The deposit macro-multiplication process (on the level of whole economy or national banking system)

Transcription

1 MONETARY POLICY Lecture 5 1 The deposit macro-multiplication process (on the level of whole economy or national banking system) Bank in deposits in reserves in loans 1. AB bank 0 0 +$1, Z bank +$1,000 +$100 +$ Q bank +$900 +$90 +$ Y +$810 +$81 +$ 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) 2

2 THE EPOSIT MULTIPLIER AN THE MONEY CREATION PROCESS The simple deposit multiplier is defined as: m = 1 r Hence, we can determine the amount of deposits created by the banking system as follows: or in our example: = = m R = R 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 r 1000 = $10,000 3 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 non-financial assets) 4

3 HOW BANKS AN INIVIUALS 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): M = m MB 1 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 5 The money multiplier is always greater than one; hence any increase in the monetary base will always 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 (), i.e. a constant currency ratio: Currency ratio = C 6

4 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 (), i.e. a constant excess reserves ratio: Excess reserves ratio = ER 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 7 The banking system s total reserves (R) is made up of two components: required reserves (RR) and excess reserves (ER): R = RR + ER The banking system s required reserves is determined by the required reserves ratio r set by the central bank: (1) RR = r (2) Substituting the required reserves from equation (2) into equation (1), we can rewrite the banking system s reserves as follows: (1 ) R = ( r ) + ER 8

5 The monetary base is made up of currency in circulation and the banking system s reserves: (3) MB = = C C + + ER R + ( r ) We can incorporate the currency and excess reserves ratios into equation (3) and rewrite the formula for the monetary base as follows: C MB = + C ER = + + r ER + ( r ) (4) 9 We can rewrite the above equation to express in terms of MB: 1 = ( C / ) + ( ER / ) + r MB (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 + = C + = 1 + C (6) Substituting the formula for from equation (5), we can rewrite the formula for the money supply as: 10

6 M 1 1+ ( C / ) = ( C / ) + ( ER/ ) + r MB (7) Since we know the relationship between the money supply and the monetary base is defined by: M 1 = m MB M = m MB 1 Comparing that relationship with equation (7), the money multiplier is: 1+ ( C/ ) m= ( C/ ) + ( ER/ ) + r (8) 11 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: m = = r r The money multiplier is primary affected by three factors: The currency ratio (C/) The excess reserves ratio (ER/) The required reserves ratio ( ) r 12

7 (1) Currency ratio (C/) 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. 13 (2) Excess reserves ratio (ER/) 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. 14

8 Other factors affecting the money supply We can classify the monetary base into two categories: MB = MB + n L where MB n = Non-borrowed monetary base L = Borrowed monetary base, i.e. discount loans Changes in the so called nonborrowed monetary base and borrowed monetary base - discount loans have also impacts on the money supply. 15 (1) Nonborrowed monetary base The non-borrowed monetary base is influenced by the central bank s open market operations. the sale of government securities by the national central bank lead to the reduction in the non-borrowed monetary base the purchase of government securities by the central bank lead to the increased in the nonborrowed 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 lead directly or indirectly to changes in the money supply (2) iscount 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 16

9 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. 17 There are many factors that can influence on the process of money creation. They include: (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?... 18

10 EXPLAINING EPOSITOR AN BANK BEHAVIORS The money supply model is defined as follows: M 1 1+ ( C / ) = ( C / ) + ( ER / ) + r ( MB + L) n Based on the money supply model as defined above: (1) The public controls the currency ratio (C/). (2) The banking system controls the excess reserve ratio (ER/). (3) The central bank controls the nonborrowed monetary base and the required reserve ratio (). (4) The central bank and the banking system jointly control the discount loans. 19 I. FACTORS AFFECTING THE BEHAVIOR OF EPOSITORS (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. 20

11 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). 21 (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. 22

12 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). 23 (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. 24

13 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. 25 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%. 26

14 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 MOEL 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) iscount 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 27 FE 28

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16 MARKET FOR RESERVES AN FEERAL FUNS RATE 31 32

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