Description
This is a presentation highlights different functions of money, macroeconomic implications of money, inflation and economic indicators, market of CPI, measuring money (M1, M2, M3), monetary aggregates in India, sweep accounts, understanding circulation of money, money multiplier, credit multiplier.
Introduction to Money
What is Money?
• Anything that is acceptable to people as payment for
– Goods – Services – And financial assets
• Money is not just currency notes and coins
– These are a very small percentage of what is considered to be money in circulation
10/24/2009 2
Why is money held?
• It performs four major functions
– It serves as a medium of exchange – It serves as a store of value – It serves as a unit of account – It serves as a standard of deferred payment
10/24/2009
3
Medium of Exchange
• Money is a medium of exchange for most economic transactions • The growth of markets and the availability of a unit of currency have gone hand in hand • Money, in its various forms, is the only item of value that anybody and everybody will accept
10/24/2009
4
Barter
• Prior to the advent of money we had a barter system • What is barter?
– Exchange of goods and services for other goods and services
10/24/2009
5
Barter (Cont…)
• Barter posed certain problems • First, to sell the goods and services that we have we should be able to locate people who desire what we have and who are endowed with what we want • Second, a sale must be accompanied with a simultaneous purchase
– In practice the two will not usually coincide
10/24/2009 6
Barter (Cont…)
• Money made things easier • No longer necessary to exchange goods and services for other goods and services
– Everything can be valued in terms of money – Money also serves as the medium of exchange – A sale need not be accompanied with a simultaneous purchase
10/24/2009
7
Barter (Cont…)
• Barter is technically known as `Counter-trade’ • It may still be occasionally observed • Why?
– The buyer may not have access to enough hard currency
10/24/2009
8
Barter (Cont…)
• Freely convertible currencies are universally acceptable as a means of payment
– US dollar – British pound – Euro
• Rupee is not freely convertible
10/24/2009
9
Example of Barter
10/24/2009
10
Example (Cont…)
• This was a win-win situation for everyone
– The Russians paid partly in cash and partly in kind – AT&T got fully paid in hard currency – The Germans, who were the middlemen, also made some money in the process
10/24/2009
11
Store of Value
• Money serves as a store of value
– Gives people the freedom to save – To put aside funds to facilitate expenditure at a later point in time
• People who want to forego current consumption for future consumption can lend to those whose need for current consumption exceeds their current stock of wealth
10/24/2009 12
Store of Value (Cont…)
• All forms of money are not good preservers of value
– The value of currency erodes with time – What we call inflation
10/24/2009
13
Inflation
• What is inflation?
– It refers to the increase in the price level of an asset or service over time
• Currency notes and coins do not offer any protection against inflation • Financial assets like bonds and bank deposits are safer bets against inflation
– They provide a periodic interest stream (with the exception of checking accounts) – However bonds are vulnerable to price risk
10/24/2009 14
What is price risk?
• Price or market risk is the risk that the price of the asset may decline • In the case of bonds, prices and interest rates are inversely related
– Consequently a rise in interest rates may lead to a capital loss when the bond is sold
10/24/2009
15
Capital Loss?
• What is a capital loss?
– If the sale price of an asset is greater than the price paid for it at the time of acquisition we call it a Capital Gain – However if the sale price is less than the purchase price we term it a Capital Loss – Bank accounts are not vulnerable to a capital loss (unless of course the bank fails) – However bonds are susceptible
10/24/2009 16
Inflation (Cont…)
• Stocks, gold, and real estate generally provide a better hedge against inflation in the long-run
– In the short-run they are vulnerable to price risk – That is they can give rise to a capital loss
• These assets do provide an income stream
– Stocks provide dividends – Real estate provides rental income
10/24/2009
17
Gold
• Gold is an eternal favorite as a hedge against inflation
– However it does not provide income – The holder can only hope for capital gains – There is however a cost to storing gold
• Storage costs • Insurance costs
10/24/2009
18
Unit of Account
• One of the major advantages of currency is that it serves as a unit of account
– Every type of good, services, or financial asset has a price in terms of money
• This reduces the information required in terms of the number of prices
10/24/2009
19
Unit of Account (Cont…)
• Consider a 1,000 good economy • In the absence of money we would require
1000 x 999 _________ = 499,500 prices 2
• However if we were to have a form of currency we would require only 1,000 prices
– The information required is reduced by 99.80%
10/24/2009 20
A Standard of Deferred Payment
• Money serves as a standard of deferred payment • There are two categories of people in this world
– Those who have more than what they want – Those who want more than what they have
10/24/2009
21
Deferred Payment (Cont…)
• Money gives people the freedom to save • People whose current wealth exceeds their current needs can lend to others who have less wealth than what they currently require
10/24/2009
22
Deferred Payment (Cont…)
• Such wealth transfers may be made in various forms
– Investors may buy bonds and shares – They may deposit money with banks – May acquire shares of mutual funds
10/24/2009
23
Evolution of Money
• In the early days all trades were based on barter • The history of money began in the form of commodity money
– What is commodity money
• It is a physical good which is used for both monetary as well as non-monetary purposes.
10/24/2009
24
Evolution (Cont…)
• The next step was the development of a commodity standard • What is a commodity standard?
– It is a unit of currency whose value is backed by the value of a monetary good - typically a precious metal like gold or silver
• The final step was the evolution of modern money known as FIAT money
10/24/2009 25
Evolution (Cont…)
• What is fiat money?
– It is money issued by a fiat from the authorities – The central bank has the authority to issue money and to withdraw money from circulation, whenever it deems it appropriate
• FIAT money has no commodity backing
– It derives its utility solely from the fact that it is universally acceptable as a mode of payment
10/24/2009
26
Evolution (Cont…)
• These days we have gone a step further with electronic money or E-money • E-money obviates the need for standard forms of money like
– Notes – Coins – Checks
10/24/2009
27
Commodity Money
• A commodity which is used as a unit of money has multiple economic uses and not just as a medium of currency
– Primitive forms included shells and stones – Subsequently precious metals like gold and silver began to be used
10/24/2009
28
Commodity Money (Cont…)
• Why were precious metals popular as mediums of exchange
– They were
• Portable • Durable • Easily recognizable
– They were universally valuable
• Their relative scarcity • Use as items of value such as jewelry
10/24/2009 29
Commodity Standards
• The use of precious metals as units of money had a problem in practice
– Units of gold and silver have different market values
• Based on the inherent purity and density
• So before a vendor could accept such money he had to verify the purity and weight of the metal.
– This was time consuming and costly
10/24/2009 30
Commodity Standards (Cont…)
• To circumvent such problems people began to use standardized units of precious metals as money
– A system where the value of the medium of exchange depends on the value of gold is called a Gold Standard – Some countries adopted a silver standard – Others chose a bimetallic standard - value depended on both gold and silver
10/24/2009 31
Commodity Standards (Cont…)
• In practice citizens of countries using a metallic standard would take the metal to a goldsmith
– He would convert them to tokens of equal purity and weight – He would also emboss the tokens to facilitate verification that this had been done
• These metal pieces were the origin of coins in the economy
10/24/2009 32
Coins
• Such coins became popular rapidly
– Why?
• There were two reasons
– First, many merchants would only accept coins validated by a goldsmith’s stamp – Second, governments got in to the act of minting such money
• They either regulated or owned the mints that produced such coins
10/24/2009 33
Coins (Cont…)
• Why did the governments envisage a role for themselves?
– The first reason was to ensure that the public had confidence in the nation’s monetary system – Second they could make profits by minting such coins
• This was because the coins were issued at a face value in excess of the value of the precious metals contained in them • The difference obviously constituted a profit for the Treasury • This is known as `Seigniorage’ • This is a form of tax
– Constitutes a transfer of wealth from the citizens to the government
10/24/2009 34
Commodity Standards (Cont…)
• For a long time gold was the asset of reference of the international monetary system • Under the Gold Standard the foundation of a nation’s monetary system was the quantity of gold held by it • In practice gold was used for both
– Monetary as well as non-monetary purposes – The gold that was devoted to monetary use was termed as `Gold Bullion’ – Thus gold bullion was the monetary base or the foundation of the monetary system
10/24/2009 35
Commodity Standards (Cont…)
• In practice goods and services were not directly valued in terms of gold
– And nor was gold used directly as currency
• Prices were measured in terms of a currency unit such as the Dollar • Such currency, both in the form of coins, as well as paper, performed the role of money
10/24/2009
36
Commodity Standards (Cont…)
• The currency’s value was directly linked to gold in the form of a rate of exchange • In most cases the monetary system was managed by a central bank
– It stood ready to freely convert dollars to gold and gold to dollar at a specified exchange rate
• Consequently
– Nobody could sell gold at a higher rate or buy it at a lower rate
10/24/2009 37
Commodity Standards (Cont…)
• Once the central bank fixed the exchange rate they could influence the quantity of money by regulating the ratio of currency issued by private mints or banks relative to the amount of gold held by them
– In other words the central banks would set the Gold Reserve Ratio
10/24/2009
38
Commodity Standards (Cont…)
• For a long time coins were the sole items of currency
– People believed that their inherent metal content was the source of their value
• However, gradually governments began to debase the coins
– They reduced the gold base by mixing other metals like Copper and Bronze
• This increased the income from seigniorage
• Such debasement broke the link between the value of the money unit and the value of the base commodity
10/24/2009
39
Paper Money
• Paper money was the next step • American colonists began to accept a paperbased commodity standard
– Those days precious metals were scarce in America – So paper money was issued backed by the value of European coins – Thus there was an indirect linkage to precious metals
10/24/2009 40
Paper Money (Cont…)
• This indirect approach was subsequently abandoned and governments in America began issuing bills of credit that they promised to redeem in the future • This was used by the governments
– To acquire goods and services – Spend on public works
10/24/2009
41
Paper Money (Cont…)
• Parties which acquired paper money from the government could use such bills as a medium of exchange • The faith of people in such money was based on the belief that the government could always raise resources by way of taxes to redeem the bills
10/24/2009
42
FIAT Money
• Bills of credit were the first step towards a modern monetary system • Modern money is FIAT money
– It is not linked to any underlying commodity
• The value is based on the faith of the people that the government will honor the currency issued
– Money derives its value solely from the fact that it is accepted by everyone as a medium of exchange
10/24/2009 43
FIAT Money (Cont…)
• The money supply consist of notes issued by the central bank
– In the US it is the Federal Reserve
• In addition depository institutions (primarily banks) issue fiat money by allowing people to operate checking accounts
10/24/2009
44
Common Terms Associated with Money
• Buck: Early settlers in North America used deer skins to finance their trades . Every skin was referred to as a BUCK • Pecuniary: Means relating to money. Comes from the Latin word PECUS, which means cattle • Fee: Based on the German word VIEH, which means cattle
10/24/2009 45
Common Terms (Cont…)
• Shell Out: People in North America used shells as units of currency. This lead to the phrase • Salary: In the earlier days soldiers in Rome were paid a part of their wages in the form of salt. Salt in Latin is known as SALARIUM • Dollar: A count in Czechoslovakia began minting coins known as TALERGROSCHEN, which was shortened to TALERS. The word dollar was derived from this.
10/24/2009 46
Macroeconomic Implications of Money
• The amount of money in circulation has implications
– For the level of prices – And other factors like the level of employment
• Too much of money chasing too few goods can lead to an increase in the price level, which we term as INFLATION
10/24/2009
47
Inflation (Cont…)
• A bottle of beer costs $2.50 at the beginning of the year • The same bottle costs $2.75 at the end of the year • The rate of inflation is 2.75 - 2.50 _________ x 100 = 10% 2.50
10/24/2009 48
Inflation (Cont…)
• In real life we do not measure inflation by analyzing the change in price of a single good. • Economists track price indices, which measure the price of a basket of goods and/or services
10/24/2009
49
Macroeconomic Factors (Cont…)
• Too much of money leads to inflation • However too little of it also causes problems • If there is too little money in circulation, supply of goods and services will exceed the demand • This will cause businesses to reduce production levels and possibly lay off workers
10/24/2009
50
Macroeconomic Factors (Cont…)
• If the problem were to persist it could lead to an economic recession or a reduction in the economy’s level of output • A sustained recession will eventually lead to an increase in the level of unemployment
10/24/2009
51
Inflation and Economic Indicators
• There are various statistics that we can use to gauge the level and impact of inflation • The Department of Labor in the US publishes the Consumer Price Index (CPI) every month, based on the prices in the previous month, of items in a representative `market basket’ • The index is based on the price changes of 80,000 items that represent a cross-section of goods and services purchased by urban households
– Such consumers represent about 87% of the US population
10/24/2009 52
Economic Indicators (Cont…)
• The CPI is released at 8:30 Eastern Time during the second or third week following the month being covered • Why is the CPI important?
– It is because inflation touches everyone
10/24/2009
53
Economic Indicators (Cont…)
• Inflation determines:
– – – – How much consumers pay for goods and services The cost of capital for businesses The value of personal and corporate investments The lifestyle of retired people
• It has implications for the benefits received by people getting Social Security payments • Landlords use it to fix future rentals on property • Judges use it to fix alimony and child support payments
10/24/2009 54
Economic Indicators (Cont…)
• The categories of goods and services on which the CPI is based are divided into eight major groups • Each group is then given a weight that signifies its importance • The weights are revised every two years to adjust for changing tastes and priorities
10/24/2009
55
Economic Indicators (Cont…)
• As of 2007 the weights were : • Housing 42.40%
– Shelter 32.30% – Fuel and Utilities 5.40% – Household furnishings and operations 4.70%
• • • •
Food and Beverages 15% Medical Care 6.20% Apparel 3.80% Recreation 5.60%
56
10/24/2009
Economic Indicators (Cont…)
• Education and Communication 6.0% • Other Goods and Services 3.50% • Transportation 17.40%
– Private Transportation 16.30%
• • • • New Vehicles 5.20% Motor Fuel 4.20% Maintenance and repairs 1.10% Used cars and trucks 1.80%
– Public transportation 1.10%
10/24/2009 57
Economic Indicators (Cont…)
• The Bureau of Labor Studies (BLS) collects price information from 23,000 retail and service businesses. • The businesses chosen are the types frequented by a sample of 14,500 families. • In practice two measures of inflation are often reported
– Core and – Non-core
10/24/2009 58
Economic Indicators (Cont…)
• Core does not include the cost of food and energy • Non-core includes everything • The FED looks at core inflation while taking steps to target the interest rate • This is because while food and energy (particularly) gasoline prices are volatile, the FED’s policy tools are slow-acting.
– Consequently the FED will desist from taking steps until the impact of a price rise has trickled through to the prices of other goods and services.
10/24/2009 59
Economic Indicators (Cont…)
• The CPI is the inflation index of direct relevance to the individual. • Consequently the FED tracks it closely. • A surge in the CPI will usually cause the FED to reduce the money supply
– This will result in a rise in interest rates
10/24/2009
60
Inflation
• What causes inflation and what are its implications for the economy • The monetarist school believes that inflation is caused by excessive growth in the money supply • If the growth rate of money supply is greater than the growth in the output of goods and services
– It means that too much of money is chasing too few products – Which will eventually show up in the form of inflation
10/24/2009 61
Inflation (Cont…)
• The Keynesian school believes that inflation is caused primarily by the overall demand for goods and services • It argues that when overall demand
– From consumers – Businesses – Government – Foreign buyers Exceeds the supply, the resulting shortage causes inflation
10/24/2009 62
Inflation (Cont…)
• The rate at which inflation increases depends on where the economy is in the business cycle • In other words it depends on how much production slack is available in the economy • A powerful pickup in demand immediately following a recession is usually not inflationary because there will be adequate idle capacity • However later on in the cycle, when material and labor resources become scarce, rising demand can cause a sharp increase in the price level
10/24/2009 63
Inflation (Cont…)
• Is inflation necessarily bad?
