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Lecture 8
DETERMINANTS OF THE
MONEY SUPPLY, AND THE TOOLS
OF CENTRAL BANKS (2)
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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ESCB monetary policy instruments
• In order to achieve its objectives,
the ESCB has at its disposal a set
of monetary policy instruments.
• The ESCB
– conducts open market operations,
– offers standing facilities and
– requires credit institutions to hold minimum
reserves on accounts with the ESCB.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Money supply process
• In order to understand the money supply
process, we have to come back to the
ECB’s balance sheet and the monetary
base (or high-powered money).
• The assets of the CB constitute the
sources of the base.
• The liabilities of the CB constitute the
uses of the base.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Schematic central bank balance
Assets
Liabilities
Gold and SDR
Bank notes
Forex
Bank lending
Securities
Bank reserves
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Bundesbank, Balance sheet 2001
31st of December, in bill. €
Gold
35.0
Foreign exchange*)
71.8
Bank lending
Main ref inancing
80.5
Long-term lending
41.1
Marginal ref inancing
1.4
Loans to gov ernment
4.4
Other assets
5.8
TOTAL
240.0
*) Including claims on the ECB.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
Banknotes
Bank reserv es
ECB claims
Rev aluation
Reserv e f und
Other liabilities
Capital
Prof its
TOTAL
76.5
57.5
30.9
41.7
5.4
11.7
5.1
11.2
240.0
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The control of the monetary base
• The quantity-oriented approach to
monetary policy purports that the central
bank can control the monetary base.
• It is basically effected via open market
operations with commercial banks.
• The ECB can control OMOs more
effectively than foreign reserves, but
she can also use interventions in forex
markets to change the monetary base.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Controlling the money supply
• Under fixed exchange rates controlling the
money supply is more difficult.
• In this case the central bank has to “sterilize”
inflows or outflows of foreign exchange.
• It renders interest rates endogenous,
i.e. they vary in response to sterilizing
interventions.
• Forex interventions will be discussed later.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Forex inflows with sterilization
Assets
Gold
Forex
Liabilities
Base money remains fixed
Securities
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Forex inflows with sterilization
Assets
Gold
Forex
Liabilities
Base money remains fixed
Securities
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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OMOs
• Among the OMOs, the main refinancing
operations (MROs) are the most important,
playing a pivotal role in steering liquidity and
signaling the stance of monetary policy.
• Three quarters of liquidity is provided by MROs.
• MROs were conducted as fixed rate and variable
rate tenders with a minimum bid rate.
• The MROs are regular, liquidity providing, reverse
transactions, conducted as standard tenders, with
a weekly frequency and normally a maturity of two
weeks.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Longer-term refinancing (LTROs)
• Longer-term refinancing operations (LTROs)
are carried out through monthly standard
tenders and have a maturity of three months.
• LTROs are regular open market operations
executed by the Eurosystem also in the form
of a reverse transaction.
• On average over the year, LTROs provided
about one quarter of the total refinancing of
banks.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Reserve requirements of banks
• The Eurosystem requires banks to hold minimum
reserves equal to 2% of certain short-term liabilities.
It is part of base money.
• The purpose is the stabilization of short-term interest
rates and the enlargement of the structural liquidity
deficit of banks.
• Reserve requirements bear interest, and must only be
fulfilled on average over a one-month reserve
maintenance period.
• It has a significant smoothing effect on the behavior of
short-term interest rates.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Short-term liquidity policy
• The monetary base is also affected when a central
bank makes a discount loan to a bank. The ECB does
not use this instrument however.
• There are two standing facilities offered
by the Eurosystem
– the marginal lending facility and
– the deposit facility,
• These instruments provide and absorb overnight
liquidity, signal the stance of monetary policy and set
an upper and lower limit for the overnight market
interest rate.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The use of the standing facility
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Key ECB interest rates
• The key ECB interest rates are
at present
– the minimum bid rate on the main
refinancing operations,
– the interest rate on the marginal lending
facility
– and the interest rate on the deposit
facility.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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ECB interest rates
EONIA (euro overnight index average):
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Interest rate policy in Europe and the US
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The notion: quantity of money
• In addition to the central bank, commercial
banks do also supply credit money.
• We assume that there is a fixed relationship
between central bank money (base money)
and credit money.
• Then the quantity of money M equals
M = m  B = multiplier  base money.
• We assume the ECB controls B,
then she also controls M.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Money creation through bank credit
• Credit money is created (destroyed) if
the sum of demand deposits of nonbanks at commercial banks increases
(declines)
• In the case of a credit to a customer by
a bank, the bank creates „book money“.
• As this credit is redeemed, money is
destroyed.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Money creation by a commercial bank
Example: A commercial bank receives a cash
deposit of € 1 Mill. and uses it for a loan
to a firm of € 1 Mill..
A
Bank
Loan + € 1 mill.
Loan + € 1 mill.
A
Outlays + € 1 mill.
Outlays etc.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
Firm
Cash deposit + € 1 mill.
Demand deposit + €1 mill.
Demand deposit etc.
L
L
Liability + € 1 mill.
Liability + € 1 mill.
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Money creation by banks: is it limited?
Yes, money creation by banks is not infinite!
• Central banks require commercial banks to
maintain minimum reserves to be held on
accounts of the central bank.
• These reserve requirements are calculated
as a percentage of demand, savings and time
deposits.
• Demand deposits represent a claim on central
bank money, which commercial banks cannot
create themselves.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Multiple money creation: An example
• Mr. K. puts € 10,000 into his acount at
A-Bank.
• The central bank requires minimum reserves
of 20% of the deposit (=1/5).
• There remains an excess reserve of € 8,000.
• A-Bank grants a loan to Mr. L. for the
purchase of a car. The amount of the loan
can only be € 8,000.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Example, continued
• Mr. L. transfers this amount to an account
of the car dealer at B-Bank.
• At B-Bank it creates excess reserves of
€8,000 minus €1,600 minimum reserves
required (= € 6,400).
• These excess reserves can be used for a
loan, etc.....
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Example, continued
• It is best to imagine this process in
terms of “rounds” of credit creation:
Round
Deposit Minimum reserve Excess reserve=
credit creation
1
10000
(primary impulse)
2000
8000
2
8000
1600
6400
3
6400
1280
5120
4
5120
1024
4096
etc.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The money creation multiplier
• The money creation multiplier is obtained
as a result of an infinite geometric series.
• In the example:
10,000 + 8,000 + 6,400+..... = 50,000
• From an initial excess reserves
of € 10,000 an an additional credit
volume of 40000 € can be derived.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The credit multiplier
By subtracting
R2 from R1
it is obtained:
[1 - (1-) ]  Cr =
[{1-}1 - {1-}+1] ER
  Cr = {1-} ER
=
 Cr=ER ({1-} /  )
or in this case: ({1-.2} / .2 ) = 4
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Critique of the simple model
• Supply of credit must meet a demand!
• Banks do not extend their lending to the
maximum because of insolvency risks.
• Lending is limited by capital adequacy
ratios (Basel I and II).
• But there are refinancing possibilities
– through the ESCB, and
– through the interbank market.
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An example: The Eurodollar market
• The Eurodollar market (better: xeno
market) is an off-shore market for the
US dollar (more generally: any hard
currency).
• It is characterized by the absence of
mandatory reserve requirements for
commercial banks.
• The experience has shown that this
market had avoided “credit explosion”.
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