Transcript Monetary policy

Liquidity and money supply changes
Monetary policy
Marijana Ivanov, Ph.D.
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•
•
•
Money supply is the entire stock of currency and other liquid
instruments circulating in a country's economy as of a particular
time.
the amount of money in circulation depends on the actions of
central banks
the central bank may increase or decrease the liquidity of banks
and thus allow more or less bank lending - that is more or less
the creation of money
MONEY SUPPLY (M1)
1. Currency in circulation
2. Deposit money (checkable deposits - demand deposits on
transaction accounts at commercial banks)
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How the central bank can affect the
reserves of commercial banks?
The central bank is a key player in the process of money
creation but not the only player.
There are 4 major players in this process:




The central bank
The banking system (i.e. depository institutions)
Depositors
Borrowers
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Central bank’s T-account (balance sheet)
Assets
Liabilities
Government securities
Currency in circulation
Discount loans
Reserves
Primary money M0
(reserve money, or monetary base)
Simplified version of central bank’s and
commercial bank’s T-accounts
Commercial bank’s T-account (balance sheet)
See more:
Mishkin,
Chapter 15: The
Money Supply
Process
Assets
Liabilities
Reserves
Deposits
Loans to public
Discount loans (borrowing)
Securities
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Central bank’s T-account (balance sheet)
Assets
Liabilities
Government securities
Currency in circulation
Discount loans
Reserves (of banking system)
Primary money M0
(monetary base)
Simplified version of central bank’s and
commercial bank’s T-accounts
Commercial bank’s T-account (balance sheet)
Assets
Liabilities
Reserves
Deposits
Loans to public
Discount loans
Securities
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1. ASSETS SIDE OF CENTRAL BANK’S BALANCE SHEET
Government securities: The CB holds government (i.e.
Treasury) securities for two reasons:
•
buying and selling of Treasury securities is one of the CB’s
major tools (known as open market operations) in
controlling the economy’s money supply, and
•
holding Treasury securities provides a return.
Discount loans: The CB makes loans to banks through its
discount window operation.
•
The CB does not encourage banks from borrowing through
its discount window on a regular basis since the CB is
acting as a lender of last resort for the banks.
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2. LIABILITIES SIDE OF CB’s BALANCE SHEET
Currency in circulation: The notes circulating in the economy are liabilities for
the CB.
Reserves: All commercial banks have to keep a certain percentage of the
deposits accepted in very liquid assets (i.e. the reserve requirement). The
banks can do so in two ways:
(a) All commercial banks are required to open an account with the CB
and they can maintain their reserves by making a deposit into that
account.
(b) The banks can keep cash in the vault (i.e. vault cash).
We can further break commercial banks’ reserves into two components:
Required reserves: This is the amount of money a bank needs to
keep by law (on statutory reserves account). This is determined by the
reserve requirement ratio (expressed as a percentage of a bank’s total
deposit) set by the CB.
Excess reserves: This is the additional amount of money a bank
chooses to hold for liquidity reason. They include the excess reserves
into settlement accounts and cash in vault.
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• It is important to note that the currency in circulation and the total
