12. The money creation process

Transcription

1 Politias maroeonomias, handout, Miuel Lere de Freitas 12. The money reation roess Index: 12. The money reation roess Introdution Aountany issues and definitions The Central ank alane sheet The alane sheet of other monetary institutions Two key ratios The onsolidated monetary setor Monetary oliy tools How does the entral ank exand the monetary ase? Intervention in the forein exhane market Liquidity rovision to (asortion from) ommerial anks: Purhases of domesti assets Lendin to the overnment Sterilization The money multilier The Money multilier Parameter instaility...12 Box The money multilier durin finanial rises...12 Fiure 3 Money suly and Monetary Base in the US, Fiure 4 Money suly and monetary ase, US Caital onstraints Demand and suly of redit Summin u A numerial examle Conlusions...19 Review questions and exerises...20 Review questions...20 Exerises /10/2017 htt://sweet.ua.t/afreitas/aulas/notas%20aoio/notasmaro.htm 1

2 Politias maroeonomias, handout, Miuel Lere de Freitas 12.1 Introdution So far, we have analysed the imliations of monetary exansions assumin that the entral ank has full ontrol over the amount of money in irulation. In the real world, however, entral anks do not determine diretly the money suly in an eonomy. Exansionary oliies y the entral ank are mediated throuh a ank lendin hannel, whih an deliver a hiher or lower monetary exansion deendin on market onditions and other onsiderations. This note riefly reviews the roess underlyin the reation of money in an eonomy, to disuss the ossile soures of instaility in the relationshi etween monetary oliy ations and money suly outomes. In Setion 12.2, we introdue the main onets and aountin identities. In Setion 12.3 we riefly desrie the main tools of monetary oliy. In Setion 12.4 we exlain why we shouldn t trust the so alled money multilier to e a onstant arameter. In Setion 12.5, we ive a numerial examle to illustrate how a finanial risis may redue the effetiveness of monetary oliy and the alternative avenues exlored y entral anks. Setion 12.6 onludes Aountany issues and definitions The Central ank alane sheet The entral ank alane sheet oeys to the followin identity (see Fiure 1): * eb L L D H, (1) where, denotes for the net worth of the entral ank, the entral ank exressed in domesti urreny, ank, * eb for net forein assets held y D for overnment det held y the entral L for loans to ommerial anks, L for loans to the rivate setor, and H for the Monetary Base (or Hih-Powered money). The Monetary Base (H) is the most relevant liaility of the entral ank. It omrehends the Notes and Coins held y the Puli ( ) and the Reserves held y ommerial anks (R). The later onsists in ash holdins in anks vaults lus deosits at the entral ank. 04/10/2017 htt://sweet.ua.t/afreitas/aulas/notas%20aoio/notasmaro.htm 2

3 Politias maroeonomias, handout, Miuel Lere de Freitas H=X+R (2) Fiure 1: The Central Bank Balane sheet The alane sheet of other monetary institutions Commerial anks are a seial kind of finanial institution, eause they are authorised to issue deosits. The seifi harateristi of ank deosits is that they are so liquid that they an serve as means of ayment. Beause of this, ank deosits are art of what we all money, toether with urreny in irulation (X) 1 : M=X+D (3) With the funds raised y deosits and any eventual loans otained from the entral ank, L, ommerial anks enae in their main ativity, whih is rantin redit to the nonfinanial setor 2. 1 In the real world, entral anks monitor wider monetary areates, inludin short term seurities held y the uli (e., treasuries). For onveniene, we inore this omliation. 2 For simliity, we are inorin funds raised y anks throuh the aital market, suh as lon term onds. Note that individual anks also rely on lendin from eah other as a soure of finane, ut when onsiderin the ankin system as a whole, these inter-ank loans anel out 04/10/2017 htt://sweet.ua.t/afreitas/aulas/notas%20aoio/notasmaro.htm 3

4 Politias maroeonomias, handout, Miuel Lere de Freitas The alane sheet of the ankin setor oeys to the followin identity: R L D D L, (4) where L denotes for anks loans to the rivate setor, D for overnment seurities, for the net worth of ommerial anks, and the remainin variales are defined as efore. Fiure 2: The Balane sheet of Deosit anks Two key ratios As art of the eneral rinile of rudential manaement, anks must make sure that they remain liquid, havin ash enouh to fae the day-to-day ayment oliations, inludin deosit outflows. When a ank finds itself illiquid, it may e fored to sell seurities at disount, or to request an emereny loan from the entral ank, whih may rove exensive. Another matter of onern is to remain solvent, havin aital enouh to meet the ank det oliations. Key indiators of the ank s liquidity osition and solveny risk are the reservesratio and the aital ratio. The desired reserves- ratio ( r d ) an e defined as follows: R r d. (5) D This indiator ives the erentae of ank deosits D that are aked y reserves, R. 04/10/2017 htt://sweet.ua.t/afreitas/aulas/notas%20aoio/notasmaro.htm 4

