Stephen G. CECCHETTI Kermit L. SCHOENHOLTZ The Central Bank Balance Sheet and the Money Supply...

Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ

The Central Bank Balance Sheet and the Money Supply Process

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Chapter Seventeen

17-2

Introduction

• During the September 11, 2001 crisis, the financial community was on the edge of a systemwide collapse.

• Because of the immediate action of the Fed officials, the financial system held together, and most of us never realized how close we came to catastrophe.

• This was one of the greatest successes of modern central banking.

17-3

Introduction

• The financial system, one of the terrorists’ primary targets, returned to near normal within weeks.

• Many of the Fed’s actions in the crisis of 2007-2009 were unprecedented or had not been seen since the 1930s.

• For the first time since the Great Depression, the Fed lent to nonbanks and even to nonfinancial companies.

17-4

Introduction

• During the Great Depression, Fed officials didn’t fully understand how their actions affected the supply of credit in the economy.

• The financial system collapsed because Fed officials had failed to provide the liquidity that sound banks needed to stay in business.

17-5

Introduction

• We need to understand how the central bank interacts with the financial system.

• What is it that central banks buy and sell?

• What are the assets and liabilities on their balance sheets?

• How do they control those assets and liabilities, and why might they want to hide them from the public?

• How is the central bank’s balance sheet connected to the money and credit that flow through the economy?

• Where do the trillions of dollars in our bank accounts actually come from?

17-6

The Central Bank’s Balance Sheet

• There are numerous financial transactions leading to changes in the central bank’s balance sheet.

• The structure of the balance sheet gives us a window through which we can study how the institution operates.

• Central banks publish their balance sheets regularly.• Publication is a critical part of the transparency that

makes monetary policy effective.

17-7


17-8


• We will focus on a stripped-down version of the balance sheet.

• Figure 17.1 shows the major assets and liabilities that appear in every central bank’s balance sheet in one form or another.

• We divide the these assets and liabilities up between the role the central bank plays: the government’s bank or the banker’s bank.

17-9


• The central bank’s balance sheet shows three basic assets:• Securities,

• Foreign exchange reserves, and

• Loans.

• The first two are needed so that the central bank can perform its role as the government’s banks.

• The loans are a service to commercial banks.

17-10


1. Securities are the primary asset of most central banks.

• Traditionally, the Fed exclusively held Treasury securities, which are virtually free of default risk.

• During the 2007-2009 crisis, the central bank chose to acquire a variety of risky assets.

• The quantity of securities it holds is controlled through purchases and sales known as open market operations.

17-11


2. Foreign exchange reserves are the central bank’s and government’s balances of foreign currency.

• These are held in the form of bonds issued by foreign governments.

• These reserves are used in foreign exchange interventions, when officials attempt to change the market values of various currencies.

17-12


3. Loans are usually extended to commercial banks.

• In 2008 and 2009, the Fed made substantial loans to nonbanks as well.

• Discount loans are the loans the Fed makes when commercial banks need short-term cash.

• Through its liquid securities holdings the Fed controls the federal funds rate and the availability of money and credit.

17-13


• On the liabilities side of the central bank’s balance sheet, we see three major entries:• Currency,• The government's deposit account, and• The deposit accounts of the commercial banks.

• The first two items allow the central bank to perform its role as the government’s bank, while the third allows it to fulfill its role as the bankers’ bank.

17-14


1. Currency. Nearly all central banks have a monopoly on the issuance of the currency used in everyday transactions.

• Currency circulating in the hands of the nonbank public is the central bank’s principal liability.

17-15


2. Government’s account. Governments need a bank account like the rest of us.

• The central bank provides the government with an account into which the government deposits funds (mostly tax revenue) and from which the government makes payments.

• By shifting funds between its accounts at commercial banks and the Fed, the Treasury usually keeps its account balance at the Fed fairly constant.

17-16


3. Commercial Bank accounts (reserves). • Commercial bank reserves are the sum of two

parts:

• Deposits at the central bank, plus

• The cash in the bank’s own vault.

• In the same way that you can take cash out of a commercial bank, the bank can withdraw its deposits at the central bank.

• Vault cash is part of reserves.