– Rising prices allow companies to generate greater revenues – This can boost stock prices
• Which will benefit shareholders
– Governments count on inflation to generate more tax revenues
• This helps to fund government spending programs and reduce the budget deficit
10/24/2009 64
Inflation (Cont…)
• But obviously there are negatives about inflation
– It creates a climate of instability and uncertainty – Firms love rising profits
• But they would rather accomplish by selling more instead of raising prices • Besides they also stand to lose from rising input costs • The cost of labor is also likely to rise due to inflation
10/24/2009
65
Inflation (Cont…)
• From the government’s standpoint
– While inflation brings in more tax revenue – It can also turn voters against the government
• Sometimes however, a dash of inflation may be deliberately sought
– This can happen if the economy comes face to face with deflation or a downward price spiral
10/24/2009
66
Inflation (Cont…)
• Why is deflation bad?
– It leads to falling prices which benefit consumers – But lower prices means lower corporate profits – This can lead to job layoffs – Higher unemployment shows up as reduced consumer expenditure – This can cause further layoffs
• During the Great Depression in the US the CPI dropped 24%
10/24/2009 67
Inflation (Cont…)
• So the goal of the government and the FED is to avoid both inflation and deflation by following policies that promote price stability
– In practice central banks target a modest level of inflation
• Say 1-2% per year
10/24/2009
68
Market Impact of CPI
• An unexpected increase in the CPI can cause bond prices to sharply decline • A benign CPI report is bullish for bond markets • So when inflation is low, bond prices trend upwards • Rising CPI also indicates that the cost of borrowing for corporates will rise • Inflation will usually cause the FED to intervene and raise interest rates which is a negative for shareholders
10/24/2009 69
Market Impact (Cont…)
• It can be argued that inflation boosts the topline and perhaps even the bottomline • But shareholders value rising profits due to enhanced sales and productivity and not profits due to price hikes. • This is because such hikes may not be sustainable • They may cause sales to dip • They may reduce competitiveness
10/24/2009 70
Economic Indicators (Cont…)
• Another measure of the level of inflation is the Producer Price Index (PPI)
– It measures the average changes in prices received by domestic producers for their output
• Until 1978 it was referred to as the Wholesale Price Index (WPI)
• Data is collected by sampling producers in
– Manufacturing – Mining – Service
industries
10/24/2009 71
Economic Indicators (Cont…)
• There is actually a family of PPI indexes which are computed
– However each of these is based on the same pool of price information – The three most important are
• Industry based indexes • PPI commodity index • Stage of processing indexes
10/24/2009
72
Economic Indicators (Cont…)
• In India too we had a Whole sale Price Index (WPI) till 1978 • In that year it was replaced by the Producer Price Index. • The index is used to measure the change in the average price level of goods traded in the wholesale market
– A total of 435 commodity prices are used to compute the index – It is available on a weekly basis
10/24/2009 73
Defining and Measuring Money
• There is no unique definition as to what is money • One schools says - `Money is the aggregate of assets that can be deployed for making immediate payments’ • Obviously the following will qualify
– – – –
10/24/2009
Paper Money Coins Checking Accounts Traveler’s Checks
74
Defining...(Cont…)
• Others say that this definition is too narrow
– Money is not just a medium of exchange, it is also a store of value
• Thus assets like savings account deposits and other assets which can easily be converted to a medium of exchange should also be counted
10/24/2009
75
Liquidity
• The crux of the debate is liquidity • What is a liquid asset?
– An asset is said to be liquid if it can be easily converted to cash and vice versa
• The first school believes that a liquid asset
– Is not something that can be converted to cash – But rather is what constitutes cash itself
• Something that can be used as a medium for acquiring goods and services
10/24/2009 76
Liquidity (Cont…)
• The second school believes that in practice other assets such as savings account balances can be easily converted to cash • According to them – money is not just cash but should also include cash-like assets
10/24/2009
77
The Monetary Base
• The monetary base, also known as High Powered Money, is the narrowest measure of money • Refers to money produced directly by the actions of
– The government or the central bank
10/24/2009
78
The Monetary Base (Cont…)
• In the U.S., the monetary base is
– Sum of currency held with the public – Plus the reserves held by depository institutions
• What do we mean by Public?
10/24/2009
79
Definition of Public
• It excludes
– Domestic US Banks – The US Treasury – The Federal Reserve
• It includes
– All foreign households – Foreign businesses – Foreign governments – International organizations
10/24/2009 80
M1
• M1 is a broader definition.
– It views money purely as a medium of exchange
• It has three components
– Currency – Traveler’s checks issued by non-banking institutions – Transactions deposits held at depository institutions
10/24/2009 81
M1 (Cont…)
• The currency component of M1 is the same as what is included in the monetary base • Who are non-banking institutions and why is it that only TCs issued by them are counted
– Examples are American Express and Thomas Cook – The reason why only their TCs are included is that when a conventional bank issues TCs it places the money required to redeem such instruments in special transactions deposits which are already included
10/24/2009 82
Transactions Deposits
• What are transactions deposits?
– They include checking account referred to as Current Accounts in India – Checkable accounts like
• Negotiable Order of Withdrawal or (NOW) Accounts • ATS (Automatic-Transfer-System) Accounts
10/24/2009
83
Types of Bank Deposits
• Deposits can be classified into four categories
– Demand deposits – Savings deposits – Time deposits – Hybrid deposits
10/24/2009
84
Demand Deposits
• What is a demand deposit?
– `A demand deposit in one where the bank is required to honor immediately, any withdrawals made by the account holder, either in person or by designating a third party as the beneficiary’
• They are meant for day to day banking needs
– Balances can be used to pay the bills of third parties from whom goods and services have been procured
10/24/2009 85
Demand Deposits (Cont…)
• They are called Checking Accounts in the US
– Because account holders can write checks against their balances – They have traditionally been non-interest bearing in the US – The same is true in India
10/24/2009
86
Savings Accounts
• What is a savings account?
– `it is an account that is designed to attract funds from customers who wish to set aside money in anticipation of planned as well as unanticipated future expenses’
• In practice the account holder can make deposits and effect withdrawals as desired • Legally the bank can insist on notice prior to a withdrawal
– This provision is rarely if ever invoked
10/24/2009 87
Savings Accounts (Cont…)
• In the US savings accounts, unlike in India, do not offer check writing facilities • Regulations limit the withdrawals, payments, and transfers that an account holder may perform • The deposit holder is permitted to make up to 6 transfers or withdrawals per month or statement cycle (of at least 4 weeks duration)
10/24/2009 88
Savings Accounts (Cont…)
• The bank may authorize up to 3 of these payments to be made by check, draft, debit card or similar order, to third parties
10/24/2009
89
Time Deposits
• These are deposits with a fixed maturity date
– What we call fixed deposits in India
• They pay higher interest than savings accounts
– But there are penalties for premature withdrawals
• By law such deposits must have a minimum maturity of 7 days • In practice they have a duration of 30, 60, 90 or 180 days
10/24/2009 90
Time Deposits (Cont…)
• In the US such deposits are referred to as CDs – Certificates of Deposit • CDs can be of two types
– Negotiable and – Non-negotiable
10/24/2009
91
Non-Negotiable CDs
• They cannot be transferred from one party to another • They represent a customized contract between the bank and the depositor • They are used mainly by retail investors • They tend to have small denominations
10/24/2009
92
Negotiable CDs
• Can be freely transferred from one party to another
– They are marketable securities
• They tend to be of large denominations
– Usually a multiple of 1MM USD
• They are used primarily by institutional investors
10/24/2009
93
Hybrid Accounts
• They have features of more than one type of account • Prominent examples are
– NOW accounts – Money Market Deposit accounts – Automatic Transfer Services
10/24/2009
94
NOW Accounts
• These can be used like checking accounts to pay for goods and services • Unlike checking accounts they pay interest • They can be held only by individuals and nonprofit organizations • Legally the bank can insist on prior notice of withdrawal
– But such a provision is rarely invoked
10/24/2009 95
Money Market Deposit Accounts
• Let us first consider a money market mutual fund • A mutual fund is an entity that pools the investment made by its shareholders and invests the corpus in the securities markets. • Money market funds are specialized funds that invest exclusively in money market securities
– Debt securities with an original term to maturity of one year or less
10/24/2009
96
MMDA (Cont…)
• Money market securities are
– Short-term in nature – Highly liquid – Carry a low risk of default
• Such funds began to permit shareholders to write checks against their balances • Thus they began to compete directly with banks for attracting investments
10/24/2009 97
MMDA (Cont…)
• Money market mutual funds offered market determined rates of return
– Which was higher than what banks were offering
• So banks were losing business to MMMFs • MMDA accounts were a response to such funds • With government approval, banks began to offer short-term deposits on which they could pay competitive rates of interest
10/24/2009 98
MMDA (Cont…)
• These accounts permit up to 6 pre-authorized withdrawals per month to pay third parties • But only three of these withdrawals may be by way of issuing checks to third parties • There is no limit on the number of withdrawals for personal use • Banks reserve the right to set minimum limits for each withdrawal and to regulate the frequency of such withdrawals • Unlike NOW accounts, such accounts can be held by a business
10/24/2009 99
Automatic Transfer Services
• An ATS is a combination of a checking and a savings account • Funds are primarily maintained as savings deposits
– Thus they earn interest
• Checks can be issued against balances in the checking account with a proviso that
– In the event of an overdraft funds will be automatically transferred from savings to checking
10/24/2009 100
M2
• Both high-powered money and M1 are definitions of CASH MONEY
– They include only highly liquid assets
• High-powered money measures funds made directly available by the Treasury and the FED • M1 measures funds more broadly available to the public
10/24/2009
101
M2 (Cont…)
• M2 is a broader measure of money • It treats money not just as a medium of exchange but also as a store of value • It includes
– M1 – Savings accounts – Small denomination (less than $100,000) time deposits excluding retirement accounts – Money market deposit accounts – Shares of money market mutual funds other than those held by institutions
10/24/2009 102
M2 (Cont…)
• Investments in MMMFs are made by
– Individuals – Brokers – Dealers – Financial institutions
• The FED is of the opinion that institutional investments in such funds are not very liquid • Thus only investments made by individuals and broker-dealers are included
10/24/2009 103
M3
• This is an even broader definition of money • It includes
– M2 – Time deposits with a denomination of $100,000 or more held with depository institutions – Terms repos and term Eurodollars – Repos at depository institutions and ED deposits held by US residents (other than banks) at foreign branches of US depository institutions – Shares of MMMFs held by institutions
10/24/2009 104
Repos
• A repurchase agreement is an arrangement by which a borrower raises money by selling securities with an agreement to buy back, usually on the following day, at a higher price
– So a repo is a collateralized loan – The difference between the purchase and sale prices constitutes the interest for the loan
• Most repos are over-night transactions • Those for a longer period are referred to as Term Repos
10/24/2009 105
Repos (Cont…)
• From the borrower’s perspective such transactions are called repos • From a lender’s perspective they are called reverse repos • Thus every repo must be matched with a reverse repo
10/24/2009
106
Eurodollars
• What is a Eurocurrency?
– `it is a freely traded currency deposited in a bank outside its country of origin’ – Eurodollars are dollars deposited outside the US – Euroyen are yen deposited outside Japan
10/24/2009
107
Market for EDs
• The rapid growth of the ED market was due to various factors • There was a high demand for the US dollar as an international vehicle currency
– By the end of WWII the US was the most dominant country – So the dollar became the most preferred currency for global trade
10/24/2009
108
Market for EDs (Cont…)
• East European countries wanted to hold dollar balances to fund their imports
– But a Cold War was on – So they were reluctant to hold dollar balances with US banks
• What if deposits were impounded by the US government
– So they began opening dollar accounts with banks in Europe
10/24/2009 109
Market for EDs (Cont…)
• European banks soon realized that there was an active market for such dollars • As a consequence an active ED market came into existence • These days the ED market extends beyond Europe
– We have active markets in Hong Kong, Singapore and Tokyo – These are called Asian Dollar markets
10/24/2009 110
Markets for EDs (Cont…)
• Through a legislation called Regulation Q, the US government imposed low interest rate ceilings on US banks
– That is they could not offer more than the stipulated rate to their depositors
• The FED also imposed significant reserve requirements
10/24/2009
111
Reserves
• What is a reserve?
– When a unit of currency is deposited with a bank, only a fraction can be lent out – The balance has to be kept in the form of approved government securities or as cash – In India we have the Statutory Liquidity Ratio (SLR) and the Cash Reserve Ratio (CRR)
10/24/2009
112
SLR
• The SLR provision requires banks to maintain an amount equivalent to 24% of their demand and time liabilities in the following forms
– Cash – Gold valued at a price not exceeding the current market price – Unencumbered approved securities valued at a price as specified by the RBI from time to time
10/24/2009
113
SLR(Cont…)
• The upper limit for SLR is 40% • The lower limit is 24% • The current requirement is 24%
10/24/2009
114
CRR
• An additional reserve has to be maintained in the form of a deposit with the RBI
– This is known as the Cash Reserve Ratio – The current requirement is 5%
10/24/2009
115
Reserves (Cont…)
• The lower the reserve ratio the more is the money available with the bank for commercial lending • So the lower the reserve ratio
– Higher will be the rate paid on deposits – Lower will be the lending rate
• Thus the spread or the Net Interest Margin (NIM) for the bank will be lower
– NIM is the difference between a bank’s lending rate and its borrowing rate
10/24/2009 116
EDs (Cont…)
• There are virtually no government regulations on ED deposits
– For instance there are no reserve requirements – However even if statutorily there are no reserve requirements , most banks will keep some reserves as a matter of caution
10/24/2009
117
EDs (Cont…)
• The ED market got a big boost due to the large flow of Petrodollars • After the 1973 war, OPEC countries hiked their crude oil prices
– Thus Arab nations were flush with funds – Most of this money flowed into the ED market
10/24/2009
118
EDs (Cont…)
• Why did petrodollars flow to European banks?