reserves of banking system make up the monetary base (MB,
monetary aggregate M0 or the primary money).
MONETARY BASE (M0)
1. Currency in circulation
2. Commercial banks’ deposits
into settlement accounts
3. Required reserves of commercial banks
4. Banks’ cash in vaults
MB = C + R This formula shows the structure of monetary base (M0).
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(2) + (3) + (4) = R (Total reserves of banking system)
We will see in the single model that an increase in the banks’ reserves will
lead to an increase in the economy’s money supply.
This simple model works only if the banks hold no excess reserves.
•
•
In other words, the banks will only keep the required amount of money as
required reserves, and use the excess money to make loans.
Namely, banks earn no interest on its reserve but do on a loan.
Between money supply in the economy and the reserves in the banking
system, there is a direct relationship; i.e. when the reserves go up, the
money supply also goes up.
There are two ways the CB can alter the reserves of a bank or the banking
system:
 buying and selling securities to the banks, and
 making and recalling discount loans from banks.
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EXAMPLE 1: Suppose the CB decides to buy $1,000 worth of government securities
from the “AB” bank (one of commercial banks).
When the CB buys the government securities from AB bank, the value of the
securities in its portfolio increases by $1,000. Central bank pays for this securities
simply by crediting (or transferring money into) the AB bank’s settlement account at
the CB.
As a result, the reserve money at the CB (as a form of liability) and the bank’s
reserve (as a form of AB bank’s asset) increase due to the purchase of government
securities by the CB from “AB” bank.
•
The purchase of government securities by the CB result in an increase in
excess reserve of the AB bank equivalent to the value of the securities.
The following tables show the results of that particular transaction on the CB’s and
AB’s T-accounts.
Central bank
AB bank
Assets
Liabilities
Assets
Securities +$1000
Reserve +$1,000
Securities -$1,000
Reserve +$1,000
Liabilities
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EXAMPLE 2: Suppose the CB made a $1,000 loan to “AB” bank through its discount
window.
When the CB makes the $1,000 discount loan (DL) to “AB” bank, that represents an
increase of $1,000 in the CB’s asset (since a discount loan represents an asset to
the CB).
On the liabilities side of the CB balance sheet we can see that CB simply “deposit”
the money in AB’s settlement account opened at the CB (the CB credits AB’s
account, i.e. the reserve goes up $1,000).
•
When the CB makes a discount loan to a bank, the excess reserve will
increase by the amount of the loan.
Central bank
AB bank
Assets
Liabilities
Assets
Liabilities
DL +$1000
Reserve +$1,000
Reserve +$1,000
DL +$1,000
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Money creation process (or deposit creation process)
In the above two scenarios, we have seen that the CB can change the reserve of a
bank simply by buying/selling Treasury securities and making/recalling loans. With
these two scenarios in mind, we will proceed to examine the impact of such changes in
a bank’s reserve on the economy’s money supply.
EXAMPLE 3: Following the example 1, the CB bought $1,000 worth of government
securities from “AB” bank. (CB simply credited “AB” bank’s settlement account.) We
will assume that “AB” bank use its excess reserves in the purpose of making the loan
of $1,000 to Bob
This example will be based on a very simple model with the following two assumptions:

Banks hold no excess reserve because excess reserve earns no return (and they are
not required by law). It is assumed that the bank will use a total amount of excess
reserve to make loans.

Only central bank affect the level of commercial banks’ liquidity. (Namely, in real
situation there is a many transaction of collecting or shrinking the deposits by which
commercial bank can increase the level of liquidity.)
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•
in any situation when commercial banks make loans to
public, they also create the deposit money (as part of total
money supply M1 in circulation)
•
the situation is different in the case of interbank loans and
discount loans
interbank loans influence on the level of liquidity for any
particular bank (its excess reserves) but have no influence on
the amount of money supply
•
MONEY SUPPLY (M1)
1. Currency in circulation
2. Deposit money (checkable deposits - demand deposits on
transaction accounts at commercial banks)
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AB bank
Assets
Securities -$1,000
Reserve +$0
Loan +$1,000
Bob
Liabilities
Deposit on Bob’s
current account
+$1,000
Assets
Deposit on current
account at AB bank
+$1,000
* Bob use the $1,000 to buy a
car and transfer this money on
the car-shop’s account opened
at some other bank, for
example “Z” bank. As a result,
the deposit at “Z” bank has
gone up by $1,000.
Liabilities
Loan +$1,000
Z bank
Assets
Liabilities
Reserve +$1,000
Deposits +$1,000
(on car-shop’s
account)
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Suppose the reserve requirement for the banks has been set at 10%.
 In this case, “Z” bank is required to keep $100 from Bob’s deposit as
required reserve (RR).
 The rest of the deposit (i.e. $900) represents the bank’s excess reserve
(ER).
*
Since “Z” bank is not earning return for holding excess reserve, it will make
the $900 consumer loan to Mary for buying some goods in supermarket “G”.
Z bank
Assets
RR +$100
ER +$900
Z bank
Liabilities
Deposits +$1,000
(on car-shop’s
account)
Assets
RR +$100
ER +$0
Loan to Mary +$900
Liabilities
Deposits +$1,000
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* “Z” bank will transfer this money on account of supermarket “G”. The
account of supermarket “G” is opened at “Q” bank.
Q bank
Assets
Liabilities
Reserve +$900
Deposits +$900
(on supermarket’s
account)
Q bank
Assets
RR +$90
ER +$810
Q bank
Liabilities
Deposits +$900
(on supermarket’s
account)
Assets
RR +$90
ER +$0
New loan +$810
Liabilities
Deposits +$900
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We know “Q” bank needs only keep $90 of deposits as required
reserves and loan out the other $810.
This process will continue from one bank to another bank. We
realized that the amount of loan a bank can make decreases in size
(or amount) as the process continues.
 It is important to note that a bank cannot make a
loan that is greater than the amount of excess
reserves it has.
The following table summarizes what has happen when the central
bank initially bought $1,000 worth of securities from the “AB” bank.
•
Based on the above scenario, we will see that the purchase of
Treasury securities of $1,000 by the central bank resulted in an
increase of $10,000 of checkable deposits in the economy.
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The deposit macro-multiplication process (on the
level of whole economy or national banking system)
Bank
 in deposits
1. “AB” bank
 in reserves
 in loans
0
0
+$1,000
2. “Z” bank
+$1,000
+$100
+$900
2. “Q” bank
+$900
+$90
+$810
3. “Y”
+$810
+$81
+$729
Total
...
...
...
...
...
...
...
...
+$10,000
+$1,000
+$10,000
$10,000 =
= $9,000 of multiplicated loans (from Z bank to all another bank)
+ $1,000 of initial loan to Bob in the case of AB bank)
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THE DEPOSIT MULTIPLIER AND THE MONEY
CREATION PROCESS
The simple deposit multiplier is defined as:
•
1
m
rD
Hence, we can determine the amount of deposits created by the banking system
as follows:
or in our example:
R
D  m  R 
rD
1
D 
1000  $10,000
0.1