• Reserves are assets of the commercial banking system and liabilities of the central bank.

17-17


• While banking system reserves usually aren’t the central bank’s largest liability, they are the most important in determining the amount of money in the economy.

• Central banks run their monetary policy operations through changes in these reserves.

• There are two types of reserves.• Required reserves that banks must hold, and

• Excess reserves, which banks hold voluntarily.

17-18

• The Fed’s response to the crisis of 2007-2009 transformed the size and composition of its assets and liabilities in unprecedented fashion.

• The Fed’s actions helped to prevent a repeat of the plunge of the money supply and nominal GDP that occurred in the Great Depression.

• Table 17.2 contrasts the balance sheet at an early state in the crisis with that after the worst of the crisis has passed.

17-19

Importance of Disclosure

• Every central bank publishes a statement of the bank’s own financial condition.

• Without public disclosure of the level and change in the size of foreign exchange reserves and currency holdings, it is impossible for us to tell whether the policymakers are doing their job properly.

17-20

Importance of Disclosure• Publication of the balance sheet is an essential aspect

of central bank transparency.• A sign of trouble is misrepresentation of the central

bank’s financial position.• In 1986 the president of the Philippines ordered the central

bank to print enormous amount of money.• They had been restricted in doing so by the IMF, so the IMF

was monitoring the serial numbers on new bills.• So instead of printing one bill per serial number, the central

bank printed three.• And the central bank kept quiet about the scheme.

17-21

The Monetary Base

• Together, currency in the hands of the public and reserves in the banking system make up the monetary base.• This is the privately held liabilities of the central

bank.

• It is also called high-powered money.

• The central bank can control the size of the monetary base.• When the monetary base increases by a dollar, the

quantity of money typically rises by several dollars.

17-22

Changing the Size and Composition of the Balance

Sheet• Policymakers can enlarge or reduce their assets

and liabilities at will, without asking anyone.• What is the difference between a purchase you

make and one the central bank makes?• To pay for the bond, the central bank writes a $1

million check payable to the bond dealer.• The dealer’s commercial bank account is credited

with $1 million when the check is deposited.• The commercial bank then sends the check back to

the central banks.• The central bank credits the reserve account of the

bank presenting the $1 million.

17-23


Sheet• The central bank can simply buy things and

then create liabilities to pay for them. • It can increase the size of its balance sheet as much

as it wants.

• We will look at four types of transactions taken by the central bank.• Each of these have an impact on both the central

bank’s balance sheet and the banking system’s balance sheet.

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Sheet1. Open Market Operation.

• Buying or selling a security initiated by the central bank.

2. Foreign Exchange Intervention. • Buy or sell foreign exchange reserves initiated by

the central bank.

3. Extend a discount loan.• Initiated by commercial banks.

4. Decision by an individual to withdraw cash from their bank.

• Initiated by the nonbank public.

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Sheet• When the value of an asset on the balance sheet

increases, one of two things happens so that the net change is zero:• The value of another asset decreases, or• The value of a liability rises by the same amount.

• What’s true for assets is also true for liabilities.• Remember that the securities and foreign

exchange transactions are managed by the Federal Reserve Bank of New York, while the discount loans are extended by all 12 Reserve Banks.

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• Why hasn’t cash disappeared?• Convenience.

• Avoid paying taxes.

• Anonymity.

• Because cash is almost completely anonymous, there is little chance that electronic products will replace paper currency any time soon.

17-27

Open Market Operations

• When the Fed buys or sells securities in financial markets, it engages in open market operations.

• To see how the process works, we can track the purchase of $1 billion in U.S. Treasury bonds from a commercial bank.

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• The Fed transfers $1 billion into the reserve account of the seller, called a T-account.

• The Fed’s assets and liabilities both go up $1 billion, increasing the monetary base by the same amount.

• Both the $1 billion in securities and in reserves are banking system assets.

17-29


• Notice that the reserves are an asset to the banking system but a liability to the Fed.• This is similar to the balance in your bank account

is your asset, but it is your bank’s liability.

• If the Fed sells a U.S. Treasury bond through an open market sale, the impact on everyone’s balance sheet is reversed.