– No reserve requirements – Low cost of operations due to economies of scale – Thus banks could accept deposits at relatively higher rates and make loans at relatively lower rates
• In other words they could afford to operate with a lower NIM
10/24/2009
119
US Monetary Aggregates
10/24/2009
120
US Aggregates (Cont…)
10/24/2009
121
US Aggregates (Cont…)
10/24/2009
122
Monetary Aggregates in India
• The RBI defines five measures of the money supply
– The narrowest is M0 – The broadest is M4
10/24/2009
123
Definition (Cont…)
• M0: is known as RESERVE MONEY
– Consists of currency in circulation + bankers’ deposits with the RBI + Other deposits with the RBI
• M1: This is equal to
– Currency with the public + demand deposits with the banking system + other deposits with the banking system
10/24/2009 124
Definition (Cont…)
• M2: This is defined as
– M1 + Savings deposits with Post Office Savings Banks
• M3: This is equal to
– M2 + Time deposits with the banking system
• M4: This is the broadest aggregate It is equal to
– M3 + all deposits with Post Office Savings Banks
10/24/2009 125
Types of Accounts offered by Indian Banks
• Banks in India generally offer four kinds of accounts. These are:
– Current accounts – Savings accounts – Recurring deposits – Fixed deposits
10/24/2009
126
Types of Accounts (Cont…)
• Current accounts correspond to checking accounts in the US • There is no limit on the number of transactions or the amount of transactions on any given day • Such accounts are normally used by businesses
– An individual may opt for it if he has to make frequent check payments to third parties
• Like in the US banks do not pay interest on such deposits
10/24/2009 127
Types of Accounts (Cont…)
• Savings accounts are used primarily by individuals • Unlike in the US banks in India permit account holders to write checks • Most banks have stipulated rules for
– The maximum # of withdrawals in a specified period – And for the maximum amount that can be withdrawn
10/24/2009 128
Types of Accounts (Cont…)
• These rules are rarely, if ever, enforced • If a bank were to feel that an account holder is seeking to enjoy the interest benefit while using it as a current account from the standpoint of issuing checks, it can impose restrictions on withdrawals • The rate of interest is fixed by the RBI
10/24/2009
129
Types of Accounts (Cont…)
• Recurring deposits are for investors seeking to set aside funds periodically in order to build a corpus
– Usually a fixed amount has to be deposited every month – The minimum deposit is usually Rs 100 – Failure to make a scheduled deposit will attract a penalty – Premature withdrawals will attract a penalty
10/24/2009 130
Types of Accounts (Cont…)
• A new innovation is an FRD (Flexible Recurring Deposit)
– The investor has to choose a base amount – This is usually a minimum of Rs 500 and multiples of Rs 100 for larger amounts – The minimum chosen must be deposited every month – However if excess funds are available in a particular month, a higher amount subject to a ceiling which is usually 10 times the base amount may be deposited
10/24/2009
131
Types of Accounts (Cont…)
• Fixed deposits in India are like time deposits in the US
– They pay higher interest – But require commitment of funds for a fixed period – Premature encashment is possible but usually attracts a penalty
• Typically a reduction in the rate of interest paid
– Banks can offer any rate of interest that is required to attract and hold such deposits
10/24/2009 132
Monetary Statistics for India
10/24/2009
133
Statistics (Cont…)
10/24/2009
134
Statistics (Cont…)
10/24/2009
135
Creation of Coins and Currency
• The US Mint produces coins • The US Bureau of Engraving and Printing (BEP) prints paper currency • Both are operated by the Treasury
10/24/2009
136
Creation (Cont…)
• The Mint is headquartered in Washington DC
– It has facilities in
• • • • Denver, Colorado Philadelphia San Francisco West Point (New York State)
• The BEP has production facilities in
– Washington DC – Forth Worth, Texas
• The coins and currency are sold to the twelve Federal Reserve banks
10/24/2009 137
Facilities in India
• Production of coins and currency in India is undertaken by Security Printing & Minting Corporation of India Ltd. (SPMCIL) • It is wholly owned by GOI • It controls 4 mints
– Hyderabad – Kolkata – Mumbai – Noida
10/24/2009 138
Facilities in India (Cont…)
• There are two currency note presses
– Nashik Road – Dewas
• They have a combined capacity of printing in excess of 5.5 billion pieces of currency of different sizes and denominations
10/24/2009
139
Reserve Requirements in the US
• A reserve is that portion of a bank’s assets that have not been lent out or invested, but are held in a form readily available for use. • Legal reserves in the US take two forms
– Currency held in the vaults of the banks (Vault Cash) – Deposits held by the bank with the Federal Reserve
10/24/2009
140
Reserve Requirements
• Reserve requirements have implications for the ability of the banks to create money
– A bank can only lend what remains after accounting for required reserves
• As per law the FED can impose a reserve requirement ranging from 8-14% on transactions deposits • And up to 9% on non-personal time deposits
10/24/2009 141
Reserve Requirements (Cont…)
• Transactions accounts are checking and other accounts from which payments can be made to third parties • Non-personal time deposits are fixed deposits held by entities other than individuals and sole proprietorships • The FED can also impose any reserve that it deems appropriate on the amount that US banks owe on a net basis to their foreign affiliates or other foreign banks
10/24/2009 142
Reserve Requirements (Cont…)
• To reduce the reserve burden, the law provided that reserves would only be 3% of the first 25MM of transactions accounts
– And that this figure would be adjusted annually by a factor equal to80% of the percentage change in total transactions account in the US
10/24/2009
143
Reserve Requirements (Cont…)
• Subsequent legislation stipulated that the first 2MM dollars of a bank’s deposits would attract NIL reserves
– This will be adjusted upward if the quantum of deposits held by US banks were to increase – But there will be no downward adjustment if there were to be a decline in the deposit base
10/24/2009
144
Requirements as of 1 January 2009
10/24/2009
145
Reserve Requirements (Cont…)
• These figures are for transactions deposits • Currently non-personal time deposits are exempt from reserve requirements
10/24/2009
146
Reserve Maintenance
• The reserve requirement is calculated on a daily average basis over a two-week period
– This is called the Reserve Computation Period – Stretches from a Tuesday to a Monday 2-weeks later – To determine the required legal reserves the FED will calculate the daily average of transactions deposits held during the period and multiply it by the required percentage
10/24/2009 147
Reserve Maintenance (Cont…)
• The reserves held by a bank must equal the required amount over a two-week period
– Known as the Reserve Maintenance Period – It starts on a Thursday 17 days after the computation period ends – It ends on a Wednesday 2-weeks later
• While computing the level of required reserves, vault cash is adjusted
10/24/2009 148
Reserve Maintenance (Cont…)
• In practice the process involves three 14-day periods. • These are
– The base computation period – The vault cash computation period – The reserve maintenance period
10/24/2009
149
Reserve Maintenance (Cont…)
• Assume that today is Tuesday the 13th of October 2009 • A new base computation period will commence today and will end on Monday the 26th of October • The required reserves are calculated by multiplying the average checking account balance during this period, by the required reserve ratio
10/24/2009 150
Reserve Maintenance (Cont…)
• The corresponding vault cash computation period will commence on Tuesday the 27th of October and will end on Monday the 9th of November • During this period the bank will compute its average vault cash holdings • The reserve deposit requirement for the base computation period = Required reserves – Average Vault Cash
10/24/2009 151
Reserve Maintenance (Cont…)
• The reserve maintenance period will commence on Thursday the 12th of November and will end on Wednesday the 25th of November. • The average balance in the reserve account at the FED, during this period must be greater than or equal to the reserve deposit requirement
10/24/2009 152
Reserve Maintenance (Cont…)
• If there is a shortage or a surplus, it can be carried over to the next period • However if the deficit is more than 4% of the reserve deposit requirement, the FED will levy a fine
– This is equal to 2% more than the FED’s discount rate multiplied by the deficit
10/24/2009
153
Reserve Maintenance (Cont…)
• The next base computation period will commence on Tuesday the 27 of October • Thus the computation calendars overlap • That is banks are continuously satisfying reserve requirements • But are doing it with a consistent one month lag
10/24/2009
154
Sweep Accounts
• Excess reserves do not earn any income for the banks
– Vault cash and reserves at the FED are non-interest earning
• Banks make money by commercial lending • So while reserves are essential for contingency purposes they are costly • One way of reducing the reserve burden and the related opportunity cost is by using sweep accounts
10/24/2009 155
Sweep Accounts (Cont…)
• The reserve requirement for sweep account is nil • By sweeping un-needed balances from a checking to a sweep account the bank reduces the reserve requirement and the associated cost • This is commonly done on weekends
10/24/2009
156
Sweep Accounts (Cont…)
• At the close of business on Fridays the bank’s computers will reclassify checking accounts as Money Market Deposit Accounts on which the reserve requirement is zero • The funds are switched back at the opening of business on Monday • This reduces the bank’s reserve requirement because the 14-day balance averaging period includes week-ends
10/24/2009 157
Sweep Accounts (Cont…)
• These weekend sweeps can reduce average balances significantly – by reducing the balance to zero on 4 out of 14 days • However MMDA accounts require the bank to pay interest • This interest expense partially offsets the opportunity cost savings achieved by reducing required reserves
10/24/2009 158
Creation of Money by Banks
• Reserve requirements have implications for
– The deposit base of financial institutions – And consequently the creation of money
• Consider a simple economy with five people
– Alfred – Brad – Charlie – Doug – Eric
10/24/2009 159
Creation…(Cont…)
• • • • • Brad has 75 bushels of wheat Charlie has 60 bushels of corn The price of wheat is $5 per bushel The price of corn is $4 per bushel Alfred is a government employee who has to be paid a monthly salary of $100
10/24/2009
160
Creation…(Cont…)
• The Fed will create this currency • That is the US government will issue bonds worth $100 • In return it will get $100 in currency from the Fed • The Fed’s balance sheet at this stage may be depicted as follows.
10/24/2009
161
Creation…(Cont…)
10/24/2009
162
Creation…(Cont…)
• At this point in time
– Money in circulation is $100 – The monetary base is $100 – M1 = M2 = $100
• If there is no bank in the economy
– Alfred can buy 20 bushels of wheat from Brad – Brad can buy 25 bushels of wheat from Charlie – The amount of money in circulation is $100
10/24/2009 163
Creation…(Cont…)
• Let us introduce a bank called First National • Alfred buys 20 bushels of wheat from Brad who deposits the money with the bank • The required reserve ratio is 10% • Thus the bank has to keep $10 as reserves • But can make loans worth $90 • Assume it loans $90 to Doug
– He buys another 18 bushels from Brad – Brad deposits the money with First National
10/24/2009 164
Creation…(Cont…)
• First National has to keep a statutory reserve of $9 • It can therefore lend $81 • Assume that it makes a loan of $81 to Eric
– He buys 20.25 bushels from Charlie – Charlie deposits the money with First National
• After this transaction
– Brad has a bank balance of $190 – Charlie has a bank balance of $81
10/24/2009 165
Creation…(Cont…)
• The amount of money as measured by the ability of people to pay for goods and services is: 190 + 81 = $271 • Now let us extend the analysis to include more people
– Each time a person makes a deposit with a bank it can loan out 90% of the amount to someone
10/24/2009
166
Creation…(Cont…)
• The creation of money due to the initial deposit of $100 follows the sequence given below
100 + .9x100 + .9x90 + .9X81 + …… • In general if the amount deposited is D and the reserve ratio is r the sequence may be stated as D + (1-r)xD + (1-r)2xD + (1-r)3xD +…. • Since r <1, the series will converge to D/r
10/24/2009 167
Creation…(Cont…)
• In our case since the required reserve ratio is 10% , and the amount initially deposited is $100 the money in circulation can increase to a maximum of 100/0.10 = $1000 • The extension of loans by commercial banks has an impact on the deposit base
– Because borrowers usually prefer to keep the proceeds as bank deposits rather than in the form of cash
10/24/2009 168
Creation…(Cont…)
• In practice the deposit base cannot be enlarged without limit • Because very time a bank accepts a deposit it is undertaking an obligation to clear checks issued by the depositor
– Thus a contingency fund is required – This is precisely the concept of a reserve
10/24/2009
169
Creation…(Cont…)
• Thus an original cash deposit of $100 by a customer can create a deposit base of $1,000 by a process of expansion • The deposit multiplier in this case is 10
– The reciprocal of the reserve ratio
10/24/2009
170
Creation…(Cont…)
• In practice if Brad deposits $100 it may not lead to an increase of $1000 in the deposit base.
– What if Charlie withdraws $11 as cash and deposits $70 with the bank – Assume that this cash does not subsequently reenter the banking system – The $70 deposit if allowed to multiply to its logical limit will lead to an aggregate deposit of $700
10/24/2009 171
Creation…(Cont…)
• In this case Brad has $190 • Charlie has $11 in cash • Charlie and other depositors together have $700 with the bank • The total amount of money in the economy is 190 + 11 + 700 = $901
10/24/2009
172
Creation…(Cont…)
• Withdrawal of cash without their subsequent deposit into the banking system is called a LEAKAGE • Greater the leakage
– The smaller is the money multiplier
• There is yet another reason why the deposit base may not reach its theoretical limit
– What if the bank is unable to find new borrowers after a point – For instance if Charlie deposits $81 and there are no further demands for loans the deposit base will only be 190+81 = $271
10/24/2009 173
Accounting for Brad’s Initial Deposit
10/24/2009
174
Accounting for Doug’s Loan and the subsequent deposit by Brad
10/24/2009
175
Accounting for the loan to Eric and the subsequent deposit by Charlie
10/24/2009
176
Reserves
• Since vault cash is counted as reserves the bank has $100 as reserves
– 10% of the deposits or $27.1 in this case is the required reserve – Thus the bank has excess reserves of $72.90 – This can be used to make additional loans – Or may be invested in securities
10/24/2009
177
Reserves (Cont…)
• In practice all reserves need not be held as vault cash
– In practice most reserves are maintained as deposits with the Fed – Assume that First National retains $15 as cash – And transfers $85 to the Fed – The Fed will withdraw this money from circulation
10/24/2009
178
Fed’s Balance Sheet after this transaction
10/24/2009
179
A Second Bank
• We will now introduce a second bank First Global • When Brad gets $100 he deposits it with First National • The same occurs when he receives $90 after the second transaction
– The bank has $100 as vault cash – The requires reserve is $19 – Thus it has excess reserves of $81
10/24/2009 180
A Second Bank (Cont…)
• Charlie borrows $81 from First National but deposits it with First Global • If so, $81 will be transferred from First National to First Global
– The Fed will debit the reserve account of First National and credit the reserve account of First Global
10/24/2009
181
The Fed’s Balance Sheet
10/24/2009
182
Reserves (Cont…)
• First Global has $81 deposited with it
– It has excess reserves of $72.9 – The total reserves in the banking system is $100
• $15 in the form of vault cash at First National • $4 in the form of a reserve deposit at the Fed by First National • $81 in the form of a reserve deposit at the Fed by First Global
• Now assume that First Global seeks to hold $6 as vault cash
– The Fed will issue the notes and debit the reserve account of First Global
10/24/2009 183
Fed’s Balance Sheet after the transaction
10/24/2009
184
Reserves (Cont…)
• The total reserves held by the banking system as a whole is independent of the number of banks in the system • First Global too is empowered to make loans after maintaining the required reserves • Thus the two banks taken together can cause the total deposit base in the economy to reach $1,000
10/24/2009 185
Deposits, Withdrawals, and Reserves
• The reserves held by a bank will go up when a customer makes a deposit • Deposit may be in the form of
– Cash – Or a check
• If it is a cash deposit, vault cash will go up by the amount deposited
– The bank may choose to keep all or some of the deposit amount as cash
10/24/2009 186
Deposits…(Cont…)
• If it were to choose not to retain the entire amount as cash
– The excess will be transferred to the Fed – Which will credit its reserve account by an equivalent amount – So the sum of vault cash and the reserve balance at the Fed will increase by the amount deposited
10/24/2009
187
Deposits…(Cont…)
• What if the customer deposits a check drawn on another bank
– Funds will be transferred from the reserve account of the drawer’s bank to the reserve account of the drawee’s bank – So the reserves of the drawer’s bank will stand reduced – The reserves of the drawee’s bank will increase
10/24/2009
188
Illustration of a Check Transaction
• An IT firm in Chicago has sold software worth $100,000 to a party in Boston • The Boston party issues a check drawn on a Boston bank • The supplier will deposit the check with its bank in Chicago • The bank will send the check to the Chicago Fed
10/24/2009 189
Illustration (Cont…)
• The Chicago Fed will send the check to the Boston Fed • The Boston Fed will send the check to the drawer’s bank • The bank will first debit the drawer’s account
– It may then remit funds to the Boston Fed – Or authorize it to debit its reserve account
10/24/2009
190
Illustration (Cont…)
• The funds will be transferred from the Boston Fed to the Chicago Fed • The Chicago Fed will credit the reserve account of the drawee’s bank • The bank will credit the drawee’s account • The net result is a transfer of $100,000 from a party in Boston to a party in Chicago
10/24/2009
191
Illustration (Cont…)
• Checks which are collected and cleared by the Federal Reserve system must be paid in full by the drawer’s bank
– No deduction of fees – To be paid at PAR – The drawee’s bank may recover collection charges from the drawee
10/24/2009
192
Inter District Transfers
• How do funds move from one Federal Reserve Bank to another • To facilitate transfers between two member banks • The 12 banks as a whole maintain a fund in DC called the Inter-District Settlement Fund
– All 12 banks have a share in it
• By way of this fund, money is routinely transferred from one member bank to another
10/24/2009 193
Clearing Balances
• Banks which are not members of the Federal Reserve System may choose to maintain a Clearing Balance with a district bank • When checks drawn on other banks are deposited with it
– Its clearing balance will be credited
• When checks drawn on it are deposited with other banks
– Its clearing balance will be debited
10/24/2009 194
Monetary Aggregates
• When the FED issues currency equivalent to $100
– It adds $100 to the monetary base – The monetary base will remain at this figure
• Whether the amount is held with the public • By a commercial bank • Or by a combination of the two
• But when checking accounts are opened with commercial banks
– M1 and obviously M2 will increase
10/24/2009 195
Aggregates (Cont…)
• When Alfred receives $100 from the government
– Currency in circulation is $100 – Monetary base is also $100
• When Brad receives $100 from Alfred and deposits with the bank
– – – – –
10/24/2009
Currency with the public is reduced by $100 But the magnitude of checking deposits is $100 Bank reserves in the form of vault cash is $100 So the base remains at $100 M1 is also $100
196
Aggregates (Cont…)
• Brad receives a check for $90 from Doug, which is deposited in the bank
– The monetary base remains at $100 – M1 increases to $190
• Eric pays $81 to Charlie by way of a check
– High powered money remains at $100 – M1 is now $271
10/24/2009
197
Investments: An Alternative
• It is not necessary that a bank with excess reserves must make loans • It has the option of buying securities • When Charlie deposits $81 with the bank
– It will have excess reserves of $72.90 (81 - .1x81)
• Assume that it buys $60 worth of securities from a dealer, who has an account with it
10/24/2009
198
Investments (Cont…)
• On the assets side investments will increase by $60 • On the liabilities side the deposits (by the dealer) will increase by $60 • The position of the bank in a T-account format will be as follows.