the CB’s action of buying $1,000 government securities from “X” bank resulted in an
increase of $10,000 in money supply in the economy
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In the simple model, the reserves of the banking system are the key
target of the central banks.
However, the central banks are not always successful in changing that.
 the reserves of the banking system can be influenced by the behaviors
of the banks (to approve certain amount of loans), and by the
behaviors of general public (public’s preferences in the holding of
different types of deposits, currency, bonds and other financial or nonfinancial assets)
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Monetary aggregates and
monetary multiplier
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MONETARY AGGREGATES AND
MONETARY MULTIPLIER
M1 = m * M0
The money multiplier represents the impact of a $1 change in the
monetary base on the economy’s money supply (M1).
MONETARY BASE
(PRIMARY MONEY, M0)
MONEY SUPPLY (M1)
- Currency in circulation
- Currency in circulation
- Reserves of banking
system at the central bank
- Deposit money (demand
deposits, transactional
deposits on current and giro
accounts of non-monetary
agents
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HOW BANKS AND INDIVIDUALS AFFECT THE
MONEY SUPPLY
For this purpose we need to define the relationship between the
economy’s money supply (M1) and the monetary base (MB or M0):
M1  m  MB
where m = money multiplier, and
money supply M1 is the sum of currency in circulation and
checkable deposits (deposit money).
The money multiplier represents the impact of a $1 change in the
monetary base on the economy’s money supply (M1).
for example, if m = 4 that means a $1 increase in monetary base will
lead to a $4 increase in the money supply
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The money multiplier is usually greater than one; hence any
increase in the monetary base will lead to a much bigger increase
in the money supply. As a result, the monetary base is also known
as high-powered money.
The analysis of relationship between monetary base and
money supply includes the effect of banks and individuals
behaviors. It is assumed that:
(1) Individuals hold a constant proportion of cash (i.e. currency C) relative to their checkable deposits (D), i.e. a constant
currency ratio:
C
Currencyratio 
D
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•
•
for example, if an individual’s currency ratio is 0.5 that means the
individual will keep $5 in cash if there is $10 in a checkable
deposit
if the individual’s checkable deposit rises to $100, his/her cash
holding will also rise to $50 to keep a 0.5 currency ratio
(2) Banks hold a constant proportion of excess reserves (ER)
relative to their checkable deposits (D), i.e. a constant excess
reserves ratio:
ER
Excess reservesratio 
D
•
•
for example, if a bank’s excess reserves ratio is 0.15 that means
the bank will keep $150 in excess reserves if there is $1000 in
checkable deposits
if the bank’s checkable deposit rises to $10,000, its excess
reserves holding will also rise to $1,500 to keep a 0.15 excess
reserves ratio
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▲▲ The banking system’s total reserves (R) is made up of two
components: required reserves (RR) and excess reserves (ER):
(1)
R  RR  ER
▲▲ The banking system’s required reserves is determined by the
required reserves ratio rD set by the central bank:
RR  rD  D
(2)
Substituting the required reserves from equation (2) into equation
(1), we can rewrite the banking system’s reserves as follows:
(1’)
R  (rD  D)  ER
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• The monetary base is made up of currency in circulation and the
banking system’s reserves:
(3)
MB  C  R
 C  ER  (rD  D)
• We can incorporate the currency and excess reserves ratios into
equation (3) and rewrite the formula for the monetary base as
follows:
C
  ER

MB    D   
 D   rD  D 
D
  D

 C ER

 
 rD   D
D D

(4)
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•
We can rewrite the above equation to express D in terms of MB:
1
D
 MB
(C / D)  ( ER / D)  rD
•
(5)
Using the M1 as the representation for the economy’s money
supply, we can define the money supply as the sum of currency
and checkable deposits:
M C  D
C
C


   D   D  1    D
D
D


•
(6)
Substituting the formula for D from equation (5), we can rewrite
the formula for the money supply as:
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1  (C / D)
M1 
 MB
(C / D)  ( ER / D)  rD
(7)
Since we know the relationship between the money supply and the
monetary base is defined by:
M1  m  MB
 M1  m  MB
Comparing that relationship with equation (7), the money multiplier is:
1  (C / D)
m
(C / D)  ( ER / D)  rD
(8)
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The money multiplier of the more complex model is related to the money
multiplier (deposit multiplier) of the simple model (in case of multiple
deposit creation) in which we assumed that:
(i) Excess reserves is zero,; (ii) Currency in circulation is zero, . In this
case the multiplier is:
1 0
1
m