17-30

Foreign Exchange Intervention

• What if the U.S. Treasury instructs the Fed to buy $1 billion worth of euros. • They buy German government bonds, denominated

in euros, from foreign exchange departments of large commercial banks and pay for them with dollars.

• The $1 billion payment is credited directly to the reserve account of the bank from which the bonds were bought.• This has a similar effect on the balance sheet as the

open market operation.

17-31

Foreign Exchange Intervention

• The Fed’s assets and liabilities both rise by $1 billion, and the monetary base expands with them.

• In both cases, the banking system’s securities portfolio falls by $1 billion and reserves balances rise by an equal amount.

17-32

Discount Loans

• The commercial banks ask for loans, the Fed does not force them.

• A borrowing bank must provide collateral.• This usually takes the form of U.S. Treasury bonds,

but the Fed has been willing to accept a broad range of securities and loans as collateral.

• This changes the balance sheet of both institutions.

17-33

Discount Loans

• For the borrowing bank, it is a liability matched by an offsetting increase in the level of its reserve account.

• For the Fed, the loan is an asset that is created in exchange for a credit to the borrower’s reserve account.

• The extension of credit to the banking system raises the level of reserves and expands the monetary base.

17-34

Cash Withdrawal

• The Fed can always shift its holdings of various assets.• But the same is not true of its liabilities.

• Because the Fed stands ready to exchange reserves for currency on demand, it does not control the mix between the two.• The nonbank public, those who hold cash, controls

that.

17-35

Cash Withdrawal

• When you take cash from an ATM, you are changing the Fed’s balance sheet.• By moving your own assets out of your bank and

into currency, you force a shift from reserves to currency on the Fed’s balance sheet.

• The transaction involves three balance sheets:• The nonbank public,• The banking system, and• The central bank.

17-36

Cash Withdrawal

• Your assets shift from checkable deposits to cash with no change in liabilities.

• Cash inside the bank, vault cash, counts as bank reserves.• By withdrawing cash from your bank, you

decreased the banking system’s reserves.

• This is a change in the bank’s T-account.

• For the Fed, the change comes in the composition of the Fed’s liabilities.

17-37

Cash Withdrawal

• You changed the amount of currency outstanding, showing up on the Fed’s balance sheet as shift from reserves to currency.

• There is no change in the monetary base.

17-38

Changing the Size and Composition of the

Balance Sheet• Open market operations and foreign exchange

interventions are both done at the discretion of the central bank.

• The level of discount borrowing is decided by the commercial banks.

• The nonbank public decides how much currency to hold.

17-39

The Central Bank’s Balance Sheet:

Summary

17-40

• Days after September 11, 2001, some very large banks were forced to temporarily close.

• Although these banks could receive payments to their accounts at the Fed, they couldn’t make payments.• The banks were limiting liquidity.

• The Fed responded by increasing its security holdings by more than $70 billion, made $8 billion in discount loans, and bought almost $20 billion worth of euros.

17-41

• Because civilian planes were grounded, paper checks could not reach the district for collection.

• The amount of a credited but uncollected check is called float.• By Thursday, 9/13, float had exploded, rising from

its usual level of about $0.5 billion to $50 billion.

• Because the banking system withstood the enormous shock and was able to meet its commitments, people’s finances were more or less unaffected.

17-42

The Deposit Expansion Multiplier

• Central bank liabilities form the base on which the supplies of money and credit are built.• This is why they are called the monetary base.

• The central bank controls the monetary base.

• Our primary interest, however, is in the broader measure of money which are multiples of the monetary base.• M1.

• M2.

17-43

The Deposit Expansion Multiplier

• M1 and M2 are the money we think of as available for transactions.

• What is the relationship between the central bank’s liabilities and these broader measure of money?

• How do reserves become bank deposits?• This happens in a process called multiple

deposit creation.

17-44

Deposit Creation at a Single Bank

• We have an open market purchase in which the Fed buys $100,000 worth of securities from a bank called First Bank.• The bank’s total assets are unchanged.• $100,000 shifts out of securities into reserves.

• Reserves typically bear a lower interest rate, so if the bank does nothing, its revenues will fall and so will profits.• Remember these are excess reserves.