5 Politias maroeonomias, handout, Miuel Lere de Freitas In most ankin systems, entral anks imose a minimum level for the reserves- l ratio (the minimum reserve requirements, r ) 3. However, this leal onstraint is not always indin: in many irumstanes, anks desire to hold more reserves than the minimum requirements, to redue the risks of findin themselves in a osition of insuffiient liquidity. The onstraint takes therefore the form of an inequality: d l r r. The aital ratio (k), ives the erentae of risky assets that is aked y equity aital: k (6) L As art of ankin reulation, authorities require anks to reserve a minimum roortion of equity aital relative to risky assets. This is alled the aital adequay ratio, k : k k (7) Caital adequay ratios are set y the ankin authorities to revent hihly leveraed anks from enain in further leverae, riskin their solveny, unless they manae to raise more equity from shareholders The onsolidated monetary setor 3 In the euro area, for instane, anks are required to have a minimum amount of reserves orresondin to 1% of their deosits with areed maturity lower than 2 years. For areed maturities over 2 years, the minimum reserve requirement is zero. 4 In ratie, the denominator of the relevant aital adequay ratio is not exatly L. The international reulatory framework for anks (the Basel Aord) estalishes that anks shall hold as aital at least 8% of their risk-weihted assets. The later is omuted as the sum of four ateories of redits, with the different weihts refletin the eretion of different redit risks. For instane, reserves and overnment seurities issued y OECD sovereins have a zero weiht (so, in ratie, they are out of the ratio); laims on anks have a 20% weiht; muniial onds and residential mortaes have 50% weiht; loans to onsumers and ororations have the maximum weiht of 100%. On the other hand, the numerator of (6), whih aove onsists on equity only, may inlude lon term liailities with a hih level of suordination, whih are lose to aital for solveny uroses. 04/10/2017 htt://sweet.ua.t/afreitas/aulas/notas%20aoio/notasmaro.htm 5

6 Politias maroeonomias, handout, Miuel Lere de Freitas Takin toether the entral ank and the ommerial anks alane sheets, we otain the onsolidated alane sheet of the monetary setor: * eb That is, D D L L X D. M * eb L B, (8) where L D D L L is total domesti redit. Equation (8) reveals that the ounterarts of money suly are total domesti redit (overnment lus the rivate setor) and net redit to non-residents (net forein assets) Monetary oliy tools How does the entral ank exand the monetary ase? The rinile of doule-entry ook keein imlies that the total value of assets in a alane sheet shall e equal to the total value of liailities lus equity. Havin this in mind, one an disuss the different oerations throuh whih a entral ank an influene the monetary ase. In artiular, let s distinuish three tyes of oerations: (a) Intervention in the forein exhane market () Liquidity rovision to (or asortion from) ommerial anks: () Purhases of domesti assets from anks (d) Lendin to the Government (e) Sterilized intervention In the followin, we analyse these different oerations in more detail Intervention in the forein exhane market When the CB uys assets denominated in forein urreny or old, the monetary ase exands: H e (9) * B 04/10/2017 htt://sweet.ua.t/afreitas/aulas/notas%20aoio/notasmaro.htm 6

7 Politias maroeonomias, handout, Miuel Lere de Freitas This is the ase, for instane, when the entral ank uys dollars to avoid the areiation of the domesti urreny Liquidity rovision to (asortion from) ommerial anks: When the entral ank rovides liquidity to ommerial anks, the ounterart of monetary exansion is loans to anks: H L R. (10) Liquidity rovision to ommerial anks an our at the entral ank initiative (oen market oerations) or at the initiative of the ommerial ank (standin failities). In oen market, the entral ank deides the instrument and terms and onditions of the finanin (asortion) oeration. The most ommon tyes of oen market fundin are reurhase areements and ollateralised loans. Tyially, oen market oerations onsist in short-term lendin (one week, three months). However, in exetional irumstanes, lonterm lendin is also ossile 5. Standin failities are availale on a ermanent asis, and may e used on the initiative of ommerial anks. These are mainly aimed to rovide and asor overniht liquidity. The interest rates on these failities are set y the entral ank. By settin the interest rates on standin failities and in oen market oerations (intervention rates), entral anks lay a key role in influenin the money market interest rates. On one hand, the overniht standin failities define a orridor for the interest rate at 5 Durin the Euroean Det Crisis, in 2011, the ECB launhed the Lon Term Refinanin Oerations (LTRO), wherey liquidity to anks was oneded with a maturity of 3-years. In 2014, these oerations were relaed y Tareted Lon Term Refinanin Oerations (TLTRO), whih required that anks used the liquidity therey enerated to extend redit to the rivate setor. 04/10/2017 htt://sweet.ua.t/afreitas/aulas/notas%20aoio/notasmaro.htm 7

