the owners/bank managers are willing to take in terms of loans and they become more selective in identifying “good and creditworthy” borrowers. Otherwise, in case of aggressive and careless lending, they realize that they may lose their capital if loans turn out bad. Another safeguard is deposit insurance provided by the CB or an agency (FDIC in the U.S- Federal Deposit Insurance Corporation) Sometimes, banks may run into temporary liquidity problems (less serious than insolvency) when the required reserves and excess reserves can not cover the deposit withdrawals. Or they may simply need more funds (than made available by the depositors) to take advantage of good investment opportunities (loans?). At the extreme case of a liquidity crisis, depositors may run into a bank to withdraw funds when they lose confidence in the ability of banks to make payments (A Bank Panic and A Bank Run). In such cases, there are three major options available to banks. 1) They can borrow from the CB, a lender of last resort, through the discount window it operates. The discount rate is the rate the CB charges ion loans to the banking sector. 2) They can borrow from other banks in the interbank market, called the federal funds market in the U.S. at the interbank interest rate (or the federal funds rate in the U.S.). Banks with excess funds may choose to lend to others who happen to be short of funds that day, say, due to unexpected withdrawals. Higher the interbank (as well as the discount rate charged by the CB), more difficult and costly is to borrow for banks. Hence, banks, in a time of rising interbank and discount rates, try to prepare for unusual deposit withdrawals and investment opportunities by holding more excess reserves, behaving prudently. 3) They can directly sell part of their government bond holdings in the g-bond market or enter into a repo (repurchase agreement- when a bank borrows on a very short-term basis (1 day/ a week/ a month by selling g-bonds with the promise of purchasing them back at a higher price at the end of the maturity) with other banks and depositors to meet their short-term liquidity needs. Sometimes, government bonds are also used as collateral in the interbank market. · A bank may hold excess reserves over and beyond the required reserves by considering the advantages and the disadvantages. Advantage: It avoids cash deficiency/short-term liquidity problem that compels the bank to incur expenses by raising cash quickly, by calling in loans, selling securities (G-bonds/T-bills), borrowing from other banks in the interbank market or through the discount window. Disadvantage: Opportunity cost of holding excess reserves is the foregone interest income that could have been earned if the bank used these funds elsewhere. These funds could have been used for investment in loans and securities (G-Bonds and T-Bills) earning interest income for the bank. Instruments of Monetary Policy for the Central Bank A central bank is responsible for low inflation, high unemployment, and the regulation of the banking system so as to ensure smooth operation of the financial markets. One key objective of the CB is to control the nation’s money supply as it is directly related to the total volume of credit in an economy. Credit volume (as well as its cost in terms of interest rates), in turn, determines the nation’s aggregate output through its effect on the investment volume. In fact, what the CB controls is the monetary base rather than the total money supply. This is because in effect, banks create money through their deposit and loan activities as we will see below. Let us now see how the CB actually controls the monetary base (which is part of the Money Supply, say, M1). Monetary Base: Outstanding Currency (Banks’ vault cash and currency in circulation outside of banks) + Bank Reserves (Bank reserve deposit accounts at the CB and possible excess reserves willingly held by banks for precaution). There are three major instruments available for the CB to influence the monetary base and hence, the money supply. 1. Reserve Requirements Ratio (RRR): By changing RRR, the CB can make money easy or tight and affects the amount of reserves banks must have, relative to their deposits. If RRR is increased, then less loans can be made and less deposits are created by the banking system. As a result, the money supply contracts. Likewise, if the RRR is reduced, more loans and more deposits can be generated by the banking system, increasing the money supply. 2. Discount Rate: By changing the rate the CB charges to banks for its loans, the CB can influence the cost of having too few reserves. If the discount rate is increased, banks are less willing to make loans but keep more as liquid assets and excess reserves. As a result, there is less and less deposit creation through lending activity. This, in turn, reduces the money supply. Just the opposite holds true, if CB operates a discount window on easy terms, such that banks can make more loans as they need less liquid funds and excess reserves to meet unexpected withdrawals. 