17-45

Deposit Creation at a Single Bank

• So now First Bank loans out the reserves to a customer, Office Builders Inc. (OBI).• OBI’s checking account is credited with $100,000.

• OBI writes checks totaling $100,000.

• As the checks are paid, OBI’s checking account balance falls, and

• First Bank’s reserve account balance falls.

• The loan replaces the securities as an asset on First Bank’s balance sheet.

17-46

Deposit Creation in a Single Bank

17-47

Deposit Creation in a System of Banks

• All the checks that OBI wrote end up in someone else’s bank account.

• Only the Fed can create and destroy the monetary base.

• But the nonbank public determines how much of it ends up as reserves in the banking system and how much in currency.

17-48


• We start with the following assumptions:• Banks hold no excess reserves.

• The reserve requirement ratio is 10%.

• Currency holding does not change when deposits and loans change.

• When a borrower writes a check, none of the recipients of the funds deposit them back in the bank that initially made the loan.

17-49


• OBI pays $100,000 to American Steel.• American Steel deposits $100,000 into Second

Bank.• Second Bank’s reserve account at the Fed is

credited with $100,000.• Second Bank will make a loan of its now

excess reserves minus the 10% they are required to hold.

• The new loan is deposited into Third Bank and the process continues.

17-50


17-51


• At this point, a $100,000 open market purchase has created:• $100,000 + $90,000 + $81,000 = $271,000

• All in new combined loans at First Bank, Second Bank, and Third Bank.

• We can see how this continues in Figure 17.8.• Figure 17.3 shows the consequences of a

$100,000 open market purchase for the banking system as a whole.

17-53


17-54


• We can derive a formula for the deposit expansion multiplier.• That is the increase in commercial bank deposits

following a one-dollar open market purchase.

• This continues to assume there are no excess reserves and no changes in the amount of currency help by the nonbank public.

17-55


• Let’s being by assuming there is only one bank and everyone must use it.

• The level of reserves, then, is just the required reserve ratio rD times its deposits.

• If required reserves are RR and deposits are D, then the level of reserves can be expressed as:

RR = rDD.

17-56

• Any change in deposits creates a corresponding change in reserves:

ΔRR = rDΔD

• The change in deposits is:

• For each dollar increase in reserves, deposits increase by (1/rD).


D 1

rD

RR

17-57

• This is the simple deposit expansion multiplier.• For example:

• An open market sale will decrease deposits in the same way.


rD 0.10

D $100,000

RR 1

0.10($100,000)

RR $1,000,000

17-58

The Monetary Base and the Money Supply

• The simple deposit expansion multiplier is too simple.

• In deriving it, we ignored a few details:• We assumed banks lend out all their excess reserves,

but banks do hold some of their excess reserves.• We ignored the fact that the nonbank public holds

cash.• As people’s account balances rise, they tend to

hold more cash.

• Both of these affect the relationship among reserves, the monetary base, and the money supply.

17-59

Deposit Expansion With Excess Reserves and Cash

Withdrawals• Now let’s assume:

• Checking account holders withdraw 5% of cash.

• Banks hold excess reserves of 5% of deposits.

• From our previous example, if American Steel takes some of the $100,000 in cash and Second Bank wishes to hold excess reserves, then the next loan cannot be $90,000.

17-60


Withdrawals• American Steel holds the 5% in cash leaving

$95,000 in checking account.• Second Bank holds 5% excess reserves, so they

are left with $80,750 to loan out.• Remember they hold 10% as required by the Fed

and 5% excess reserves for a total of 15%.

• We can follow this as we did before to show the smaller the deposit expansion becomes if we take excess reserves and cash withdrawals into account.

17-61


Withdrawals

17-62

The Arithmetic of the Money Multiplier

• We can derive the money multiplier.• This shows how the quantity of money is related to

the monetary base.

• If we label the quantity of money M and the monetary base MB, the money multiplier m is defined as:

M = m x MB

17-63

• We will start with the following relationships:• Money equals currency, C, plus checkable deposits,

D,

• The monetary base MB equals currency plus reserves in the banking system R, and

• Reserves equal required reserves RR plus excess reserves ER.