8 Politias maroeonomias, handout, Miuel Lere de Freitas whih ommerial anks rovide loans to eah other with the maturity of one day 6. On the other hand, one week and three month oen market oerations, y reatin and asorin liquidity at different maturities, influene the terms struture of interest rates at whih ommerial anks lend to eah other 7. Note however that the relevant oortunity ost for investment and durale onsumtion is the lon term interest rate, not the money market interest rate. Hene, when the entral ank tarets a iven money market interest rate, its influene in the lon term interest rate is mediated y the term struture of interest rates, wherey the lon run interest rate orresonds to the averae of the future exeted short term interest rates. This means that exetations reardin the future stane of monetary oliy matter for its effetiveness today Purhases of domesti assets In exetional irumstanes, entral anks enae in urhases of finanial assets from ommerial anks and other finanial institutions. These assets may inlude overnment onds, asset aked seurities, overed onds, equities, and ommerial aer. In this ase, the entral ank uys seurities (onds) in the seondary market, and holds them until maturity. Sine in this ase the ownershi of the seurity moves from the ank to the entral ank alane sheet, this oeration not only rovides liquidity to anks, it also indues the deleverain of ommerial anks. 6 In the ECB framework, the ermanent disount window alies to overniht loans, and is laelled Marinal Lendin Faility. Banks an also deosit funds overniht at the ECB at their own disretion, usin the so-alled Deosit Faility. The two rates define the orridor for EONIA, the Euro Overniht Index Averae, whih is the rate at whih ommerial anks rovide overniht loans to eah other. 7 In the ase of the Euro Area, the averae short term money market interest rate for unollaterized loans is alled Eurior (Euro Interank Offered Rate). 8 Durin the reent finanial risis, oth the FED and the ECB announed that the oliy of keein low money market rates today would e extended for a lon eriod of time. The intention was to hel kee all the term struture of interest rates down and therey the lon-term interest rate. 04/10/2017 htt://sweet.ua.t/afreitas/aulas/notas%20aoio/notasmaro.htm 8

9 Politias maroeonomias, handout, Miuel Lere de Freitas When the entral ank uys overnment onds, the imated aounts are: H D R D (11) When the entral ank uys rivate seurities, the imats are: H L R L (12) The urhase of rivate and uli seurities in seondary markets y the entral ank is not a onventional tool of monetary oliy. It has een used however y many entral anks around the World sine the loal finanial risis of , under the eneral umrella of Quantitative Easin 9. The main oal of Quantitative Easin is to raise the market rie of finanial assets, lowerin their yields, when standard monetary oliy tools eome ineffetive. In artiular, when the money market interest rate reahes the zero lower ound, the entral ank an no loner rely on oen market oerations to ahieve further redutions in the lon term interest rates. Buyin lon term onds in the seondary market, the entral ank reovers its aility to drive down the ond yields, even if its money market oliy eomes imotent. As we show next, QE is also effetive in exandin the money suly when anks are aital-onstrained Lendin to the overnment When overnments find it diffiult to finane the udet defiits, they may e temted to orrow diretly from the entral ank in the rimary market. In this ase, the monetary ase exands eause the entral ank uys overnment onds: (13) H D 9 Quantitative easin was first launhed y the Bank of Jaan in With the loal finanial risis, quantitative easin was swiftly imlemented y the United States (2008) and the United Kindom (2009). In and 2014, the Eurosystem launhed two Covered Bonds Purhase Prorammes (uyin eurodenominated overed onds), ut the amounts involved were very small for these oerations to e laelled as quantitative easin. Only in 2015, the ECB enaed in a lare sale urhase of assets, under the lael of APP (for Exanded Asset Purhase Proramme ). 04/10/2017 htt://sweet.ua.t/afreitas/aulas/notas%20aoio/notasmaro.htm 9