10/24/2009
199
Balance Sheet of First National
10/24/2009
200
The Treasury’s Accounts
• The Treasury holds a part of its operating cash balances with the Fed • The rest is held with depository institutions across the US
– These are called Treasury Tax and Loan (TT&L) accounts
• All disbursements made by the Treasury are by debits to its account at the Fed
10/24/2009 201
Treasury (Cont…)
• So if the Treasury requires additional funds to cover checks issued by it
– It will transfer funds from its bank account (s) to its account at the Fed – These transfers are termed as calls on TT&L account balances
• How does the Treasury acquire a credit to the TT&L account
– From tax receipts by residents – On account of payments by the buyers of Treasury securities
10/24/2009 202
Treasury (Cont…)
• When a call is made on a TT&L account funds are transferred from the bank in which the account is held to the Treasury’s account at the Fed
– The Fed will debit the reserve account of the bank – And credit the Treasury’s account – So there will be a reduction is reserves equivalent to the full amount of the transaction – However since banks do not have to maintain reserves against TT&L accounts
• There is no reduction in the required reserves
10/24/2009
203
Illustration –The Fed’s Balance Sheet
10/24/2009
204
Treasury (Cont…)
• Charlie has $81 on deposit with First Global • He is required to pay $25 as tax to the Treasury • The Treasury has a TT&L account at First Global
– The bank will debit Charlie’s account and credit the TT&L account
• The transaction will leave the reserves unchanged but will cause the money supply to decline by $25
10/24/2009
205
The Balance Sheet of First Global
10/24/2009
206
Treasury (Cont…)
• Now assume that the Treasury wants to transfer $25 from its account at the bank to its account at the Fed
– First Global will debit the Treasury’s account with $25 – There will be a corresponding decline of $25 its the reserve account.
• After the transaction, the balance sheet will look as follows
10/24/2009 207
Treasury (Cont…)
10/24/2009
208
Treasury (Cont…)
• The Fed will
– Debit First Global’s reserve account by $25 – It will credit the Treasury’s account with $25 – As a consequence the reserves held by the banking system will decline by $25
• The balance sheet of the Fed after the transaction will look as depicted
10/24/2009
209
The Fed’s Balance Sheet
10/24/2009
210
Treasury (Cont…)
• The Treasury will typically spend this income by issuing checks
– Assume it gives a check for $20 to Larry – Larry deposits the check with First Global
• First Global will credit Larry’s account with $20 • It will gain $20 in reserves • The Fed will debit the Treasury’s checking account with $20 and credit the bank’s reserve account
10/24/2009 211
The Fed’s Balance Sheet
10/24/2009
212
Balance Sheet of First Global
10/24/2009
213
Treasury (Cont…)
• The Treasury keeps its funds in TT&L accounts until needed
– The required amounts are transferred to the Fed only when they have to be disbursed
• What is the reason?
– Income for the Treasury by way of taxes and bond issues is lumpy – Disbursements are steady
• Salaries, wages, pensions, fuel bills
10/24/2009 214
Treasury (Cont…)
• When a call is made on a TT&L account, there is a drain of reserves from the banking system • The reserves are restored, at least partially, when the Treasury makes a payment from its checking account at the Fed • If the Treasury were to make calls as and when funds are received it will lead to a significant and sharp decline in reserves
– Restoration obviously will not be at the same pace
10/24/2009 215
Treasury (Cont…)
• Thus the banking system will experience a substantial reduction in reserves if and when a large call is made on a TT&L account
– This has implications for the ability of banks to make loans – This can therefore lead to a recession – Thus the Treasury draws on its TT&L balances only on a JIT basis
10/24/2009
216
Deposit Contraction
• Assume that Brad has $190 on deposit with First National while Charlie has $81 on deposit with First Global • First National has reserves of $19 which is required by law
– $15 in vault cash and $4 at the Fed
• First Global has reserves of $81
– 8.1 is required by law – Consequently it has excess reserves of $72.90
10/24/2009 217
Contraction (Cont…)
• First National has made
– a loan of $90 to Doug – And $81 to Eric
• The positions of the two banks are as depicted
10/24/2009
218
Balance Sheet of First National
10/24/2009
219
Balance Sheet of First Global
10/24/2009
220
Contraction (Cont…)
• Let us consider various possibilities • Assume Charlie withdraws $40 from his account • The bank will ask the Fed to issue $40 to it in the form of currency bills • It will debit Charlie’s account by $40 and its reserve account at the Fed will be debited with $40
10/24/2009 221
Balance Sheet of First Global
10/24/2009
222
The Fed’s Balance Sheet
10/24/2009
223
Contraction (Cont…)
• The aggregate reserves held by the two banks, including vault cash = 15 + 4 + 6 + 35 = $60 • The reserves have therefore contracted by $60 • There is no change in the monetary base
– Reserves + currency = 60 + 40 = $100
• Take another case where Brad wants to withdraw $40 in cash from First National
– The bank has no excess reserves – It will have to borrow from First Global
10/24/2009 224
Contraction (Cont…)
• The Fed will
– Debit First Global’s reserve account – And credit First National’s reserve account – It will then issue $40 in currency to facilitate the withdrawal by Brad
• And in the process will debit First National’s reserve account by an equivalent amount.
10/24/2009
225
The Fed’s Balance Sheet
10/24/2009
226
Balance Sheet of First National
10/24/2009
227
Balance Sheet of First Global
10/24/2009
228
Contraction (Cont…)
• Once again the sum of vault cash and reserve balances of the two banks stands reduced from $100 to $60 • Now let us consider the following situation
– – – – – Charlie deposits $81 with First Global The bank invests $22.90 in government securities It makes loans worth $500 It keeps vault cash of $6 The balance is kept at the Fed
10/24/2009
229
Contraction (Cont...)
• Assume that the securities were bought from the Treasury
– The bank will credit the Treasury’s TT&L account with $22.90
• The bank’s balance sheet will look as follows
10/24/2009
230
Balance Sheet of First Global
10/24/2009
231
Contraction (Cont…)
• The bank is required to maintain reserves worth .10 x 581 = $58.10
– Thus it has excess reserves of $22.90
• Now assume that Charlie withdraws $40 as cash
– The excess reserves are inadequate – The bank will have to sell securities – Or else recall loans
10/24/2009 232
Contraction (Cont…)
• Borrowing of reserves is ruled out
– First National is the only other bank in the system – It has no excess reserves
• Assume First Global sells securities
– The amount to be sold may be computed as follows. If $X worth of securities is sold: 41 + 500 + 22.90 = (22.90-X)+500+0.10x(41+500) ? X = $13.10
10/24/2009 233
Contraction (Cont…)
• The securities will be sold to the Fed, which will credit the bank’s reserve account with $13.10.
10/24/2009
234
Balance Sheet of First Global
10/24/2009
235
Analysis
• • • • • The bank had $22.90 as excess reserves A withdrawal of $40 reduced the required reserves by $4 So to fund $40 the bank can rely on its reserves of $26.90 The balance of $13.10 is obtained by selling securities The reserve balance at the Fed (assuming that vault cash is maintained at $6) is 48.10
48.10 = 75 – 26.90
• Vault cash + reserve balance at the Fed = 6 + 48.10 = 54.10 = 0.10 x 541
– Remember banks do not have to maintain reserves against TT&L accounts
10/24/2009
236
Contraction (Cont…)
• The other option is to recall loans • If $X worth of loans is recalled then from the balance sheet equation 41+(500-X)+22.90=22.90+(500-X)+.1x(41+500-X) ?X = $131 • The bank’s balance sheet will appear as follows.
10/24/2009
237
Balance Sheet of First Global
10/24/2009
238
Analysis
• The bank had excess reserves of $26.90 • It thus required $40 - $26.90 = $13.10 • To acquire 13.10 in reserves, it has to recall loans worth $131, since the reserve ratio is 10% • The excess reserves of $26.90 were completely used up • The $13.10 in reserves that was freed due to the loan recall was also completely used up
10/24/2009 239
Analysis (Cont…)
• The amount with the Fed, assuming that $6 is held as vault cash is $35
– $35 = $75 - $40
• The sum of the vault cash and the reserve deposit is $41, which is 10% of the deposits
10/24/2009
240
Contraction (Cont…)
• A deposit of currency has a multiplier effect • If the required reserve ratio is 10% a deposit of $100 can lead to total deposits of $1,000 • Similarly the withdrawal of currency will lead to a contraction of deposits • In our case, the withdrawal of $40 prevented the deposit base from expanding to $1,000
10/24/2009
241
Contraction (Cont…)
• In the first case, after Charlie withdrew $40 the total reserves held by the banking system was: 19 + 6 + 48.10 = $73.10 • Prior to the withdrawal it was $100 • To meet the drain of cash the bank needed to release $40 in reserves • The Fed injected extra reserves of $13.10 into the banking system by acquiring securities
10/24/2009 242
Contraction (Cont…)
• Consequently the post withdrawal reserve balance was: 100 + 13.10 – 40 = $73.10 • This was just adequate to support a deposit base of $731 • In the second case, after loans worth $131 were recalled the reserves available were: 100 - 40 = $60 • Thus the banking system could support a deposit base of only $600
10/24/2009 243
Contraction (Cont…)
• In both cases theory predicted that a withdrawal of $40 would lead to reduction of $400 in the deposit base • In the first case this was precluded by an injection of $13.10 in reserves by The Fed
– As a consequence total deposits contracted to $731
• In the second case no additional reserves were injected and the deposit base shrank to $600
10/24/2009
244
Contraction (Cont…)
• There is therefore a critical difference between deposit expansion and deposit contraction • Leakage or slack loan demand may lead to a deposit expansion that is less than what theory would predict • However, unless the withdrawal is accompanied by a simultaneous injection of reserves, contraction must take place to the extent predicted by theory
10/24/2009 245
Borrowing by the Treasury
• In the first illustration we assumed that the Fed creates currency of $100 by buying a bond from the Treasury • In principle the federal government can borrow from the central bank
– But this is not the practice in the US – In the US the Treasury borrows to a limited extent by issuing debt securities to banks – And to a large extent by issuing such securities to the public
10/24/2009 246
Borrowing (Cont…)
• Let us consider a case where the Treasury borrows directly from the Fed by issuing government securities worth $100 • The Fed’s balance sheet would look as shown below.
10/24/2009
247
Borrowing (Cont…)
10/24/2009
248
Borrowing (Cont…)
• Assume that the Treasury spends the money by giving a check to Larry, who deposits it with First National Bank. • The Fed will debit the Treasury’s account and credit the reserve account of First National • The Fed’s balance sheet and the bank’s balance sheet would look as follows.
10/24/2009
249
Borrowing (Cont…)
10/24/2009
250
Borrowing (Cont…)
10/24/2009
251
Analysis
• High-powered money has gone up by $100
– For bank reserves have increased by $100
• M1 has increased by $100
– Transactions deposits have gone up by $100
• Thus if the Treasury were to spend the proceeds of an issue of $X worth of securities to the Fed
– Both H and M1 will increase by $X
10/24/2009 252
Borrowing (Cont…)
• What would happen if the Treasury were to directly issue securities worth $X to the bank
– Its TT&L balance would increase by $X – If it were to spend the money by issuing a check to Larry, M1 will increase by $X – However there will be no change in H
10/24/2009
253
Borrowing (Cont…)
• Finally consider a situation where the Treasury issues $X worth of securities to a dealer named Joe
– He makes payment by issuing a check on First National – The bank will debit his account and credit the TT&L A/c – Thus M1 stands reduced by $X
10/24/2009
254
Borrowing (Cont…)
• The Treasury will at some point transfer the funds to its account at the Fed
– This will reduce H by $X
• If the Treasury were to then make a payment of $X to Larry
– High powered money will be restored to its former level – M1 will be restored to its earlier level
10/24/2009 255
Analysis
• The expending of $X by the Treasury after obtaining funds by directly issuing bonds to the Fed
– Will increase both H and M1 by $X
• However if the Treasury were to issue bonds to a bank
– M1 will increase by $X, H would be unaffected
• Finally if the Treasury were to directly issue bonds to the public and spend the resources
– There will be no impact on either H or M1
10/24/2009 256
Putting Money in Circulation
• When coins or currency are produced by the Mint or the BEP – they are sold by the Treasury to the Federal Reserve Banks • Coins are sold for their face value • Notes are sold for their cost of production • Each of the 12 districts FR banks will keep the newly minted coins and notes in their storage vaults
10/24/2009 257
Money (Cont…)
• But this currency does not immediately become a part of M1 • For coins and notes to be counted as M1 they must pass into the hands of the public
– That is they must leave the possession of the Fed and the banking system
• So how does newly generated cash enter into circulation?