M = C + D

MB = C + R

R = RR + ER


17-64


• Starting with banks, we know that their holdings of required reserves depends on the required reserve ratio rD.

• The amount of excess reserve a bank holds depends on the costs and benefits of holding them.• The higher the interest rate on loans, the lower

banks’ excess reserves, and

• The greater banks’ concern over the possibility of deposit withdrawals, the higher their excess reserves.

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• Labeling the excess reserve-to-deposit ratio {ER/D}, we can rewrite the reserve equation as:

R = RR + ER

= rDD + {ER/D}D

= (rD + {ERD})D

• Banks hold reserves as a proportion of their deposits.

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• The currency-to-deposit ratio, {C/D}, is the fraction of deposits that people hold as currency.

C = {C/D}D• The decision of how much currency to hold

depends on the costs and benefits as well.• The cost of currency is the interest it would earn on

deposit.

• The benefit is its lower risk and greater liquidity.

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• Putting this all together, we can see to following.

MB = C + R

= {C/D}D + (rD + {ER/D})D

= ({C/D} + rD + {ER/D})D

• The monetary base has three uses:• Required reserves,

• Excess Reserves, and

• Cash in the hands of the nonbank public.

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• We can do the same with the equation for money.

M = C + D

= {C/D}D + D

= ({C/D} + 1)D

17-69

MBD x {ER/D}r{C/D}

1

D

MBDC

M x {ER/D}r {C/D}

1}/{

D


• We can use the equation for MB to solve for deposits:

• And substituting D into the money equation:

17-70


• This tells us that the quantity of money in the economy depends on:

1. The monetary base, which is controlled by Fed,

2. The reserve requirement,

3. The bank’s desire to hold excess reserves, and

4. The nonbank public’s demand for currency.

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• What is the impact of each of these?1. If the monetary base increases, the quantity of

money increases.

2. An increase in either the reserve requirement or banks’ excess reserve holding reduces money.

3. When an individual withdraws cash, he or she increases the currency in the public and decreases reserves.

• The decline in reserves creates a multiple deposit contraction.

• The money supply contracts.

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Factors Affecting the Quantity of Money

17-73

• Just like a bank, you need an emergency fund. • Most financial planners recommend that

individuals hold a minimum of 3 and preferably 6 to 9 months income in a cash fund just in case.

17-74

• The central bank supplies the monetary base, but it is banks and the banking system that supply money.

• When the crisis peaked in September 2008, the deposit expansion multiplier plummeted to a fraction of its normal value.

• The standard process of deposit expansion assumes that banks will lend out most of additional dollar reserves supplied by the Fed.

• However, banks panicked and sought to hold more excess reserves collapsing the deposit expansion multiplier.

17-75

The Limits on the Central Bank’s Ability to Control the

Quantity of Money• The various factors affecting the quantity of

money change over time.• Market interest rates affect the cost of holding both

excess reserves and currency.

• As interest rates increase, we expect to see {ER/D} and {C/D} fall.

• This increases the money multiplier and the quantity of money.

17-76


Quantity of Money• If these changes in the money multiplier were

predictable, the central bank might choose to exploit this link in its policymaking.

• Although this made sense in the U.S. in the 1930s, it no longer does.• For emerging countries like China and India it

might still.

• In countries like the U.S., Europe, and Japan, the link has become too weak and unpredictable to be exploited.

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Quantity of Money• The money multiplier is just too variable.• The relationship between the monetary base

and the quantity of money is not something that a central bank can exploit for short-run policy purposes.

• For short-run policy, interest rates have become the monetary policy tool of choice.

• In a financial crisis, other balance-sheet tools help address liquidity needs and market disruptions more directly.

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Quantity of Money

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• In the 1930s the Fed saw its balance sheet growing.

• Officials did not realize that the money multiplier was falling.

• Without knowing it, the Fed ran a contractionary policy during the Depression.

• Central bankers need to look at both the monetary base and the money multiplier to see if policies are working.

Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ

The Central Bank Balance Sheet and the Money Supply Process

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

End ofChapter Seventeen

Stephen G. CECCHETTI Kermit L. SCHOENHOLTZ The Central Bank Balance Sheet and the Money Supply...

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