10 Politias maroeonomias, handout, Miuel Lere de Freitas Purhases of overnment det y the entral ank are laelled overnment det monetization. Beause ontinuin det monetization is the main ause of hih inflation, this ossiility is leally ruled out in most develoed nations. Yet in many other ountries, entral ankers are often instruted y the Minister of Finane to uy overnment onds. When this is so, the entral ank is said to e under fisal dominane Sterilization Sometimes, entral anks try to offset the monetary imat of their urhases of domesti or forein seurities, y ondutin symmetri oerations with other assets. When the entral ank uys or sells finanial assets so as to offset the imat of other asset sales or urhases in order to kee the monetary ase unhaned, is said to e onduin a sterilized intervention. The most oular form of sterilization haens when the entral ank offsets the effets of forein exhane market interventions: 10 In ountries were the entral ank is rohiited from uyin overnment det diretly, entral anks still have the ossiility of uyin overnment onds from the seondary market. When this ossiility materializes, a question may arise as to whether the entral ank is in fat monetizin the overnment det, indiretly. To avoid the lael, the oliy must e justified very arefully. For instane, under quantitative easin, overnment onds have een urhased with the aim to exand money suly and avoid the risk of deflation, not to finane overnment sendin. Thus, entral anks in rinile stand ready to revert the oliy (y sellin the overnment onds ak into the market) in ase the risks of deflation vanish. 04/10/2017 htt://sweet.ua.t/afreitas/aulas/notas%20aoio/notasmaro.htm 10

11 Politias maroeonomias, handout, Miuel Lere de Freitas * H eb L 0 (14): In this ase, the entral ank uses the oen market to omletely offset the intervention in forex markets, so that the money ase does not exand at all. Sterilization may also e used to hane the omosition of domesti redit. In this ase, the sterilized intervention takes the followin form 11 : H D L 0 (15) 12.4 The money multilier The Money multilier The fat that the entral ank ontrols the monetary ase (H) does not imly that the entral ank has ontrol over the money suly. The imat of the monetary ase on the money suly is mediated y the so-alled money multilier, defined as the ratio etween the money suly and the monetary ase: M (16) H Usin (2) and (3) and dividin oth memers y D, we et: X D d x r x d X D 1,, (16a) R x r D 11 In Euroe, durin the Euroean soverein det risis of , the ECB enaed in a roram of aquisitions of soverein onds (the so-alled Seurities Market Proram), with the aim to stailize the finanial markets, whih eame dysfuntional. In order for this not to e interreted as det monetization, the entral ank ommitted with the full sterilization of these urhases, drawin the liquidity therey enerated from ommerial anks, throuh oen market oerations. By ommittin with sterilized intervention, the ECB wanted to sinal a stron ommitment with rie staility. The same rinile holds for the SMP suessor, the OMT roramme (Outriht monetary transations). 04/10/2017 htt://sweet.ua.t/afreitas/aulas/notas%20aoio/notasmaro.htm 11

12 Politias maroeonomias, handout, Miuel Lere de Freitas where x=x/d is the ratio of urreny in irulation to deosits, and reserves-to-deosits y ommerial anks. r a R D is the ratio of Parameter instaility Beause desired ank reserves and liquidity referene y the uli are ehavioural arameters that hane over time aordin to the uli referenes and market onditions, one should not trust too muh the staility of the money multilier. For instane, the onsumers liquidity referene (x) deends on the uli onfidene in the ankin system, in the interest rate on time deosits relative to other assets, and the use of redit ards. The desired ratio of reserves y anks ( r d ) deends on the market interest rate, on the time struture of anks liailities, on the ost of orrowin form the Central Bank and - when indin - on minimum reserve requirements. Durin eisodes of finanial risis, one exets the total demand for ase money to inrease, oth eause the uli refers to hold a reater roortion of their monetary holdins in the form of ash, and eause anks inrease the ratio of desired reserves. Box 12.1 illustrates this. Box The money multilier durin finanial rises a The arameters x and r may hane dramatially durin finanial risis. The followin fiures desrie the time aths of money suly and of monetary ase in the US, durin the Great Deression and durin the Great Reession. In oth ases, we oserve a shar deline in the money multilier. Fiure 3 Money suly and monetary ase, US /10/2017 htt://sweet.ua.t/afreitas/aulas/notas%20aoio/notasmaro.htm 12

13 Politias maroeonomias, handout, Miuel Lere de Freitas Fiure 4 Money suly and Monetary Base in the US, Soure: Miskhin, /10/2017 htt://sweet.ua.t/afreitas/aulas/notas%20aoio/notasmaro.htm 13