0  0  rD rD
The money multiplier is primary affected by three factors:
•
•
•
The currency ratio (C/D)
The excess reserves ratio (ER/D)
The required reserves ratio ( rD )
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(1) Currency ratio (C/D)
• The currency ratio represents the amount of cash individuals hold
relative to the amount of checkable deposits they have with the
banking system.
• EXAMPLE:
• We can suppose that an individual has currency ratio of 0.8. It
means he/she keeps $80 of cash for every $100 he/she has in a
checking account.
• If the individual’s currency ratio increases to 0.9, and everything else
remains the same, the individual will hold approximately $85.26 in
cash and $94.74 in a checking account.
• Since individuals are holding more currency and less deposits (i.e.
currency ratio increases), less “money” can be created by the
banking system.
• As a result, the money multiplier and the money supply shrink.
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(2) Excess reserves ratio (ER/D)
•
•
•
The excess reserves ratio represents the amount of excess reserves a bank
with keep for every $1 of checkable deposits it accepts.
If a bank keeps more of the deposits as excess reserves, that means there
will be a smaller pool of resources available to make loans.
This will lead to shrinkage of the money multiplier, which in turn leads to
shrinkage of the money supply.
(3) Required reserves ratio
•
•
•
•
•
The required ratio indicates the amount of reserves a bank is required to
keep for every $1 of deposits it accepts.
The reserve requirement represents the portion of the deposits that is not
available to a bank to make loans.
For example, the reserve requirement is 10% on checkable deposits
(transaction deposit)
If the required reserves ratio increases on 12%, the amount of loans a bank
can make decreases.
As a result, the money multiplier and the money supply shrink.
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Other factors affecting the money supply
• We can classify the monetary base (M0) into two categories:
MB  MB n  DL
where MB n  Non-borrowed monetary base (open market operations)
DL  Borrowed monetary base, i.e. discount loans
• The above formula shows the channels through which the central
bank creates primary money (monetary base, M0).
• Changes in the so called nonborrowed monetary base and borrowed
monetary base - discount loans have also impacts on the proces of
money creation.
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(1) Nonborrowed monetary base
•
•
•
•
The non-borrowed monetary base is influenced by the central bank’s open
market operations.
the sale of government securities (or foreign currency) by the national
central bank lead to the reduction in the non-borrowed monetary base
the purchase of government securities (or foreign currency) by the central
bank lead to the increased in the non-borrowed monetary base
as a result, any decrease (or increase) in the nonborrowed monetary base
due to an open market sale (or purchase) of government securities (or
foreign currency) lead directly to changes in the monetary base and
indirectly to changes in the money supply
(2) Discount loans
•
•
•
As commercial banks borrow more from the national central bank, that
means the commercial banks will have a larger pool of funds available to
make loans.
if everything else remains the same, this will lead to an increase in
deposits in the economy (through the banking system’s money creation
process)
hence an increase (or decrease) in commercial banks’ borrowing from the
central bank will lead to an increase (or decrease) in monetary base
which in turn results in an increase (decrease) in money supply
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Conclusion
The money supply model is defined as follows:


1  (C / D)
M1  
  MBn  DL 
 (C / D)  ( ER / D)  rD 
Based on the money supply model as defined above:
(1) The public controls the currency ratio (C/D).
(2) The banking system controls the excess reserve ratio (ER/D).
(3) The central bank controls the non-borrowed monetary base and the
required reserve ratio.
(4) The central bank and the banking system jointly control the discount
loans.
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SPECIFIC CASE:
•
•
•
•
What will be happen if commercial banks decide to
keep the obtained discount loan as excess
reserves rather than use it to make more loans?
If the commercial banks decide to keep the
obtained discount loan as excess reserves rather
than use it to make more loans, then no
additional deposits will be created by the banking
system as a result of the increase in discount loan.
In other words, the central bank’s action has a
positive impact on the monetary base but (in
the same time) there is a negative effect on the
money multiplier.
As result, those two actions cancelled each other
and the money supply remains unchanged in
the economy.
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There are many factors that can influence on the process of
money creation.
What do you think:
(1) What affects an individual’s preference for his/her cash and
deposits holdings?
(2) What affects a bank’s desire to hold excess reserves?
(3) What affects a bank’s preference to borrow from the central
bank? ....
Explain answers!
:
Read the slides below.
Be creative and offer additional explanations.
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EXPLAINING DEPOSITOR AND BANK BEHAVIORS
The money supply model is defined as follows:


