CENTRAL BANK AND THE CREATION OF MONEY - Financial Institutions and Markets by Fabozzi

CHAPTER 5

CENTRAL BANK

AND THE CREATION OF MONEY

CENTRAL BANKS AND THEIR PURPOSE

The primary role of a central bank is to maintain the stability of the currency and money supply for a country or a group of countries. The role of central banks can be categorized as: (1) risk assessment, (2) risk reduction, (3) oversight of payment systems, (4) crisis management.

One of the major ways a central bank accomplishes its goals is through monetary policy. For this reason, central banks are sometimes called monetary authority. In implementing monetary policy, central banks, acting as a reserve bank, require private banks to maintain and deposit the required reserves with the central bank. In times of financial crisis, central banks perform the role of lender of last resort for the banking system. Countries throughout the world may have central banks. Additionally, the European Central Bank is responsible for implementing monetary policy for the member countries of the European Union. 

There is widespread agreement that central banks should be independent of the government so that decisions of the central bank will not be influenced for short-term political purposes such as pursuing a monetary policy to expand the economy but at the expense of inflation.

In implementing monetary and economic policies, the United States is a member of an informal network of nations. This group started in 1976 as the Group of 6, or G6: US, France, Germany, UK, Italy, and Japan. Thereafter, Canada joined to for the G7. In 1998, Russia joined to form the G8.

THE CENTRAL BANK OF THE UNITED STATES: THE FEDERAL RESERVE SYSTEM

The Federal Reserve System consists of 12 banking districts covering the entire country. Created in 1913, the Federal Reserve is the government agency responsible for the management of the US monetary and banking systems. It is independent of the political branches of government. The Fed is managed by a seven-member Board of Governors, who are appointed by the President and approved by Congress.

The Fed’s tools for monetary management have been made more difficult by financial innovations. The public’s increasing acceptance of money market mutual funds has funneled a large amount of money into what are essentially interest-bearing checking accounts. Securitization permits commercial banks to change what once were illiquid consumer loans of several varieties into securities. Selling these securities gives the banks a source of funding that is outside the Fed’s influence.

INSTRUMENT OF MONETARY POLICY: HOW THE FED INFLUENCES THE SUPPLY OF MONEY

The Fed has three instruments at its disposal to affect the level of reserves.

Reserve Requirements

Under our fractional reserve banking system have to maintain specified fractional amounts of reserves against their deposits. The Fed can raise or lower these required reserve ratios, thereby permitting banks to decrease or increase their lending and investment portfolios. A bank’s total reserves equal its required reserves plus any excess reserves.

Open Market Operations

The Fed’s most powerful instrument is its authority to conduct open market operation. It buys and sells in open debt markets government securities for its own accounts. The Fed prefers to use Treasury bills because it can make its substantial transactions without seriously disrupting the prices or yields of bills.

The Federal Open Market Committee, or FOMC, is the unit that decides on the general issues of changing the rate of growth in the money supply, by open market sales or purchases of securities. The implementation of policy through open market operations is the responsibility of the trading desk of the Federal Reserve Bank of New York.

Open Market Repurchase Agreements

The Fed often employs variants of simple open market purchases and sales, these are called the repurchase agreement (or repo) and the reverse repo. In a repo, the Fed buys a particular amount of securities from a seller that agrees to repurchase the same number of securities for a higher price at some future time. In a reverse repo, the Fed sells securities and makes a commitment to buy them back at a higher price later.

Discount Rate

A bank borrowing from the Fed is said to use the discount window. The discount rate is the rate charged to banks borrowing directly from the Fed. Raising the rate is designed to discourage such borrowing, while lowering should have the opposite effect.

DIFFERENT KINDS OF MONEY

Money is that item which serves as a numeraire. In a basic sense money can be defined as anything that serves as a unit of account and medium of exchange. We measure prices in dollars and exchange dollars for goods. Hence coins, currency, and any items readily exchanged into dollars (checking deposits or NOW accounts) constitute our money supply.

MONEY AND MONETARY AGGREGATES

Monetary aggregates measure the amount of money available to the economy at any time. The monetary base is defined as currency in circulation (coins and federal reserve notes) and reserves in the banking system. The instruments that serve as amedium of exchange can be narrowly defined as M₁, which is currency and demand deposits. M₂ is M₁ plus time and savings accounts, and money market mutual funds. Finally, M₃ is M₂ plus short-term Treasury liabilities. While all three aggregates are watched and monitored, M₁ is the most common form of the money supply, with its trait as being the most liquid. The ratio of the money supply to the economy’s income is known as the velocity of money.

THE MONEY MULTIPIER: THE EXPANSION OF THE MONEY SUPPLY

The money multiplier effect arises from the fact that a small change in reserves can produce a large change in the money supply. Through our fractional reserve system, a small increase will allow an individual bank, to lend out the greater part of these additional funds. These loans subsequently become deposits in other banks allowing them to expand proportionately. So, while one bank can expand its loans (or deposits) by an amount 1% of reserves required, all banks in the system can do likewise. Thus, in a simple format total change in deposits can be stated as change in reserves divided by the reserve requirement, which is also the formula for perpetuity. For example, if the change in the level of reserves is $100 and the reserve requirement is 20%, the change in total deposits will be $500 for a multiplier of 5. Of course, major assumptions are that banks will fully loan out their excess reserves and that depositors will not withdraw any of these extra reserves.

THE IMPACT OF INTEREST RATES ON THE MONEY SUPPLY

High rates of interest may make keeping excess reserves costly, since unused funds represent loans not made and interest not earned. High rates of interest will also affect the public’s demand for holding cash. If deposits pay competitive interest rates, customers will be more willing to hold such bank liabilities and less cash. Therefore, a higher rate of interest can actually spur growth of the money supply. More likely, however, it will deter borrowing and slow monetary growth.