10/24/2009 258
Money (Cont…)
• For cash to enter circulation there must be a demand for cash from bank customers • If the banks do not have enough vault cash to satisfy this demand they will ask the Fed for additional supplies • The Fed will debit the reserve account of the bank and transfer cash • The bank will debit the account of the customer
– Thus newly minted cash starts its circulation
10/24/2009 259
Money (Cont...)
• There is no impact on the on M1
– Checking account balances are reduced – But there is more money in circulation with the public
• There is no impact on H
– Reserves stand depleted – But money in circulation is more
10/24/2009
260
Money (Cont…)
• The reduction in bank reserves has implications for its ability to make additional loans
– So a bank will seek to shore up reserves
• One option is to sell Treasury securities to the Fed • The purchase and sale of Treasury securities by the Fed is termed as OPEN MARKET OPERATIONS
10/24/2009 261
Money (Cont…)
• The Fed will credit the bank’s reserve account with an equivalent amount • Thus high powered money increases
10/24/2009
262
Fed’s Balance Sheet
10/24/2009
263
First National’s Balance Sheet
10/24/2009
264
Money (Cont…)
• Assume that there is no money in circulation with the public
– H = $200 – M1 = $250
• A customer called Brad approaches the bank seeking $25 in cash • The Fed will issue the cash to facilitate the withdrawal
10/24/2009 265
Fed’s Balance Sheet
10/24/2009
266
Balance Sheet of First National
10/24/2009
267
Money (Cont…)
• • • • High powered money = 175 + 25 = $200 M1 = 225 + 25 = $250 So the transaction has had no impact on H or M1 But bank reserves have declined by $25 it has implications for the bank’s ability to make loans • One way to restore reserves is by selling securities worth $25 to the Fed
10/24/2009 268
Fed’s Balance Sheet
10/24/2009
269
Balance Sheet of First National
10/24/2009
270
Money (Cont…)
• • • • • H = 200 + 25 = $225 M1 = 225 + 25 = $250 M1 is unaffected H has increased by $25 Thus the injection of $25 into the public domain has lead to the acquisition of Treasury securities worth $25 by the Fed
10/24/2009
271
Money (Cont…)
• The Treasury has to pay interest on all outstanding securities including those held by the Fed • The Fed, unlike private parties, will return such income to the Treasury at the end of the year • Thus the injection of new money leads to the retirement of an equivalent amount of securities
10/24/2009 272
Money (Cont…)
• Thus the income from the issue of currency is the interest saved by the Treasury
– Which would have otherwise been paid to the security holders
10/24/2009
273
Seigniorage
• What is Seigniorage • It is the net revenue earned by issuing coins or bank notes • There is always a difference between the face value of a coin or note and the costs entailed in production and distribution
10/24/2009
274
The Canadian Evidence
• It costs the Royal Canadian Mint about 12 cents to produce and distribute a one dollar coin • Thus the government makes a profit of 88 cents for every coin that is sold at face value. • Coins unlike notes are not redeemed by the government • So the seigniorage is generated at the time of sale
10/24/2009 275
Canada (Cont…)
• The Bank of Canada issues currency notes • Their lifespan is short
– Ranging from about 2 years for $5 and $10 notes to 7 years for $100 notes
• Institutions can redeem their surplus notes to the central bank for payment • The accounting process for the revenues and costs associated with note issuance differs from that for coins
10/24/2009 276
Canada (Cont…)
• When the central bank issues a note, which is a liability for it, it subsequently acquires interest bearing securities via open market operations.
– These may be short-term in nature (Bills) – Or medium to long term (Notes and Bonds)
• Seigniorage in the case of currency notes is the difference between the interest earned on government securities and the cost of production and distribution.
10/24/2009 277
Canada (Cont…)
• Since the banks hold such securities over a period of time, note related seigniorage is collected in installments over a number of years • Take the $20 Canadian bill • At an average interest rate of 5% is generates a revenue of $1 per year that it is in circulation which is about 3 years
10/24/2009 278
Canada (Cont…)
• The production cost of such notes is about six cents
– Works out to 2 cents per year if we amortize it
• The average annual distribution cost is about 2 cents • Thus the total annual production and distribution cost is 4 cents • Thus the annual net revenue for the central bank is about 96 cents
10/24/2009 279
Canada (Cont…)
• The interest revenue for the Bank of Canada has ranged between $1.7 billion to $2.2 billion • The Bank has used about $130 MM to finance its general operating expenses • The remainder is paid to the government • Thus seigniorage allows the government to finance a part of its expenditure without having to levy taxes
10/24/2009 280
The U.S. Evidence
• The currency bills issued by the Fed have a finite lifespan • The average life of bills in the US is given in the table below
10/24/2009
281
US (Cont…)
10/24/2009
282
US (Cont…)
• Take the $20 bill • Assume that it stays in circulation for exactly 2 years • At the end of 2 years, a depositor will return it to a bank • The bank will return it to the Fed and have its reserve account credited. • The Fed will retire the note from circulation • To offset the increase in reserves the Fed will sell securities to the bank • And debit its reserve account
10/24/2009 283
US (Cont…)
• So for 2 years the Fed earns interest on $20 • If we assume an interest rate of 6%, the annual income is $1.20 • The Fed pays 5 cents to acquire the note from the Treasury • If we assume that this is the only cost then the net income from the bill over 2 years is $2.35 • This is the seigniorage income from the bill
10/24/2009 284
US (Cont…)
• The Fed transfers the profits obtained by it to the Treasury • Thus the ultimate beneficiary of seigniorage is the Treasury
10/24/2009
285
Assets & Liabilities
• Federal reserve notes in circulation are the largest liabilities of the Fed • Treasury securities are the biggest assets of the Fed • In practice the Fed arrives at a forecast of the amount of currency required to meet the demand in a year
– It will then submit an order to the BEP
10/24/2009 286
Assets & Liabilities (Cont…)
• The BEP establishes a billing rate for the cost of manufacturing currency notes
– The cost has to be borne by the Fed
• However unlike currency notes coins are not liabilities of the Fed • The annual output of coins is determined by the Mint
– It monitors the stock held by the Fed to identify trends in the demand
10/24/2009 287
Coins & Currency
• In 2002 the Mint sold 15 billion coins
– With a face value of $1.4 billion – The production cost was $436 million
• The BEP produced 7 billion notes
– With a face value of $103.50 billion – The production cost was 384 million
• The Fed spent $30 million to process the coins • And $342 million to process the notes
10/24/2009 288
Coins & Currency (Cont…)
• In 2002 the mint transferred $1 bn in seigniorage from coins • The Fed transferred about $24.50 bn in excess earnings
– These arise mainly from the holding of government securities – And are attributable in part to the value of currency in circulation
10/24/2009
289
Credit & Debit Cards
• Are credit and debit cards money • Consider credit cards
– They represent a revolving line of credit offered by the issuer to the holder – He can use it to acquire goods and services up to a pre-defined limit – Each time he repays in part or in full his ability to make further transactions will be restored by the extent of payment made
10/24/2009 290
Credit Cards (Cont…)
• Credit cards are referred to as Plastic Money • But they are not money • When money is used in the form of currency or as a checking account balance to acquire a good or a service
– We are exchanging one asset for another
• But if the same transaction is done with a card
– A liability is created
10/24/2009 291
Credit Cards (Cont…)
• When one makes a card based payment
– The issuer will make a transfer of funds to the merchant’s bank account – This is a monetary transaction – The issuer will send a bill for the transaction – The holder will respond in the form of installments or as a bullet payment – Such payments are normally made by check – This too is a monetary transaction
10/24/2009 292
Credit Cards (Cont…)
• The transaction that created the liability is not money • It is merely an extension of credit on the part of the issuer • One may argue that most checking account balances arise on account of loans from banks • However the loan itself is not money • Money is created when the borrower deposits the loan amount in a checking account thereby creating an asset for himself
10/24/2009 293
Credit Cards (Cont…)
10/24/2009
294
Credit Cards (Cont…)
• Now assume that the bank makes a loan of $100 to Mark who deposits it with First Global • When the check clears the balance sheet of the two banks will be as depicted below
10/24/2009
295
Credit Cards (Cont…)
10/24/2009
296
Credit Cards (Cont…)
10/24/2009
297
Credit Cards (Cont…)
• M1 = $300 • Now assume First Global gives Mark a revolving line of credit of $50 in the form of a credit card • He will use it only if he wants to buy a good or a service • Assume he buys $50 worth of goods from Brad
10/24/2009 298
Credit Cards (Cont…)
• When First Global pays Brad
– The Fed will debit its reserve account by $50 – And credit First National’s reserve account by $50
• The two balance sheets will look as follows
10/24/2009
299
Credit Cards (Cont…)
10/24/2009
300
Credit Cards (Cont…)
10/24/2009
301
Credit Cards (Cont…)
• M1 has increased to $350 • Now assume that Mark repays the outstanding on his card
10/24/2009
302
Credit Cards (Cont…)
10/24/2009
303
Credit Cards (Cont…)
• M1 is back to $300 • A card based transaction has monetary implications on two occasions
– First when the issuer pays the merchant – The second is when the cardholder repays the issuer – The card based transaction by itself just creates a liability
10/24/2009 304
Debit Cards
• These are an alternative to checks • When such a card is used
– Funds are immediately transferred by a debit to the holder’s account and a credit to the merchant’s
• In a check based transaction
– It is not the check that represents money – It is the balance in the checking account which backs the check which is treated as money
10/24/2009 305
Debit Cards (Cont…)
• The checking account balances are a part of M1 and M2 • Thus withdrawal limits on debit cards do not represent any addition to the amount of money in circulation
10/24/2009
306
The Money Multiplier
• The deposit multiplier is the reciprocal of the required reserve ratio • The monetary base is equal to the sum of
– Currency held by the public – Total reserves in the banking system
10/24/2009
307
The Money Multiplier (Cont…)
• We will use the following symbols
– H ? high powered money – C ? currency held by the public – TR ? total reserves in the banking system – D ? level of transactions deposits in the banking system – RR?? required reserves – ER ? excess reserves – r ? required reserve ratio
10/24/2009 308
The Money Multiplier (Cont…)
• If there are no excess reserves in the system
D = TR/r ? TR = rD
• Assume that the currency held by the public may be expressed as cD, where `c’ is the desired currency ratio • So: H = C+TR = cD + rD = (c+r)D • So the level of high-powered money is equal to the sum of the required reserve ratio and the desired currency ratio multiplied by the amount of deposits held in the banking system
10/24/2009 309
Money Multiplier (Cont…)
• M1 = C + D • Thus M1 = cD + D = (1+c)D • Thus the quantum of liquid money in the economy is equal to one plus the desired currency ratio multiplied by the amount of transactions deposits • M1 = (1+c)D = (1+c) x H ________ (r+c)
10/24/2009 310
Money Multiplier (Cont…)
• So for a given level of high-powered money, the amount of money in the economy as measured by M1 is a function of
– The required reserve ratio – The desired currency ratio
• If these ratios are constant then ?M1 = (1+c) x ?H _____ (r+c)
10/24/2009 311
Money Multiplier (Cont…)
• Thus a dollar’s increase in high-powered money will increase M1 by (1+c)/(r+c) • Since r is less than 1.0, this factor will always be greater than 1.0 • This factor is known as the MONEY MULTIPLIER
10/24/2009
312
Money Multiplier (Cont…)
• If the desired currency ratio is zero then the Money Multiplier = Deposit Multiplier • However if the desired currency ratio is > 0, which is normally the case Money Multiplier < Deposit Multiplier • This is because
–
•
Every time a bank makes a loan or an investment there will be a leakage
That is some money will exit the banking system
•
So the ability of banks to expand the money supply by making additional loans or investments is reduced.
313
10/24/2009
Excess Reserves
• Thus far we have assumed that there are no excess reserves in the banking system • That is TR = RR • In other words the banks are fully loaned up • In practice most banks keep excess reserves
– One reason is to facilitate larger than anticipated withdrawals – Or to deal with a sudden loan request
10/24/2009 314
Excess Reserves (Cont…)
• What would happen if there are no excess reserves
– A bank can borrow reserve funds in the FED Funds market – It can borrow directly from the FED at its discount window – Or recall loans made to borrowers – Or sell securities from its investment portfolio
10/24/2009
315
Excess Reserves (Cont…)
• TR = RR + ER • ? H = C + TR = c + RR + ER • Assume that the banks want to hold a fraction `e’ of their deposit liabilities as excess reserves ? ER = eD • Thus H = cD + rD + eD = (c+r+e)D • M1 = cD + D + (1+c)D = (1+c) x H _________ (c+r+e)
10/24/2009 316
Excess Reserves (Cont…)
• Thus in the presence of excess reserves the money multiplier is (1+c)/(r+e+c) • Thus the higher the level of excess reserves, the smaller will be the money multiplier
10/24/2009
317
Illustration
• Alfred receives a $100 bill which he deposits in a bank. • The required reserve ratio is 10% • Bob then receives a loan of $90 from the bank.
– He withdraws $25 as cash and deposits the balance $65 with the bank.
• The bank lends the money deposited by Bob to other parties till it has no excess reserves
– That is, the deposit base multiplies till it reaches the limit
10/24/2009 318
Illustration (Cont…)
• The total deposits in the banking system will be:
100 + 65/0.10 = $750
• The amount of cash with the public is $25 • The reserves in the banking system is $75 • Thus the amount of high-powered money is $100 while M1 = 25 + 750 = 775
10/24/2009
319
Illustration (Cont…)
• The cash to deposit ratio is 25/750 = 1/30 • The money multiplier is: (1 + 1/30)/(1/10 + 1/30) = 31/4 = 7.75 • Thus M1 = 775 = 7.75 x 100 = m x H
10/24/2009
320
Illustration (Cont…)
• Now assume that when Bob deposits $65 with the bank the bank decides to hold $15 as excess reserves • Thus the next borrower gets only $43.50 • If we assume no further leakages the deposit will get multiplied to $435 • The high powered money in the economy continues to be $100 • However M1 = 100 + 25 + 65 + 435 = $625
10/24/2009 321
Illustration (Cont…)
• The cash to deposit ratio is 25/600 = 1/24 • The excess reserves to deposit ratio is 15/600 = 1/40 • The money multiplier is: (1+1/24)/(4/40 + 1/40 + 1/24) = 25/4 = 6.25 • Thus M1 = 625 6.25 x 100 = m X H
10/24/2009 322
The Credit Multiplier
• When a bank receives a deposit
– It will maintain a portion as reserves
• Perhaps a combination of required and excess reserves
– And use the balance to make loans and investments
• The magnitude of loans and investments or the level of credit offered by the bank is: D – RR – ER = (1 – r – e)D
10/24/2009 323
The Credit Multiplier (Cont…)
• D = H/(r+c+e) • Thus the credit multiplier is • [(1-r-e)/(c+r+e)] x H
10/24/2009
324
Illustration
• • • • • The monetary base is $100 The required reserve ratio is 0.10 The cash to deposit ratio is 1/24 The excess reserves ratio is 1/40 The credit multiplier is: [(120-12-3)/120]/[(12+5+3)/120] = 5.25 • The amount of credit offered by the banking system is 5.25 x 100 = 525
10/24/2009 325
doc_191683280.pptx
This is a presentation highlights different functions of money, macroeconomic implications of money, inflation and economic indicators, market of CPI, measuring money (M1, M2, M3), monetary aggregates in India, sweep accounts, understanding circulation of money, money multiplier, credit multiplier.