14 Politias maroeonomias, handout, Miuel Lere de Freitas Durin the Great Deression, the fall in the money multilier was asially driven y the raisin liquidity referene, x, motivated y a series of ank failures that eroded the uli onfidene in the ankin system. Durin that eisode, anks also resonded to the inreased liquidity risk y holdin more reserves, further lowerin the money multilier. In the ase of the Great Reession, the fall in multilier was mostly driven y the inrease in anks reserves: in an environment were risk was ereived to e unusually hih, hihly leveraed anks referred to hold ash or deosits at the entral ank, rather than to a lend to eah other or to the uli. The shar inrease in the ratio of desired reserves, r, y lowerin the money multilier, larely mitiated the entral anks efforts to the exand the money suly. In oth eisodes, the fast inrease in the demand for ase money translated into a deline in the money multilier. Note however, that in the ase of the Great Reession, the Federal Reserve manaed to inrease the money ase the enouh to revent the money suly from fallin. Durin the Great Deression, that was not the ase. In their monetary history of the united states, , Milton Friedman and Anna Shwartz, Friedman ontended that the Great Deression was sinifiantly aravated y a fall in money suly that the Federal Reserve ould have revented Caital onstraints Risin liquidity amon anks may e an effetive measure to ahieve a monetary exansion when anks are liquidity onstrained, ut is not a suffiient ondition. One reason why liquidity rovision may fail in exandin the money suly is that anks may lak the aital to enae in further redit exansion. When aital ratios are lose to the aital adequay limit, anks will e unale to exand further the redit to the rivate setor, unless they manae to raise more aital from shareholders. The existene of aital onstraints may indue a ro-ylial ehaviour in the money suly. Indeed, durin eisodes of ooms, ank are more likely to make rofits, in whih ase it will e easy for them to attrat new aital. Then, with more equity, anks will e ale to lend aain. Durin downturns, on the ontrary, risin nom-erformin loans ause anks to have losses, erodin the existin aital and makin more diffiult for anks to attrat new aital. Whenever anks do not omly with the aital adequay ratio, they will tend to 04/10/2017 htt://sweet.ua.t/afreitas/aulas/notas%20aoio/notasmaro.htm 14

15 Politias maroeonomias, handout, Miuel Lere de Freitas redue redit to the rivate setor and eventually to hane the omosition of asset holdins towards overnment det, whih does not onsume anks aital. An imliation of this fliht-to-quality is that it drives down the interest rates on overnment onds, at the same time redit eomes sarer to the uli in eneral Demand and suly of redit Finally, extendin liquidity to anks will ause an exansion of domesti redit, only in ase there is demand for redit and if anks are willin to inrease their exosure to redit risk. Durin eriods of finanial stress, investment oortunities deline, drivin down the demand for redit, and anks tend to e autious in loan onession, rationin the redit, even if there is demand for it Summin u In sum, althouh theoretially an inrease in monetary ase may leads to an inrease in money suly, hanes are not neessarily roortional. To asses the imat of a iven liquidity rovision in the money suly, what matters is not the averae relationshi etween money ase H and money suly M, ut rather the marinal imat ( M H ). Sometimes, the marinal imat is sinifiantly smaller than the averae, and eventually nil. The followin numerial exerise illustrates this A numerial examle Consider the followin initial situation in a iven ankin system: D=200; X=40; R=10; * eb C 50, L L D 0, D 10, 0 and 20. Alon the exerise, assume that the aital adequay ratio, k, is 8%. (Aountany) How muh are the money suly, the monetary ase, and domesti redit ranted y ommerial anks? From the definition of money: M=X+D=240. The monetary ase is H=X+R=50. The domesti redit ranted y anks an e otained usin the anks alane sheet identity, that is: L D D L R Sine ankin 04/10/2017 htt://sweet.ua.t/afreitas/aulas/notas%20aoio/notasmaro.htm 15