THE MONEY SUPPLY PROCESS IN AN OPEN ECONOMY

In the modern era, almost every country has an open economy. Foreign commercial and central banks hold dollar accounts in the United States. Their purchases and sales of these deposits can affect exchange rates of the dollar against their own currency. The Fed has responsibility for maintaining stability in exchange rates. A purchase of foreign exchange with dollars depreciates the dollar’s value, but it also adds dollars to the accounts of foreign banks in this country, thus adding to theU.S. monetary base. Most central banks of large economies own or stand ready to own a large amount of each of the world’s major currencies, which are consideredinternational reserves. Sales of foreign exchange transactions have monetary base implication and hence consequences for the domestic money supply, emphasis is given to coordinating monetary policies among developed nations.

ANSWERS TO QUESTIONS FOR CHAPTER 5

(Questions are in bold print followed by answers.)

1. What is the role of a central bank?

The role of a central bank has several functions: risk assessment, risk reduction, oversight of payment systems, and crisis management. It can do this through monetary policies, and through the implementation of regulations.

2. Why is it argued that a central bank should be independent of the government?

Central banks should be independent of the short-term political interests and political influences generally in setting economic policies.

3. Identify each participant and its role in the process by which the money supply changes and monetary policy is implemented.

The Fed determines monetary policy and seeks to implement it through changes in reserves. It is up to the nation’s banking system to act on changes in reserves thereby affecting deposits, which constitute the greater part of the M₁ definition of the money supply.

4. Describe the structure of the board of governors of the Federal Reserve System.

The Board of Governors of the Federal Reserve System consists of 7 members who are appointed to staggered 14-year terms. The Board reviews discount operations and sets legal reserve requirements. In addition, all 7 members of the Board serve on the Federal Open Market Committee (FOMC), which determines the direction and magnitude of open-market operations. Such operations constitute the key instrument for implementing monetary policy.

5.

1. Explain what is meant by the statement “the United States has a fractional reserve banking system.”
2. How are these items related: total reserves, required reserves, and excess reserves?

a.       A fractional reserve system requires that a fraction or percent of a bank’s reserve be placed either in currency in vault or with the Federal Reserve System.

b.      Total reserves are the amounts that banks hold in cash or at the Fed. Required reserves are amounts required by the Fed to meet some specific or legal reserve ratio to deposits. Excess reserves are bank reserves in currency and at the Fed which are in excess of legal requirements. Since these amounts are non-interest bearing, banks are often willing to lend these surplus funds to deficit banks at the Fed funds rate.

6. What is the required reserve ratio, and how has the 1980 Depository Institutions Deregulation and Monetary Control Act constrained the Fed’s control over the ratio?

The required reserve ratio is the fraction of deposits a bank must hold as reserves. The DIDMCA constrained the Fed’s control over the ratio by letting Congress set ranges of reserves for demand and time deposits.

7. In what two forms can a bank hold its required reserves?

A bank can hold its reserves in the form of currency in vault or in deposit at the Fed.

8.

1. What is an open market purchase by the Fed?
2. Which unit of the Fed decides on open market policy, and what unit implements that policy?
3. What is the immediate consequence of an open market purchase?

a.       An open market purchase by the Fed consists of the purchase of U.S. Treasury securities.

b.      The FOMC decides on open market policy and directs the Federal Reserve Bank ofNew York to implement it through sales and purchases of these securities.

c.       The immediate consequence of an open market purchase is to supply the seller of the security with a check on the Federal Reserve System that he can deposit in his bank, thereby immediately increasing the excess reserves and thus nation’s money supply.

9. Distinguish between an open market sale and a matched sale (which is the same as a matched sale-purchase transaction or a reverse repurchase agreement).

A matched sale or reverse repo involves the sale of a Treasury security with an agreement to buy it back at a later date and at a higher price as the cost for borrowing the funds. This contrasts with an outright sale at some discounted or premium price.

10. What is the discount rate, and to what type of action by a bank does it apply?

The discount rate is the rate a bank pays to borrow at the “discount window” of the Fed. Such borrowings are often undertaken to meet temporary liquidity needs. Bank needs are monitored and the Fed likes to state that borrowing from it is a “privilege and not a right.”

11. Define the monetary base and M₂

The monetary base includes total bank reserves plus currency in the hands of the public. M₂ = M₁ (currency and demand deposits) + savings and time deposits.

12. Describe the basic features of the money multiplier.

The money multiplier is crucial to the concept of money creation and is analogous to the idea of the autonomous spending multiplier and formula for a perpetuity. It is the inverse of the required reserve ratio (1/rr). If the reserve ratio is .2 then the money supply will expand five times any increase in new deposits. The multiplier will be less if banks hold excess reserves or experience cash drains.

13. Suppose the Fed were to inject $100 million of reserves into the banking system by an open market purchase of Treasury bills. If the required reserve ratio were 10%, what is the maximum increase in M₁ that the new reserves would generate? Assume that banks make all the loans their reserves allow, that firms and individuals keep all their liquid assets in depository accounts, and no money is in the form of currency.

The maximum increase in M₁ will be $1 billion assuming no cash drains in the system, and banks are fully loaned up.     

14. Assume the situation from question 13, except now assume that banks hold a ratio of 0.5% of excess reserves to deposits and the public keeps 20% of its liquid assets in the form of cash. Under these conditions, what is the money multiplier? Explain why this value of the multiplier is so much lower than the multiplier from question 13.

Substitute the given values of currency ratio, required reserves ratio, and excess reserves ratio of 20%, 10% and 0.5% respectively into the formula given on page 94 of the textbook. Now we have a lower multiplier value of 3.9=1.20/. 305. This is because public and banks do not deposit or lend, all they can