Introduction to Money
What is Money?
• Anything that is acceptable to people as payment for
– Goods – Services – And financial assets
• Money is not just currency notes and coins
– These are a very small percentage of what is considered to be money in circulation
10/24/2009 2
Why is money held?
• It performs four major functions
– It serves as a medium of exchange – It serves as a store of value – It serves as a unit of account – It serves as a standard of deferred payment
10/24/2009
3
Medium of Exchange
• Money is a medium of exchange for most economic transactions • The growth of markets and the availability of a unit of currency have gone hand in hand • Money, in its various forms, is the only item of value that anybody and everybody will accept
10/24/2009
4
Barter
• Prior to the advent of money we had a barter system • What is barter?
– Exchange of goods and services for other goods and services
10/24/2009
5
Barter (Cont…)
• Barter posed certain problems • First, to sell the goods and services that we have we should be able to locate people who desire what we have and who are endowed with what we want • Second, a sale must be accompanied with a simultaneous purchase
– In practice the two will not usually coincide
10/24/2009 6
Barter (Cont…)
• Money made things easier • No longer necessary to exchange goods and services for other goods and services
– Everything can be valued in terms of money – Money also serves as the medium of exchange – A sale need not be accompanied with a simultaneous purchase
10/24/2009
7
Barter (Cont…)
• Barter is technically known as `Counter-trade’ • It may still be occasionally observed • Why?
– The buyer may not have access to enough hard currency
10/24/2009
8
Barter (Cont…)
• Freely convertible currencies are universally acceptable as a means of payment
– US dollar – British pound – Euro
• Rupee is not freely convertible
10/24/2009
9
Example of Barter
10/24/2009
10
Example (Cont…)
• This was a win-win situation for everyone
– The Russians paid partly in cash and partly in kind – AT&T got fully paid in hard currency – The Germans, who were the middlemen, also made some money in the process
10/24/2009
11
Store of Value
• Money serves as a store of value
– Gives people the freedom to save – To put aside funds to facilitate expenditure at a later point in time
• People who want to forego current consumption for future consumption can lend to those whose need for current consumption exceeds their current stock of wealth
10/24/2009 12
Store of Value (Cont…)
• All forms of money are not good preservers of value
– The value of currency erodes with time – What we call inflation
10/24/2009
13
Inflation
• What is inflation?
– It refers to the increase in the price level of an asset or service over time
• Currency notes and coins do not offer any protection against inflation • Financial assets like bonds and bank deposits are safer bets against inflation
– They provide a periodic interest stream (with the exception of checking accounts) – However bonds are vulnerable to price risk
10/24/2009 14
What is price risk?
• Price or market risk is the risk that the price of the asset may decline • In the case of bonds, prices and interest rates are inversely related
– Consequently a rise in interest rates may lead to a capital loss when the bond is sold
10/24/2009
15
Capital Loss?
• What is a capital loss?
– If the sale price of an asset is greater than the price paid for it at the time of acquisition we call it a Capital Gain – However if the sale price is less than the purchase price we term it a Capital Loss – Bank accounts are not vulnerable to a capital loss (unless of course the bank fails) – However bonds are susceptible
10/24/2009 16
Inflation (Cont…)
• Stocks, gold, and real estate generally provide a better hedge against inflation in the long-run
– In the short-run they are vulnerable to price risk – That is they can give rise to a capital loss
• These assets do provide an income stream
– Stocks provide dividends – Real estate provides rental income
10/24/2009
17
Gold
• Gold is an eternal favorite as a hedge against inflation
– However it does not provide income – The holder can only hope for capital gains – There is however a cost to storing gold
• Storage costs • Insurance costs
10/24/2009
18
Unit of Account
• One of the major advantages of currency is that it serves as a unit of account
– Every type of good, services, or financial asset has a price in terms of money
• This reduces the information required in terms of the number of prices
10/24/2009
19
Unit of Account (Cont…)
• Consider a 1,000 good economy • In the absence of money we would require
1000 x 999 _________ = 499,500 prices 2
• However if we were to have a form of currency we would require only 1,000 prices
– The information required is reduced by 99.80%
10/24/2009 20
A Standard of Deferred Payment
• Money serves as a standard of deferred payment • There are two categories of people in this world
– Those who have more than what they want – Those who want more than what they have
10/24/2009
21
Deferred Payment (Cont…)
• Money gives people the freedom to save • People whose current wealth exceeds their current needs can lend to others who have less wealth than what they currently require
10/24/2009
22
Deferred Payment (Cont…)
• Such wealth transfers may be made in various forms
– Investors may buy bonds and shares – They may deposit money with banks – May acquire shares of mutual funds
10/24/2009
23
Evolution of Money
• In the early days all trades were based on barter • The history of money began in the form of commodity money
– What is commodity money
• It is a physical good which is used for both monetary as well as non-monetary purposes.
10/24/2009
24
Evolution (Cont…)
• The next step was the development of a commodity standard • What is a commodity standard?
– It is a unit of currency whose value is backed by the value of a monetary good - typically a precious metal like gold or silver
• The final step was the evolution of modern money known as FIAT money
10/24/2009 25
Evolution (Cont…)
• What is fiat money?
– It is money issued by a fiat from the authorities – The central bank has the authority to issue money and to withdraw money from circulation, whenever it deems it appropriate
• FIAT money has no commodity backing
– It derives its utility solely from the fact that it is universally acceptable as a mode of payment
10/24/2009
26
Evolution (Cont…)
• These days we have gone a step further with electronic money or E-money • E-money obviates the need for standard forms of money like
– Notes – Coins – Checks
10/24/2009
27
Commodity Money
• A commodity which is used as a unit of money has multiple economic uses and not just as a medium of currency
– Primitive forms included shells and stones – Subsequently precious metals like gold and silver began to be used
10/24/2009
28
Commodity Money (Cont…)
• Why were precious metals popular as mediums of exchange
– They were
• Portable • Durable • Easily recognizable
– They were universally valuable
• Their relative scarcity • Use as items of value such as jewelry
10/24/2009 29
Commodity Standards
• The use of precious metals as units of money had a problem in practice
– Units of gold and silver have different market values
• Based on the inherent purity and density
• So before a vendor could accept such money he had to verify the purity and weight of the metal.
– This was time consuming and costly
10/24/2009 30
Commodity Standards (Cont…)
• To circumvent such problems people began to use standardized units of precious metals as money
– A system where the value of the medium of exchange depends on the value of gold is called a Gold Standard – Some countries adopted a silver standard – Others chose a bimetallic standard - value depended on both gold and silver
10/24/2009 31
Commodity Standards (Cont…)
• In practice citizens of countries using a metallic standard would take the metal to a goldsmith
– He would convert them to tokens of equal purity and weight – He would also emboss the tokens to facilitate verification that this had been done
• These metal pieces were the origin of coins in the economy
10/24/2009 32
Coins
• Such coins became popular rapidly
– Why?
• There were two reasons
– First, many merchants would only accept coins validated by a goldsmith’s stamp – Second, governments got in to the act of minting such money
• They either regulated or owned the mints that produced such coins
10/24/2009 33
Coins (Cont…)
• Why did the governments envisage a role for themselves?
– The first reason was to ensure that the public had confidence in the nation’s monetary system – Second they could make profits by minting such coins
• This was because the coins were issued at a face value in excess of the value of the precious metals contained in them • The difference obviously constituted a profit for the Treasury • This is known as `Seigniorage’ • This is a form of tax
– Constitutes a transfer of wealth from the citizens to the government
10/24/2009 34
Commodity Standards (Cont…)
• For a long time gold was the asset of reference of the international monetary system • Under the Gold Standard the foundation of a nation’s monetary system was the quantity of gold held by it • In practice gold was used for both
– Monetary as well as non-monetary purposes – The gold that was devoted to monetary use was termed as `Gold Bullion’ – Thus gold bullion was the monetary base or the foundation of the monetary system
10/24/2009 35
Commodity Standards (Cont…)
• In practice goods and services were not directly valued in terms of gold
– And nor was gold used directly as currency
• Prices were measured in terms of a currency unit such as the Dollar • Such currency, both in the form of coins, as well as paper, performed the role of money
10/24/2009
36
Commodity Standards (Cont…)
• The currency’s value was directly linked to gold in the form of a rate of exchange • In most cases the monetary system was managed by a central bank
– It stood ready to freely convert dollars to gold and gold to dollar at a specified exchange rate
• Consequently
– Nobody could sell gold at a higher rate or buy it at a lower rate
10/24/2009 37
Commodity Standards (Cont…)
• Once the central bank fixed the exchange rate they could influence the quantity of money by regulating the ratio of currency issued by private mints or banks relative to the amount of gold held by them
– In other words the central banks would set the Gold Reserve Ratio
10/24/2009
38
Commodity Standards (Cont…)
• For a long time coins were the sole items of currency
– People believed that their inherent metal content was the source of their value
• However, gradually governments began to debase the coins
– They reduced the gold base by mixing other metals like Copper and Bronze
• This increased the income from seigniorage
• Such debasement broke the link between the value of the money unit and the value of the base commodity
10/24/2009
39
Paper Money
• Paper money was the next step • American colonists began to accept a paperbased commodity standard
– Those days precious metals were scarce in America – So paper money was issued backed by the value of European coins – Thus there was an indirect linkage to precious metals
10/24/2009 40
Paper Money (Cont…)
• This indirect approach was subsequently abandoned and governments in America began issuing bills of credit that they promised to redeem in the future • This was used by the governments
– To acquire goods and services – Spend on public works
10/24/2009
41
Paper Money (Cont…)
• Parties which acquired paper money from the government could use such bills as a medium of exchange • The faith of people in such money was based on the belief that the government could always raise resources by way of taxes to redeem the bills
10/24/2009
42
FIAT Money
• Bills of credit were the first step towards a modern monetary system • Modern money is FIAT money
– It is not linked to any underlying commodity
• The value is based on the faith of the people that the government will honor the currency issued
– Money derives its value solely from the fact that it is accepted by everyone as a medium of exchange
10/24/2009 43
FIAT Money (Cont…)
• The money supply consist of notes issued by the central bank
– In the US it is the Federal Reserve
• In addition depository institutions (primarily banks) issue fiat money by allowing people to operate checking accounts
10/24/2009
44
Common Terms Associated with Money
• Buck: Early settlers in North America used deer skins to finance their trades . Every skin was referred to as a BUCK • Pecuniary: Means relating to money. Comes from the Latin word PECUS, which means cattle • Fee: Based on the German word VIEH, which means cattle
10/24/2009 45
Common Terms (Cont…)
• Shell Out: People in North America used shells as units of currency. This lead to the phrase • Salary: In the earlier days soldiers in Rome were paid a part of their wages in the form of salt. Salt in Latin is known as SALARIUM • Dollar: A count in Czechoslovakia began minting coins known as TALERGROSCHEN, which was shortened to TALERS. The word dollar was derived from this.
10/24/2009 46
Macroeconomic Implications of Money
• The amount of money in circulation has implications
– For the level of prices – And other factors like the level of employment
• Too much of money chasing too few goods can lead to an increase in the price level, which we term as INFLATION
10/24/2009
47
Inflation (Cont…)
• A bottle of beer costs $2.50 at the beginning of the year • The same bottle costs $2.75 at the end of the year • The rate of inflation is 2.75 - 2.50 _________ x 100 = 10% 2.50
10/24/2009 48
Inflation (Cont…)
• In real life we do not measure inflation by analyzing the change in price of a single good. • Economists track price indices, which measure the price of a basket of goods and/or services
10/24/2009
49
Macroeconomic Factors (Cont…)
• Too much of money leads to inflation • However too little of it also causes problems • If there is too little money in circulation, supply of goods and services will exceed the demand • This will cause businesses to reduce production levels and possibly lay off workers
10/24/2009
50
Macroeconomic Factors (Cont…)
• If the problem were to persist it could lead to an economic recession or a reduction in the economy’s level of output • A sustained recession will eventually lead to an increase in the level of unemployment
10/24/2009
51
Inflation and Economic Indicators
• There are various statistics that we can use to gauge the level and impact of inflation • The Department of Labor in the US publishes the Consumer Price Index (CPI) every month, based on the prices in the previous month, of items in a representative `market basket’ • The index is based on the price changes of 80,000 items that represent a cross-section of goods and services purchased by urban households
– Such consumers represent about 87% of the US population
10/24/2009 52
Economic Indicators (Cont…)
• The CPI is released at 8:30 Eastern Time during the second or third week following the month being covered • Why is the CPI important?
– It is because inflation touches everyone
10/24/2009
53
Economic Indicators (Cont…)
• Inflation determines:
– – – – How much consumers pay for goods and services The cost of capital for businesses The value of personal and corporate investments The lifestyle of retired people
• It has implications for the benefits received by people getting Social Security payments • Landlords use it to fix future rentals on property • Judges use it to fix alimony and child support payments
10/24/2009 54
Economic Indicators (Cont…)
• The categories of goods and services on which the CPI is based are divided into eight major groups • Each group is then given a weight that signifies its importance • The weights are revised every two years to adjust for changing tastes and priorities
10/24/2009
55
Economic Indicators (Cont…)
• As of 2007 the weights were : • Housing 42.40%
– Shelter 32.30% – Fuel and Utilities 5.40% – Household furnishings and operations 4.70%
• • • •
Food and Beverages 15% Medical Care 6.20% Apparel 3.80% Recreation 5.60%
56
10/24/2009
Economic Indicators (Cont…)
• Education and Communication 6.0% • Other Goods and Services 3.50% • Transportation 17.40%
– Private Transportation 16.30%
• • • • New Vehicles 5.20% Motor Fuel 4.20% Maintenance and repairs 1.10% Used cars and trucks 1.80%
– Public transportation 1.10%
10/24/2009 57
Economic Indicators (Cont…)
• The Bureau of Labor Studies (BLS) collects price information from 23,000 retail and service businesses. • The businesses chosen are the types frequented by a sample of 14,500 families. • In practice two measures of inflation are often reported
– Core and – Non-core
10/24/2009 58
Economic Indicators (Cont…)
• Core does not include the cost of food and energy • Non-core includes everything • The FED looks at core inflation while taking steps to target the interest rate • This is because while food and energy (particularly) gasoline prices are volatile, the FED’s policy tools are slow-acting.
– Consequently the FED will desist from taking steps until the impact of a price rise has trickled through to the prices of other goods and services.
10/24/2009 59
Economic Indicators (Cont…)
• The CPI is the inflation index of direct relevance to the individual. • Consequently the FED tracks it closely. • A surge in the CPI will usually cause the FED to reduce the money supply
– This will result in a rise in interest rates
10/24/2009
60
Inflation
• What causes inflation and what are its implications for the economy • The monetarist school believes that inflation is caused by excessive growth in the money supply • If the growth rate of money supply is greater than the growth in the output of goods and services
– It means that too much of money is chasing too few products – Which will eventually show up in the form of inflation
10/24/2009 61
Inflation (Cont…)
• The Keynesian school believes that inflation is caused primarily by the overall demand for goods and services • It argues that when overall demand
– From consumers – Businesses – Government – Foreign buyers Exceeds the supply, the resulting shortage causes inflation
10/24/2009 62
Inflation (Cont…)
• The rate at which inflation increases depends on where the economy is in the business cycle • In other words it depends on how much production slack is available in the economy • A powerful pickup in demand immediately following a recession is usually not inflationary because there will be adequate idle capacity • However later on in the cycle, when material and labor resources become scarce, rising demand can cause a sharp increase in the price level
10/24/2009 63
Inflation (Cont…)
• Is inflation necessarily bad?