3. Open Market Operations (OMO): The most important and frequently used monetary policy instrument by the CB. In an open market operation, the CB buys or sells g-bonds to banks and the public. If the CB sells g-bonds, public and the banks use their currency/demand deposits (for the public) and the excess reserves (or by calling in loans for the banks) to purchase these securities, as a result, less money can circulate, and be deposited in a bank which reduces the money supply. On the other hand, if the CB purchases bonds from the public and the banks, more reserves are available for loans and deposit creation. Hence, the money supply increases. Bank Money Creation in a Fractional Banking System The combined balance sheet of the banking sector in Granada is given as follows. Also assume that the money supply (M1) consists of deposits and money in circulation and the required reserve ratio is 10%. Shock 1: Suppose that Uncle Tom finds $1 Million in paper money under his mattress and deposits it in a bank. Initial Situation After Depositing Banking System Banking System Assets Liabilities Assets Liabilities Loans $8 Million | Deposits $10 Million Loans $8 Million | Deposits $11 Million G-Bonds $2 Million | G-Bonds $2 Million | Reserves $1Million | Net Worth $1 Million Reserves $2Million | NW $1 Million Total Assets $11 M | Total Liabilities $11 TAssets $12 M |TLiabilities $12 M Step 1: The Bank (the Banking System as a whole) receives the deposit and puts the money in its reserves (vault cash). Soon it realizes that it has excess reserves over and beyond what is legally required. For deposits of $11M, the bank needs to keep only $11M*0.10=$1.1M as required reserves. So, the bank finds itself with excess reserves of $2M-$1.1M=$0.9M. The story gets really interesting in terms of its effect on the money supply if the bank decides to loan this excess reserve rather than keeping it as excess reserves or investing it in G-bonds. Route One: Bank keeps this excess reserve as G-bonds. Route Two: Bank make new loans. Banking System Banking System Assets Liabilities Assets Liabilities Loans $8 M | Deposits $11 Million Loans $8 Million | Deposits $11 Million G-Bonds $2.9 M | G-Bonds $2 Million | Reserves $1.1M | Net Worth $1 Million Reserves $2Million | NW $1 Million Total Assets $12 M | Total Liabilities $12 TAssets $12 M |TLiabilities $12 M Stop here if Route One was taken: Ms=CC+Deposits Initially=$1M(assume that was the total CC under the mattress)+$10M.=$11M Now:=$0+$11M=$11M (No Change in Money Supply if Banks invest the excess reserves generated by new deposits on g-bonds) Route Two: If banks loan out the excess reserves in the amount of $0.9M=new loans, then if these loan proceeds find their way back to the banking system as deposits, then the second round of deposit and money creation takes place. This is our step 2. Step 2: New loans deposited into the banking system. Hence, the following occurs. After new loans are deposited. Banking System Banking System Assets Liabilities Assets Liabilities Loans $8.9 M | Deposits $11 Million Loans $8.9 M | Deposits $11.9 M G-Bonds $2 M | G-Bonds $2 Million | Reserves $1.1M | Net Worth $1 Million Reserves $2Million | NW $1 Million Total Assets $12 M | Total Liabilities $12 TAssets $12.9 M |TLiabilities $12.9 M The sector is not in balance, for Deposits of 11.9M, only 11.9*0.1=1.19 should be kept as required reserves, the rest can be loaned out. If again, the excess reserves=$2-1.19=$0.81M is loaned out as new loans, we have the following changes in the bank accounts. Step 2: Several more steps in between till µ. Final Stage Banking System Banking System Assets Liabilities Assets Liabilities Loans $8.9+0.81 M| Deposits $11.9 M Loans $17 M | Deposits $20 Million G-Bonds $2 M | G-Bonds $2 Million | Reserves $1.19M | Net Worth $1 Million Reserves $2Million | NW $1 Million Total Assets $12.9 M | Total Liabilities $12.9 Tassets $21 M |TLiabilities $21 M The initial deposit of $1M=D Reserves generates a multiple expansion in deposits till the D Deposits=(1/RR)*D Reserves=1/0.1*$1M=$10M increase in deposits. (1/RR) is called the money multiplier or the deposit multiplier. Therefore, the new money supply=$0 (CC)+$20 M (Deposits) and old money supply was=1+10=$11M. The increase in Money Supply is $9M. New Loans=D Loans=17-8=$9M, New Reserves=$1M and New Deposits=$10. (They add up!) Alternatively, think of the total deposit creation in terms of new loans. In Step 1, new loans=$0.9M, in step 2, new loans=$0.81M, in step 3, they will be (1-0.1)3 =0.729 and in step 4, (1-0.1)4 =0.6561 so on. Think of this as an infinite series, 1+b+b3+b4+…..=1/1-b in the limit. If b=(1-RRR)=1/1-0.1, then the limiting case=1/1-b=1/1-(1-0.1)=1/0.1=10 (voila, the money multiplier). Therefore, if new loans add to the deposits, together with the initial deposit of 1M, the total deposit creation will be a multiple of the initial deposit such that D Deposits=(1/RR)*D Reserves (or Initial Deposit). Shock 2: Suppose Aunt Seema dies in Sierra Madre (another country!) and leaves an inheritance to Lucky Tom in Granada a wonderful amount of $1M. (So that he does not have to search under his mattress.). Initial Money Supply=$1M (CC-under the mattress)+$10M(Deposits). He happily takes it to a bank in Granada. Again, the new deposit creation will be $10M (extra). But this time, the money supply will go up from $11M to $21M as the new deposits were not drawn out of circulation but transferred from abroad. Shock 3: Suppose that the Central Bank of Granada conducts an Open Market operation purchasing G-Bonds from the Banking System in the amount of $1M, what will be the effect on the Money Supply if banks loan out all of their excess reserves? Will there be a contraction or an expansion in the Money Supply? Show your calculations. Shock 4: Suppose that the CB increases the RRR from 10% to 20%. What is the impact on the money supply if a) banks sell their G-bonds to meet the new RRR, b) banks call in loans to meet the new reserve ratio? Shock 5: Treasury issues T-Bills in the amount of $1M to finance government deficits and the public draws from its deposit funds in the banking system to pay for the proceeds. Shock 6: Treasury sells securities to the CB in the amount of $1M and the CB pays for these securities by creating new notes (Monetization of Deficits). Bibliography:

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