16 Politias maroeonomias, handout, Miuel Lere de Freitas redit to the overnment is equal to 20, the ankin redit to the rivate setor equals L 210 D 200. (Caital adequay) Assume that anks in this eonomy are required to hold a minimum aital ratio of 8%. Does the ankin setor in this numerial examle satisfy the aital adequay ondition? The aital ratio is equal to k L %, so anks are in shae with the aital adequay ratio. a) (Money multilier) Find out the reserves ratio, the liquidity referene oeffiient and the money multilier. The money multilier is equal to M H 240 / The reserves ratio is r d R D 10/ 200 5% The liquidity referene oeffiient is x X D 40 / % x 1 1,2 We an hek with the formula for the money multilier 4. 8 d x r 0.25 ) (Monetary exansion unhaned multilier): Assumin that the ratio of desired reserves and the liquidity referene arameter were onstant, what would e the imat on money suly of an oen market oeration inreasin the entral ank liailities y 12.5? Will the ankin system as a whole still meet the aital ratio? The oliy onsists in H L With the reserve ratio and the liquidity referene onstant, the money multilier will e onstant, so M H 4.8* The new money suly will e M=300. [Note that this resumes that there is demand for redit and that anks are willin to inrease its exosure to the rivate setor]. In the new equilirium, we have: D=250; X=50; R=12.5. The total redit ranted y anks will e L D D L R If the redit to the overnment setor remained onstant, redit to the rivate setor would e L 270 D 260. In this ase, the ank would not e satisfyin the aital adequay ratio: k %. L In order to meet the aital ratio, some of the redit exansion has to e ahieved throuh urhases of safe assets. For instane, if D 20, then L 270 D 250, in whih ase k %. L [Note that exandin the redit to the overnment may imly an inreased ometition for overnment onds, drivin down the resetive yields; in alternative, the ank may uy forein overnments onds]. ) (Liquidity risis) Returnin to the initial situation, assume that, due to a ank sare, the oeffiient of liquidity referene inreased to x=0.25. Also assume that, in fae of a ollase in the inter-ank money market, anks deided to inrease the ratio of desired reserves to rr= /10/2017 htt://sweet.ua.t/afreitas/aulas/notas%20aoio/notasmaro.htm 16

17 Politias maroeonomias, handout, Miuel Lere de Freitas (1) If the entral ank did not intervene, what would haen to domesti redit? With the new ehavioral arameters, the money multilier eomes x d x r 0.4 Hene, if the money ase remained unhaned, there would e a ontration of money suly to M H 3.125* Aordinly, in the new equilirium: D=125; X=31.25; R= The total redit ranted y anks would e L D D L R If the redit to the overnment setor remained onstant, redit to the rivate setor would ollase to L D e2) If the entral ank, as a lender of last resort, deided to launh a lare refinanin oeration (e. LTRO) amountin to L 26. 8, would this e enouh to avoid the ontration of domesti redit? An exansion of the monetary ase y 26.8 will rodue a hane in money suly amountin to M H 3.125* , 75. Thus, the new money suly will e M H 3.125* Aordinly, in the new equilirium: D=192; X=48; R=28,8. The total redit ranted y anks would e L D D L R If the redit to the overnment setor remained onstant, the oliy would have een suessful in avoidin the ollase of the ankin redit to the rivate setor. Note however that ank reserves inreased dramatially: the entral ank liquidity rovision aimed reisely satisfy this extra demand for reserve money y ommerial anks. d) (Caital onstraints): Returnin aain to the initial situation, suose that nonerformin loans and erosion is asset ries fored anks to write off an amount of 10 in their redit ookins. d1) With all else onstant, desrie the alane sheet of ommerial anks immediately after the write off. Does the ankin system in this ase satisfy the aital adequay onstraint? With the write off, redit to the rivate setor would eome L Sine this omes at a loss, the ankin setor aital would erode to 10. In this ase, the aital adequay ratio would deline to k L %, thus not meetin the leal standard. d2) If nothin was done how muh would anks want to realloate redit out of the rivate setor towards overnment onds or reserves? If nothin was done, redit to the rivate setor would have to deline to L Banks would try to uy =65 of overnment onds, or otherwise they would have to hold the exess reserves. 04/10/2017 htt://sweet.ua.t/afreitas/aulas/notas%20aoio/notasmaro.htm 17