– Rising prices allow companies to generate greater revenues – This can boost stock prices
• Which will benefit shareholders
– Governments count on inflation to generate more tax revenues
• This helps to fund government spending programs and reduce the budget deficit
10/24/2009 64
Inflation (Cont…)
• But obviously there are negatives about inflation
– It creates a climate of instability and uncertainty – Firms love rising profits
• But they would rather accomplish by selling more instead of raising prices • Besides they also stand to lose from rising input costs • The cost of labor is also likely to rise due to inflation
10/24/2009
65
Inflation (Cont…)
• From the government’s standpoint
– While inflation brings in more tax revenue – It can also turn voters against the government
• Sometimes however, a dash of inflation may be deliberately sought
– This can happen if the economy comes face to face with deflation or a downward price spiral
10/24/2009
66
Inflation (Cont…)
• Why is deflation bad?
– It leads to falling prices which benefit consumers – But lower prices means lower corporate profits – This can lead to job layoffs – Higher unemployment shows up as reduced consumer expenditure – This can cause further layoffs
• During the Great Depression in the US the CPI dropped 24%
10/24/2009 67
Inflation (Cont…)
• So the goal of the government and the FED is to avoid both inflation and deflation by following policies that promote price stability
– In practice central banks target a modest level of inflation
• Say 1-2% per year
10/24/2009
68
Market Impact of CPI
• An unexpected increase in the CPI can cause bond prices to sharply decline • A benign CPI report is bullish for bond markets • So when inflation is low, bond prices trend upwards • Rising CPI also indicates that the cost of borrowing for corporates will rise • Inflation will usually cause the FED to intervene and raise interest rates which is a negative for shareholders
10/24/2009 69
Market Impact (Cont…)
• It can be argued that inflation boosts the topline and perhaps even the bottomline • But shareholders value rising profits due to enhanced sales and productivity and not profits due to price hikes. • This is because such hikes may not be sustainable • They may cause sales to dip • They may reduce competitiveness
10/24/2009 70
Economic Indicators (Cont…)
• Another measure of the level of inflation is the Producer Price Index (PPI)
– It measures the average changes in prices received by domestic producers for their output
• Until 1978 it was referred to as the Wholesale Price Index (WPI)
• Data is collected by sampling producers in
– Manufacturing – Mining – Service
industries
10/24/2009 71
Economic Indicators (Cont…)
• There is actually a family of PPI indexes which are computed
– However each of these is based on the same pool of price information – The three most important are
• Industry based indexes • PPI commodity index • Stage of processing indexes
10/24/2009
72
Economic Indicators (Cont…)
• In India too we had a Whole sale Price Index (WPI) till 1978 • In that year it was replaced by the Producer Price Index. • The index is used to measure the change in the average price level of goods traded in the wholesale market
– A total of 435 commodity prices are used to compute the index – It is available on a weekly basis
10/24/2009 73
Defining and Measuring Money
• There is no unique definition as to what is money • One schools says - `Money is the aggregate of assets that can be deployed for making immediate payments’ • Obviously the following will qualify
– – – –
10/24/2009
Paper Money Coins Checking Accounts Traveler’s Checks
74
Defining...(Cont…)
• Others say that this definition is too narrow
– Money is not just a medium of exchange, it is also a store of value
• Thus assets like savings account deposits and other assets which can easily be converted to a medium of exchange should also be counted
10/24/2009
75
Liquidity
• The crux of the debate is liquidity • What is a liquid asset?
– An asset is said to be liquid if it can be easily converted to cash and vice versa
• The first school believes that a liquid asset
– Is not something that can be converted to cash – But rather is what constitutes cash itself
• Something that can be used as a medium for acquiring goods and services
10/24/2009 76
Liquidity (Cont…)
• The second school believes that in practice other assets such as savings account balances can be easily converted to cash • According to them – money is not just cash but should also include cash-like assets
10/24/2009
77
The Monetary Base
• The monetary base, also known as High Powered Money, is the narrowest measure of money • Refers to money produced directly by the actions of
– The government or the central bank
10/24/2009
78
The Monetary Base (Cont…)
• In the U.S., the monetary base is
– Sum of currency held with the public – Plus the reserves held by depository institutions
• What do we mean by Public?
10/24/2009
79
Definition of Public
• It excludes
– Domestic US Banks – The US Treasury – The Federal Reserve
• It includes
– All foreign households – Foreign businesses – Foreign governments – International organizations
10/24/2009 80
M1
• M1 is a broader definition.
– It views money purely as a medium of exchange
• It has three components
– Currency – Traveler’s checks issued by non-banking institutions – Transactions deposits held at depository institutions
10/24/2009 81
M1 (Cont…)
• The currency component of M1 is the same as what is included in the monetary base • Who are non-banking institutions and why is it that only TCs issued by them are counted
– Examples are American Express and Thomas Cook – The reason why only their TCs are included is that when a conventional bank issues TCs it places the money required to redeem such instruments in special transactions deposits which are already included
10/24/2009 82
Transactions Deposits
• What are transactions deposits?
– They include checking account referred to as Current Accounts in India – Checkable accounts like
• Negotiable Order of Withdrawal or (NOW) Accounts • ATS (Automatic-Transfer-System) Accounts
10/24/2009
83
Types of Bank Deposits
• Deposits can be classified into four categories
– Demand deposits – Savings deposits – Time deposits – Hybrid deposits
10/24/2009
84
Demand Deposits
• What is a demand deposit?
– `A demand deposit in one where the bank is required to honor immediately, any withdrawals made by the account holder, either in person or by designating a third party as the beneficiary’
• They are meant for day to day banking needs
– Balances can be used to pay the bills of third parties from whom goods and services have been procured
10/24/2009 85
Demand Deposits (Cont…)
• They are called Checking Accounts in the US
– Because account holders can write checks against their balances – They have traditionally been non-interest bearing in the US – The same is true in India
10/24/2009
86
Savings Accounts
• What is a savings account?
– `it is an account that is designed to attract funds from customers who wish to set aside money in anticipation of planned as well as unanticipated future expenses’
• In practice the account holder can make deposits and effect withdrawals as desired • Legally the bank can insist on notice prior to a withdrawal
– This provision is rarely if ever invoked
10/24/2009 87
Savings Accounts (Cont…)
• In the US savings accounts, unlike in India, do not offer check writing facilities • Regulations limit the withdrawals, payments, and transfers that an account holder may perform • The deposit holder is permitted to make up to 6 transfers or withdrawals per month or statement cycle (of at least 4 weeks duration)
10/24/2009 88
Savings Accounts (Cont…)
• The bank may authorize up to 3 of these payments to be made by check, draft, debit card or similar order, to third parties
10/24/2009
89
Time Deposits
• These are deposits with a fixed maturity date
– What we call fixed deposits in India
• They pay higher interest than savings accounts
– But there are penalties for premature withdrawals
• By law such deposits must have a minimum maturity of 7 days • In practice they have a duration of 30, 60, 90 or 180 days
10/24/2009 90
Time Deposits (Cont…)
• In the US such deposits are referred to as CDs – Certificates of Deposit • CDs can be of two types
– Negotiable and – Non-negotiable
10/24/2009
91
Non-Negotiable CDs
• They cannot be transferred from one party to another • They represent a customized contract between the bank and the depositor • They are used mainly by retail investors • They tend to have small denominations
10/24/2009
92
Negotiable CDs
• Can be freely transferred from one party to another
– They are marketable securities
• They tend to be of large denominations
– Usually a multiple of 1MM USD
• They are used primarily by institutional investors
10/24/2009
93
Hybrid Accounts
• They have features of more than one type of account • Prominent examples are
– NOW accounts – Money Market Deposit accounts – Automatic Transfer Services
10/24/2009
94
NOW Accounts
• These can be used like checking accounts to pay for goods and services • Unlike checking accounts they pay interest • They can be held only by individuals and nonprofit organizations • Legally the bank can insist on prior notice of withdrawal
– But such a provision is rarely invoked
10/24/2009 95
Money Market Deposit Accounts
• Let us first consider a money market mutual fund • A mutual fund is an entity that pools the investment made by its shareholders and invests the corpus in the securities markets. • Money market funds are specialized funds that invest exclusively in money market securities
– Debt securities with an original term to maturity of one year or less
10/24/2009
96
MMDA (Cont…)
• Money market securities are
– Short-term in nature – Highly liquid – Carry a low risk of default
• Such funds began to permit shareholders to write checks against their balances • Thus they began to compete directly with banks for attracting investments
10/24/2009 97
MMDA (Cont…)
• Money market mutual funds offered market determined rates of return
– Which was higher than what banks were offering
• So banks were losing business to MMMFs • MMDA accounts were a response to such funds • With government approval, banks began to offer short-term deposits on which they could pay competitive rates of interest
10/24/2009 98
MMDA (Cont…)
• These accounts permit up to 6 pre-authorized withdrawals per month to pay third parties • But only three of these withdrawals may be by way of issuing checks to third parties • There is no limit on the number of withdrawals for personal use • Banks reserve the right to set minimum limits for each withdrawal and to regulate the frequency of such withdrawals • Unlike NOW accounts, such accounts can be held by a business
10/24/2009 99
Automatic Transfer Services
• An ATS is a combination of a checking and a savings account • Funds are primarily maintained as savings deposits
– Thus they earn interest
• Checks can be issued against balances in the checking account with a proviso that
– In the event of an overdraft funds will be automatically transferred from savings to checking
10/24/2009 100
M2
• Both high-powered money and M1 are definitions of CASH MONEY
– They include only highly liquid assets
• High-powered money measures funds made directly available by the Treasury and the FED • M1 measures funds more broadly available to the public
10/24/2009
101
M2 (Cont…)
• M2 is a broader measure of money • It treats money not just as a medium of exchange but also as a store of value • It includes
– M1 – Savings accounts – Small denomination (less than $100,000) time deposits excluding retirement accounts – Money market deposit accounts – Shares of money market mutual funds other than those held by institutions
10/24/2009 102
M2 (Cont…)
• Investments in MMMFs are made by
– Individuals – Brokers – Dealers – Financial institutions
• The FED is of the opinion that institutional investments in such funds are not very liquid • Thus only investments made by individuals and broker-dealers are included
10/24/2009 103
M3
• This is an even broader definition of money • It includes
– M2 – Time deposits with a denomination of $100,000 or more held with depository institutions – Terms repos and term Eurodollars – Repos at depository institutions and ED deposits held by US residents (other than banks) at foreign branches of US depository institutions – Shares of MMMFs held by institutions
10/24/2009 104
Repos
• A repurchase agreement is an arrangement by which a borrower raises money by selling securities with an agreement to buy back, usually on the following day, at a higher price
– So a repo is a collateralized loan – The difference between the purchase and sale prices constitutes the interest for the loan
• Most repos are over-night transactions • Those for a longer period are referred to as Term Repos
10/24/2009 105
Repos (Cont…)
• From the borrower’s perspective such transactions are called repos • From a lender’s perspective they are called reverse repos • Thus every repo must be matched with a reverse repo
10/24/2009
106
Eurodollars
• What is a Eurocurrency?
– `it is a freely traded currency deposited in a bank outside its country of origin’ – Eurodollars are dollars deposited outside the US – Euroyen are yen deposited outside Japan
10/24/2009
107
Market for EDs
• The rapid growth of the ED market was due to various factors • There was a high demand for the US dollar as an international vehicle currency
– By the end of WWII the US was the most dominant country – So the dollar became the most preferred currency for global trade
10/24/2009
108
Market for EDs (Cont…)
• East European countries wanted to hold dollar balances to fund their imports
– But a Cold War was on – So they were reluctant to hold dollar balances with US banks
• What if deposits were impounded by the US government
– So they began opening dollar accounts with banks in Europe
10/24/2009 109
Market for EDs (Cont…)
• European banks soon realized that there was an active market for such dollars • As a consequence an active ED market came into existence • These days the ED market extends beyond Europe
– We have active markets in Hong Kong, Singapore and Tokyo – These are called Asian Dollar markets
10/24/2009 110
Markets for EDs (Cont…)
• Through a legislation called Regulation Q, the US government imposed low interest rate ceilings on US banks
– That is they could not offer more than the stipulated rate to their depositors
• The FED also imposed significant reserve requirements
10/24/2009
111
Reserves
• What is a reserve?
– When a unit of currency is deposited with a bank, only a fraction can be lent out – The balance has to be kept in the form of approved government securities or as cash – In India we have the Statutory Liquidity Ratio (SLR) and the Cash Reserve Ratio (CRR)
10/24/2009
112
SLR
• The SLR provision requires banks to maintain an amount equivalent to 24% of their demand and time liabilities in the following forms
– Cash – Gold valued at a price not exceeding the current market price – Unencumbered approved securities valued at a price as specified by the RBI from time to time
10/24/2009
113
SLR(Cont…)
• The upper limit for SLR is 40% • The lower limit is 24% • The current requirement is 24%
10/24/2009
114
CRR
• An additional reserve has to be maintained in the form of a deposit with the RBI
– This is known as the Cash Reserve Ratio – The current requirement is 5%
10/24/2009
115
Reserves (Cont…)
• The lower the reserve ratio the more is the money available with the bank for commercial lending • So the lower the reserve ratio
– Higher will be the rate paid on deposits – Lower will be the lending rate
• Thus the spread or the Net Interest Margin (NIM) for the bank will be lower
– NIM is the difference between a bank’s lending rate and its borrowing rate
10/24/2009 116
EDs (Cont…)
• There are virtually no government regulations on ED deposits
– For instance there are no reserve requirements – However even if statutorily there are no reserve requirements , most banks will keep some reserves as a matter of caution
10/24/2009
117
EDs (Cont…)
• The ED market got a big boost due to the large flow of Petrodollars • After the 1973 war, OPEC countries hiked their crude oil prices
– Thus Arab nations were flush with funds – Most of this money flowed into the ED market
10/24/2009
118
EDs (Cont…)
• Why did petrodollars flow to European banks?