1  (C / D)
M1  
  MBn  DL 
 (C / D)  ( ER / D)  rD 
Based on the money supply model as defined above:
(1) The public controls the currency ratio (C/D).
(2) The banking system controls the excess reserve ratio (ER/D).
(3) The central bank controls the non-borrowed monetary base and the
required reserve ratio.
(4) The central bank and the banking system jointly control the discount
loans.
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I.
FACTORS AFFECTING THE BEHAVIOR OF DEPOSITORS (I.E. THE
CURRENCY RATIO)
The theory of asset demand
•
The currency ratio is determined mainly by the costs and benefits of using
currency relative to the costs and benefits of using checking accounts.
Currency is the most liquid way of conducting transaction for an individual
(especially small-ticket items) and they are widely accepted (as a medium
of exchange). However, since currency earns no return for the holder,
there is an opportunity cost for holding it. In addition, currency’s purchasing
power is easily eroded by inflation. On the other hand, some checking
accounts do pay some interest and this lowers the opportunity cost of
holding such accounts. In addition, a check is the most common way for
paying bills, large-ticket items at stores, etc., and it is much safer to carry
than cash. Furthermore, canceled checks provide a paper trail of the
transaction, which can be used as evidence of payments, records for tax
deduction items, and others. However, checks are not widely accepted in a
lot of places. For example, most restaurants do not accept checks as a
form of payment and most retail stores do not accept out of state checks.
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•
Using the concept of the relative costs and benefits of using currency and
checking accounts (together with the theory of asset demand), we will look
at how the following factors affect the currency ratio: (a) wealth and income,
(b) interest rates on checking deposits, (c) bank panics, (d) illegal activities,
and (e) personal income tax.
(a) Wealth and income
•
Currency is considered to be a necessity asset relative to checking
deposits. This is especially true with low-income families that use
predominantly cash to carry out their transactions. In addition, we know
from the theory of asset demand that as an individual’s wealth and income
go up, his/her demand for large-ticket items also go up. Since most
individuals pay for such items with checks, this means that they will keep
most of their money in checking accounts (and not as much in cash).
Hence, as the wealth level of individuals goes up, the holdings of
individuals’ cash and checking deposits also go up, but checking deposits
go up by a bigger proportion than cash holding. As a result, the currency
ratio drops (as wealth and income increase).
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(b) Interest rates on checking deposits
•
Currency earns no interest rate while banks traditionally pay interest on
checking deposits (even though banks are not fast in changing this interest
rate when the economy changes). According to the theory of asset demand,
checking deposits represent a more “attractive” option in storing purchasing
power than currency. In other words, there is an opportunity cost in holding
currency, i.e. the potential interest lost in not holding checking deposits.
Hence, the higher interest rate on checking deposits influence on the growth
of opportunity costs of cash holding. As a result, the currency ratio falls as
interest rate on checking deposits increases.
(c) Bank panics
•
A bank panic takes place when a collective number of banks failed. What
does it mean that a bank failed? A bank is said to have failed (i.e. a bank
failure) when it is unable to pay back its depositors on demand. Under such
condition, the depositors will experience a negative return.
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Example: John deposited $1000 in his checking account that pays an
annual interest of 3%. Unfortunately, the bank failed shortly after that and it
is unable to pay John any interest or let him withdraw any of his money. As
a result, John’s return will be as follows:
•
In the above example, John has experienced a return of -100% if he keeps
his money in a checking account. On the other hand, if John keeps his
money in cash, then he would have experienced a return of 0%. According
to the theory of asset demand, during the period of bank panics, individuals
will hold more currency than checking deposits and this leads to an increase
in currency ratio.
(d) Illegal activities
•
Transactions conducted with cash can remain anonymous while
transactions conducted with checks are traceable. It is easier and “safer” to
conduct illegal activities such as drug transaction, prostitution, black market,
illegal gambling, etc. with cash. In addition, money laundering is a popular
way to channel funds from “underground” organization to a legitimate
organization. As a result, as the amount of illegal activities rises, the amount