18 Politias maroeonomias, handout, Miuel Lere de Freitas d3) (Ineffetive liquidity rovision) Would in this ase an oen market oeration avoid the ontration of redit to the rivate setor? An oen market oeration in this ase does not hel redit to the rivate setor to reover, eause anks are aital-onstrained. The rolem in this ase is not of liquidity, ut instead exess leverae. e) (Asset urhases) Followin (d), suose the entral ank ouht assets from the ankin system amountin to 65, with full sterilization. Would this oeration avoid the ontration of domesti redit? In this ase, the oliy onsists in a monetary exansion H L L 65 followed y full sterilization H L 65 (that is, the entral ank retains the roeeds of this oeration y sellin seurities to anks in the amount of 65). Sine the monetary ase does not exand, total money in the eonomy will e M H 4.8*50 240, just like in this initial state. Aordinly, D=200; X=40; R=10. The total redit ranted y anks will e L D D L R If redit to the overnment setor remained onstant, redit to the rivate setor would e L 135 D 125. In this ase, the ank would e exatly satisfyin the aital adequay ratio: k %. L Note that, althouh ommerial anks redued domesti redit, this was relaed y entral ank redit. Usin the onsolidated alane sheet of the monetary setor, we see * that M eb L B , with L D D L L f) (Asset urhases) Bak from (d), suose that the entral ank ouht assets from the ankin system amountin to 90, ut sterilizin only 85. Would total redit exand in this ase? In this ase, the entral ank uys more than needed for anks to meet the aital adequay ratio. Moreover, the intervention is suh as to inrease the suly of ase money, reatin the onditions for redit to exand. The net inrease in the monetary ase amounts to H 5. Thus as lon as there is demand for redit - the money suly will inrease to M H 4.8* In the new equilirium, D=220; X=44; R=11. The total redit ranted y anks will e L D D L R If the redit to the overnment setor remained onstant, redit to the rivate setor would e L 134 D 124. In this ase, the ommerial ank would meet the mandatory aital ratio: k %. L The onsolidated alane sheet of the monetary setor, will show u as * M eb L B , with L D D L L /10/2017 htt://sweet.ua.t/afreitas/aulas/notas%20aoio/notasmaro.htm 18

19 Politias maroeonomias, handout, Miuel Lere de Freitas 12.6 Conlusions The money multilier is not a onstant arameter: it deends on ehavioral arameters that are out of ontrol of monetary authorities. In normal times, exandin the monetary ase will imly more money, deosits and loans in the eonomy. Caital onstrained anks will have an inentive to raise more aital or otherwise they will e fored to realloate their holdins towards less risky assets, suh as overnment onds. A onfidene rises may translate into hiher liquidity referene y the uli and hiher desired reserves y anks. In this ase, the money multilier falls sharly. If the entral ank doesn t at, there will e a ontration of money suly and of domesti redit. In the ase of a liquidity risis, the entral ank as the lender of last resoure - may rovide extraordinary liquidity to the ankin system. This will avoid the ontration of domesti redit. The oliy will not e inflationary as lon as the extra liquidity rovided is just the enouh to revent the money suly from fallin. In that ase, the entral ank is just resondin to an inreasin demand for ase money with an inreasin in suly of ase money. Durin finanial risis, asset values erode, imatin neatively on the ankin system net worth. When losses are lare enouh to make the aital adequay onstraints indin, aital onstrained anks (that is, anks findin diffiult to raise aital in the markets) will redue their exosure to the rivate setor, realloatin as muh as ossile towards overnment onds, whih are not sujet to aital onstraints. In the worst ase, anks will aumulate exess reserves (deosits in the entral ank). In nothin is done, the redit to the rivate setor will ontrat sharly. In the ase in whih anks are aital onstrained, risin liquidity in the inter-ank money market will not work. With a roramme of asset urhases, the entral ank ould, at least in theory, urhase the exess assets of leveraed anks, avoidin the ontration of redit y aital onstrained anks. In that ase, the total redit to the eonomy would not derease; it would only hane hands away from aital onstrained anks to the entral ank, whih is not sujet to aital requirements. Note that a quantitative easin may not hel alleviate aita-onstrained anks. The main oal of quantitative easin is to drive down the loner term interest rate when money market oerations fail to do so. Sine in the real World most assets urhased y the entral ank under quantitative easin have low risk, the imat of aital adequay is in ratie very small. 04/10/2017 htt://sweet.ua.t/afreitas/aulas/notas%20aoio/notasmaro.htm 19

20 Politias maroeonomias, handout, Miuel Lere de Freitas Review questions and exerises Review questions Exerises Consider the followin initial situation in a iven ankin system: D=100; X=20; R=10; eb * 30, and the ommerial anks equity is NW=10. C a) (Aountany) How muh will e the money suly, the monetary ase, and domesti redit ranted y ommerial anks? ) (Caital adequay) Assume that anks in this eonomy are required to hold a ratio of equity to total redit equal to 8%, irresetively of the risk weiht in eah artiular loan. Does this ankin system satisfy the aital adequay ondition? ) (Money multilier) Find out the reserves ratio, the liquidity referene oeffiient and the money multilier. d) (Money exansion - normal times): Assumin that the ratio of desired reserves and the liquidity referene oeffiient were onstant at the levels estimated in (), what would e the imat on money suly of an oen market oeration inreasin the entral ank liailities y 8.4? e) (Liquidity risis) Returnin to the initial situation, assume that, due to a ank sare, the liquidity referene oeffiient inreased to Also assume that, in fae of suh hane, anks deided to inrease the ratio of desired reserves to (e1) If the entral ank did not intervene, what would haen to domesti redit? (e2) If the entral ank, as a lender of last resort, deided to extend an emereny redit line to the ankin system (e., LTRO) amountin to L C 8. 4, would this e enouh to avoid the ontration of domesti redit? f) (Caital onstraints): Returnin aain to the initial situation, suose that nonerformin loans in this eonomy amounted 5, forin anks to assume the orresondin losses. f1) All else onstant, desrie the alane sheet of ommerial anks after the write off. Does the ankin system in this ase satisfy the aital adequay onstraint? f2) If nothin was done how muh would anks like to realloate out of redit into exess reserves, so as to satisfy the aital adequay ratio? Would an oen market oeration avoid the ontration of domesti redit in this ase? f3) (Asset urhases) Now suose the entral ank ouht assets from the ankin system amountin to Would this oeration avoid the ontration of domesti redit? What aout the exess liquidity in the ankin system? 04/10/2017 htt://sweet.ua.t/afreitas/aulas/notas%20aoio/notasmaro.htm 20

21 Politias maroeonomias, handout, Miuel Lere de Freitas Consider the followin initial situation in a iven ankin system: D=480; X=36; R=24; L 60 D 240, and 24. Further assume that anks in this eonomy are required to hold a minimum amount of aital, orresondin to 8% of the redit ranted to the rivate setor, L. Liquidity referene stands at x=x/d=7.5% and the ratio of a desired reserves y anks is r =R/D=5%. a) (Aountany) Find out the amount of redit to the rivate setor, L, total money suly, M, and the money multilier in the initial situation. ) (Refinanin oeration) Suose that the entral ank inreased the amount redit ranted to ommerial anks y 16,444 to L Would this oliy translate into an exansion of redit to the rivate setor? Why? ) (Liquidity risis) Returnin to e), suose that, due to a onfidene risis, oth the liquidity referene ratio and the desired reserves ratio inreased to 8%. If the entral ank did not intervene, what would haen to domesti redit? How should the entral ank intervene in this ase? Quantify. d) (Solveny risis): Returnin aain to e), suose that, in the sequene of a soverein det risis, anks were fored to assume losses amountin to 5% of their holdins of overnment det (5%*240=12). (h1) with all else onstant, desrie the alane sheet of ommerial anks immediately after the write off; (h2) If nothin was done, how muh redit would anks need to realloate redit away from the rivate setor? (h3) In order to revent this ontration, how should the entral ank intervene? Quantify Consider the followin initial situation in a iven ankin system: D=100; X=20; R=10; eb * C 30, and 0. Further assume that in this eonomy the money demand is iven y M PY, where Y=120 denotes for the (onstant) outut level and that PPP holds, with e P * 1. a) How muh will e the money suly, the monetary ase, and domesti redit ranted y ommerial anks? ) Find out the reserves ratio, the liquidity referene oeffiient and the money multilier. ) Assumin that the ratio of desired reserves and the liquidity referene oeffiient were onstant, what would e the imat on money suly of an oen market oeration inreasin the entral ank liailities y 40? d) Returnin to the initial situation, assume that, due to a ank sare, itizens in this eonomy wanted to hold 1/2 of their money in the form of ash. Also assume that, in fae of suh hane, anks deided to inrease the amount of desired reserves to 20. (d1) If the entral ank did not intervene, what would haen to domesti redit? (d2) If the entral ank, as a lender of last resort, deided to extend an emereny redit line to the ankin system amountin to L C 40, would this e enouh to avoid the ontration in the money suly? What aout domesti redit? Comute the new arameters of the money multilier and exlain. 04/10/2017 htt://sweet.ua.t/afreitas/aulas/notas%20aoio/notasmaro.htm 21

22 Politias maroeonomias, handout, Miuel Lere de Freitas (d3) If the entral ank aim was to kee domesti redit unhaned relative to (a) and at the same time avoid the monetary exansion, what should it do? e) (Bailout) Returnin aain to the initial situation, suose that non-erformin loans in this eonomy amounted to one third of the redit ranted y ommerial anks. What would e the monetary imliations of resuin the ankin system usin entral ank money? 04/10/2017 htt://sweet.ua.t/afreitas/aulas/notas%20aoio/notasmaro.htm 22