of currency in circulation will also rise to facilitate the transactions of such
activities (which lead to an increase in the currency ratio).
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(e) Personal income tax
•
•
•
Federal and state governments finance part of their “consumption” through
taxation. One of the ways for the government units to increase their
consumption is to raise the personal income tax rate. A rise in the personal
income tax rate will lead to a rise in tax evasion. In other words, individuals
are not reporting all the income they received so that they do not have to
pay large amount of taxes. One way to do that is conduct the “transaction”
in cash rather than with checks. For example, a landlord will have the
tenants pay half the rent with cash and the other half with checks so that
he/she needs to report only half of the rent income. As a result, we know
that as the personal income tax rate rises, the currency ratio also rises.
Nowadays, most checking deposits paid no or very low interest rates, and
there has not been any major bank panics recently. As a result, illegal
activities and income tax rate are responsible for changes in the currency
ratio.
There are also other factors affecting an economy’s currency ratio such as
changing age distribution of the population (i.e. older population tends to
have lower currency ratio because of their wealth and income), urbanization
(i.e. a check is a more common medium of exchange than cash in an urban
environment compares to a rural environment), etc.
43
II. FACTORS AFFECTING THE BEHAVIORS OF BANKS
•
So far, we have discussed the impact of certain events on the behaviors of
individuals in terms of their cash and checking deposit holdings. In this
section, we will look at the factors affecting the banks’ behaviors. To be
more specific, we want to know what affects (a) the banks’ holding of
excess reserves and (b) the banks’ borrowing from the central bank.
(a) Factors affecting a bank’s excess reserves
•
It is important to remember than a bank earns no return on its excess
reserves. Hence, there is an opportunity cost for a bank to hold excess
reserves. That opportunity cost is based on the return the bank will be able
to earn if it uses the excess reserves to make loans or buy more securities.
As the opportunity cost (or return on securities or loans) rises, the
opportunity cost for holding excess reserves also rises. This will lead to a
bank lowering its holding of excess reserves.
44
•
In addition, there is also another factor affecting a bank’s holding of excess
reserves. If you remember, a bank is required by the central bank to keep a
certain amount of its deposits as reserves (i.e. required reserves) to meet
any deposits withdrawal by its customers. If the bank expects deposit
withdrawal to go up and it is unable to meet the withdrawal demand simply
with the required reserves, it will keep additional reserves (i.e. excess
reserves) to meet this demand. In this case, the bank’s excess reserves are
insurance for the bank. It is important to note that there is a cost for the
bank if it needs to borrow from other institutions or selling securities to meet
its deposits withdrawal.
(b) Factors affecting banks’ borrowing from the central bank (i.e. discount
loans)
•
A bank’s borrowing from the central bank depends on two conditions: (1)
the market interest rate, and (2) the Fed’s discount rate. The difference
between those two rates represents the bank’s opportunity cost for not
borrowing from the central bank. For example, suppose the market interest
rate is currently 8% while the national central bank’s discount rate is 6%. In
this situation, the bank can borrow from the discount window at the rate of
6%, turn around and use that money to make loans or buy securities to earn
8%. There is a “pure” profit of 2%.
45
•
From the above example, we know the amount of borrowing depends on a bank’s
opportunity cost for not borrowing from the central bank. As the market interest rates
raise the opportunity cost also raise, which leads to more borrowing from the central
bank. On the other hand, as the discount rate rises, the opportunity cost drops which
leads to less borrowing from the discount window.
A COMPLETE MONEY SUPPLY MODEL
•
•
•
•
•
•
•
•
•
•
We can begin to put a more complete money supply model after our discussion on
factors affecting the individuals’ and banks’ behaviors. The following is a list of factors
affecting the money supply.
(1) Required reserve ratio
(2) Non-borrowed monetary base
(3) Discount rate
(4) Wealth and income
(5) Interest rates on checking deposits
(6) Bank panics
(7) Illegal activities
(8) Personal income tax
(9) Market interest rate
46
Appendix:
BALANCE SHEET OF THE CENTRAL
BANK
Case of the Federal Reserve System
Total assets
$4,443 billion
on Nov 2, 2016
$Billions
$5,000
$4,000
$3,000
$2,000
$869
billion
Aug.
2007.
Nov.
2008.
Oct.
2010.
Feb.
2013.
Dec.
2014.
Oct.
2016.
Deposits of Depository
Institutions $2,065
billion on Oct 26, 2016
kolovoz
2007.
studeni
2008.
listopad
2010.
veljača
2013.
prosinac
2014.
listopad
2016.