– No reserve requirements – Low cost of operations due to economies of scale – Thus banks could accept deposits at relatively higher rates and make loans at relatively lower rates
• In other words they could afford to operate with a lower NIM
10/24/2009
119
US Monetary Aggregates
10/24/2009
120
US Aggregates (Cont…)
10/24/2009
121
US Aggregates (Cont…)
10/24/2009
122
Monetary Aggregates in India
• The RBI defines five measures of the money supply
– The narrowest is M0 – The broadest is M4
10/24/2009
123
Definition (Cont…)
• M0: is known as RESERVE MONEY
– Consists of currency in circulation + bankers’ deposits with the RBI + Other deposits with the RBI
• M1: This is equal to
– Currency with the public + demand deposits with the banking system + other deposits with the banking system
10/24/2009 124
Definition (Cont…)
• M2: This is defined as
– M1 + Savings deposits with Post Office Savings Banks
• M3: This is equal to
– M2 + Time deposits with the banking system
• M4: This is the broadest aggregate It is equal to
– M3 + all deposits with Post Office Savings Banks
10/24/2009 125
Types of Accounts offered by Indian Banks
• Banks in India generally offer four kinds of accounts. These are:
– Current accounts – Savings accounts – Recurring deposits – Fixed deposits
10/24/2009
126
Types of Accounts (Cont…)
• Current accounts correspond to checking accounts in the US • There is no limit on the number of transactions or the amount of transactions on any given day • Such accounts are normally used by businesses
– An individual may opt for it if he has to make frequent check payments to third parties
• Like in the US banks do not pay interest on such deposits
10/24/2009 127
Types of Accounts (Cont…)
• Savings accounts are used primarily by individuals • Unlike in the US banks in India permit account holders to write checks • Most banks have stipulated rules for
– The maximum # of withdrawals in a specified period – And for the maximum amount that can be withdrawn
10/24/2009 128
Types of Accounts (Cont…)
• These rules are rarely, if ever, enforced • If a bank were to feel that an account holder is seeking to enjoy the interest benefit while using it as a current account from the standpoint of issuing checks, it can impose restrictions on withdrawals • The rate of interest is fixed by the RBI
10/24/2009
129
Types of Accounts (Cont…)
• Recurring deposits are for investors seeking to set aside funds periodically in order to build a corpus
– Usually a fixed amount has to be deposited every month – The minimum deposit is usually Rs 100 – Failure to make a scheduled deposit will attract a penalty – Premature withdrawals will attract a penalty
10/24/2009 130
Types of Accounts (Cont…)
• A new innovation is an FRD (Flexible Recurring Deposit)
– The investor has to choose a base amount – This is usually a minimum of Rs 500 and multiples of Rs 100 for larger amounts – The minimum chosen must be deposited every month – However if excess funds are available in a particular month, a higher amount subject to a ceiling which is usually 10 times the base amount may be deposited
10/24/2009
131
Types of Accounts (Cont…)
• Fixed deposits in India are like time deposits in the US
– They pay higher interest – But require commitment of funds for a fixed period – Premature encashment is possible but usually attracts a penalty
• Typically a reduction in the rate of interest paid
– Banks can offer any rate of interest that is required to attract and hold such deposits
10/24/2009 132
Monetary Statistics for India
10/24/2009
133
Statistics (Cont…)
10/24/2009
134
Statistics (Cont…)
10/24/2009
135
Creation of Coins and Currency
• The US Mint produces coins • The US Bureau of Engraving and Printing (BEP) prints paper currency • Both are operated by the Treasury
10/24/2009
136
Creation (Cont…)
• The Mint is headquartered in Washington DC
– It has facilities in
• • • • Denver, Colorado Philadelphia San Francisco West Point (New York State)
• The BEP has production facilities in
– Washington DC – Forth Worth, Texas
• The coins and currency are sold to the twelve Federal Reserve banks
10/24/2009 137
Facilities in India
• Production of coins and currency in India is undertaken by Security Printing & Minting Corporation of India Ltd. (SPMCIL) • It is wholly owned by GOI • It controls 4 mints
– Hyderabad – Kolkata – Mumbai – Noida
10/24/2009 138
Facilities in India (Cont…)
• There are two currency note presses
– Nashik Road – Dewas
• They have a combined capacity of printing in excess of 5.5 billion pieces of currency of different sizes and denominations
10/24/2009
139
Reserve Requirements in the US
• A reserve is that portion of a bank’s assets that have not been lent out or invested, but are held in a form readily available for use. • Legal reserves in the US take two forms
– Currency held in the vaults of the banks (Vault Cash) – Deposits held by the bank with the Federal Reserve
10/24/2009
140
Reserve Requirements
• Reserve requirements have implications for the ability of the banks to create money
– A bank can only lend what remains after accounting for required reserves
• As per law the FED can impose a reserve requirement ranging from 8-14% on transactions deposits • And up to 9% on non-personal time deposits
10/24/2009 141
Reserve Requirements (Cont…)
• Transactions accounts are checking and other accounts from which payments can be made to third parties • Non-personal time deposits are fixed deposits held by entities other than individuals and sole proprietorships • The FED can also impose any reserve that it deems appropriate on the amount that US banks owe on a net basis to their foreign affiliates or other foreign banks
10/24/2009 142
Reserve Requirements (Cont…)
• To reduce the reserve burden, the law provided that reserves would only be 3% of the first 25MM of transactions accounts
– And that this figure would be adjusted annually by a factor equal to80% of the percentage change in total transactions account in the US
10/24/2009
143
Reserve Requirements (Cont…)
• Subsequent legislation stipulated that the first 2MM dollars of a bank’s deposits would attract NIL reserves
– This will be adjusted upward if the quantum of deposits held by US banks were to increase – But there will be no downward adjustment if there were to be a decline in the deposit base
10/24/2009
144
Requirements as of 1 January 2009
10/24/2009
145
Reserve Requirements (Cont…)
• These figures are for transactions deposits • Currently non-personal time deposits are exempt from reserve requirements
10/24/2009
146
Reserve Maintenance
• The reserve requirement is calculated on a daily average basis over a two-week period
– This is called the Reserve Computation Period – Stretches from a Tuesday to a Monday 2-weeks later – To determine the required legal reserves the FED will calculate the daily average of transactions deposits held during the period and multiply it by the required percentage
10/24/2009 147
Reserve Maintenance (Cont…)
• The reserves held by a bank must equal the required amount over a two-week period
– Known as the Reserve Maintenance Period – It starts on a Thursday 17 days after the computation period ends – It ends on a Wednesday 2-weeks later
• While computing the level of required reserves, vault cash is adjusted
10/24/2009 148
Reserve Maintenance (Cont…)
• In practice the process involves three 14-day periods. • These are
– The base computation period – The vault cash computation period – The reserve maintenance period
10/24/2009
149
Reserve Maintenance (Cont…)
• Assume that today is Tuesday the 13th of October 2009 • A new base computation period will commence today and will end on Monday the 26th of October • The required reserves are calculated by multiplying the average checking account balance during this period, by the required reserve ratio
10/24/2009 150
Reserve Maintenance (Cont…)
• The corresponding vault cash computation period will commence on Tuesday the 27th of October and will end on Monday the 9th of November • During this period the bank will compute its average vault cash holdings • The reserve deposit requirement for the base computation period = Required reserves – Average Vault Cash
10/24/2009 151
Reserve Maintenance (Cont…)
• The reserve maintenance period will commence on Thursday the 12th of November and will end on Wednesday the 25th of November. • The average balance in the reserve account at the FED, during this period must be greater than or equal to the reserve deposit requirement
10/24/2009 152
Reserve Maintenance (Cont…)
• If there is a shortage or a surplus, it can be carried over to the next period • However if the deficit is more than 4% of the reserve deposit requirement, the FED will levy a fine
– This is equal to 2% more than the FED’s discount rate multiplied by the deficit
10/24/2009
153
Reserve Maintenance (Cont…)
• The next base computation period will commence on Tuesday the 27 of October • Thus the computation calendars overlap • That is banks are continuously satisfying reserve requirements • But are doing it with a consistent one month lag
10/24/2009
154
Sweep Accounts
• Excess reserves do not earn any income for the banks
– Vault cash and reserves at the FED are non-interest earning
• Banks make money by commercial lending • So while reserves are essential for contingency purposes they are costly • One way of reducing the reserve burden and the related opportunity cost is by using sweep accounts
10/24/2009 155
Sweep Accounts (Cont…)
• The reserve requirement for sweep account is nil • By sweeping un-needed balances from a checking to a sweep account the bank reduces the reserve requirement and the associated cost • This is commonly done on weekends
10/24/2009
156
Sweep Accounts (Cont…)
• At the close of business on Fridays the bank’s computers will reclassify checking accounts as Money Market Deposit Accounts on which the reserve requirement is zero • The funds are switched back at the opening of business on Monday • This reduces the bank’s reserve requirement because the 14-day balance averaging period includes week-ends
10/24/2009 157
Sweep Accounts (Cont…)
• These weekend sweeps can reduce average balances significantly – by reducing the balance to zero on 4 out of 14 days • However MMDA accounts require the bank to pay interest • This interest expense partially offsets the opportunity cost savings achieved by reducing required reserves
10/24/2009 158
Creation of Money by Banks
• Reserve requirements have implications for
– The deposit base of financial institutions – And consequently the creation of money
• Consider a simple economy with five people
– Alfred – Brad – Charlie – Doug – Eric
10/24/2009 159
Creation…(Cont…)
• • • • • Brad has 75 bushels of wheat Charlie has 60 bushels of corn The price of wheat is $5 per bushel The price of corn is $4 per bushel Alfred is a government employee who has to be paid a monthly salary of $100
10/24/2009
160
Creation…(Cont…)
• The Fed will create this currency • That is the US government will issue bonds worth $100 • In return it will get $100 in currency from the Fed • The Fed’s balance sheet at this stage may be depicted as follows.
10/24/2009
161
Creation…(Cont…)
10/24/2009
162
Creation…(Cont…)
• At this point in time
– Money in circulation is $100 – The monetary base is $100 – M1 = M2 = $100
• If there is no bank in the economy
– Alfred can buy 20 bushels of wheat from Brad – Brad can buy 25 bushels of wheat from Charlie – The amount of money in circulation is $100
10/24/2009 163
Creation…(Cont…)
• Let us introduce a bank called First National • Alfred buys 20 bushels of wheat from Brad who deposits the money with the bank • The required reserve ratio is 10% • Thus the bank has to keep $10 as reserves • But can make loans worth $90 • Assume it loans $90 to Doug
– He buys another 18 bushels from Brad – Brad deposits the money with First National
10/24/2009 164
Creation…(Cont…)
• First National has to keep a statutory reserve of $9 • It can therefore lend $81 • Assume that it makes a loan of $81 to Eric
– He buys 20.25 bushels from Charlie – Charlie deposits the money with First National
• After this transaction
– Brad has a bank balance of $190 – Charlie has a bank balance of $81
10/24/2009 165
Creation…(Cont…)
• The amount of money as measured by the ability of people to pay for goods and services is: 190 + 81 = $271 • Now let us extend the analysis to include more people
– Each time a person makes a deposit with a bank it can loan out 90% of the amount to someone
10/24/2009
166
Creation…(Cont…)
• The creation of money due to the initial deposit of $100 follows the sequence given below
100 + .9x100 + .9x90 + .9X81 + …… • In general if the amount deposited is D and the reserve ratio is r the sequence may be stated as D + (1-r)xD + (1-r)2xD + (1-r)3xD +…. • Since r <1, the series will converge to D/r
10/24/2009 167
Creation…(Cont…)
• In our case since the required reserve ratio is 10% , and the amount initially deposited is $100 the money in circulation can increase to a maximum of 100/0.10 = $1000 • The extension of loans by commercial banks has an impact on the deposit base
– Because borrowers usually prefer to keep the proceeds as bank deposits rather than in the form of cash
10/24/2009 168
Creation…(Cont…)
• In practice the deposit base cannot be enlarged without limit • Because very time a bank accepts a deposit it is undertaking an obligation to clear checks issued by the depositor
– Thus a contingency fund is required – This is precisely the concept of a reserve
10/24/2009
169
Creation…(Cont…)
• Thus an original cash deposit of $100 by a customer can create a deposit base of $1,000 by a process of expansion • The deposit multiplier in this case is 10
– The reciprocal of the reserve ratio
10/24/2009
170
Creation…(Cont…)
• In practice if Brad deposits $100 it may not lead to an increase of $1000 in the deposit base.
– What if Charlie withdraws $11 as cash and deposits $70 with the bank – Assume that this cash does not subsequently reenter the banking system – The $70 deposit if allowed to multiply to its logical limit will lead to an aggregate deposit of $700
10/24/2009 171
Creation…(Cont…)
• In this case Brad has $190 • Charlie has $11 in cash • Charlie and other depositors together have $700 with the bank • The total amount of money in the economy is 190 + 11 + 700 = $901
10/24/2009
172
Creation…(Cont…)
• Withdrawal of cash without their subsequent deposit into the banking system is called a LEAKAGE • Greater the leakage
– The smaller is the money multiplier
• There is yet another reason why the deposit base may not reach its theoretical limit
– What if the bank is unable to find new borrowers after a point – For instance if Charlie deposits $81 and there are no further demands for loans the deposit base will only be 190+81 = $271
10/24/2009 173
Accounting for Brad’s Initial Deposit
10/24/2009
174
Accounting for Doug’s Loan and the subsequent deposit by Brad
10/24/2009
175
Accounting for the loan to Eric and the subsequent deposit by Charlie
10/24/2009
176
Reserves
• Since vault cash is counted as reserves the bank has $100 as reserves
– 10% of the deposits or $27.1 in this case is the required reserve – Thus the bank has excess reserves of $72.90 – This can be used to make additional loans – Or may be invested in securities
10/24/2009
177
Reserves (Cont…)
• In practice all reserves need not be held as vault cash
– In practice most reserves are maintained as deposits with the Fed – Assume that First National retains $15 as cash – And transfers $85 to the Fed – The Fed will withdraw this money from circulation
10/24/2009
178
Fed’s Balance Sheet after this transaction
10/24/2009
179
A Second Bank
• We will now introduce a second bank First Global • When Brad gets $100 he deposits it with First National • The same occurs when he receives $90 after the second transaction
– The bank has $100 as vault cash – The requires reserve is $19 – Thus it has excess reserves of $81
10/24/2009 180
A Second Bank (Cont…)
• Charlie borrows $81 from First National but deposits it with First Global • If so, $81 will be transferred from First National to First Global
– The Fed will debit the reserve account of First National and credit the reserve account of First Global
10/24/2009
181
The Fed’s Balance Sheet
10/24/2009
182
Reserves (Cont…)
• First Global has $81 deposited with it
– It has excess reserves of $72.9 – The total reserves in the banking system is $100
• $15 in the form of vault cash at First National • $4 in the form of a reserve deposit at the Fed by First National • $81 in the form of a reserve deposit at the Fed by First Global
• Now assume that First Global seeks to hold $6 as vault cash
– The Fed will issue the notes and debit the reserve account of First Global
10/24/2009 183
Fed’s Balance Sheet after the transaction
10/24/2009
184
Reserves (Cont…)
• The total reserves held by the banking system as a whole is independent of the number of banks in the system • First Global too is empowered to make loans after maintaining the required reserves • Thus the two banks taken together can cause the total deposit base in the economy to reach $1,000
10/24/2009 185
Deposits, Withdrawals, and Reserves
• The reserves held by a bank will go up when a customer makes a deposit • Deposit may be in the form of
– Cash – Or a check
• If it is a cash deposit, vault cash will go up by the amount deposited
– The bank may choose to keep all or some of the deposit amount as cash
10/24/2009 186
Deposits…(Cont…)
• If it were to choose not to retain the entire amount as cash
– The excess will be transferred to the Fed – Which will credit its reserve account by an equivalent amount – So the sum of vault cash and the reserve balance at the Fed will increase by the amount deposited
10/24/2009
187
Deposits…(Cont…)
• What if the customer deposits a check drawn on another bank
– Funds will be transferred from the reserve account of the drawer’s bank to the reserve account of the drawee’s bank – So the reserves of the drawer’s bank will stand reduced – The reserves of the drawee’s bank will increase
10/24/2009
188
Illustration of a Check Transaction
• An IT firm in Chicago has sold software worth $100,000 to a party in Boston • The Boston party issues a check drawn on a Boston bank • The supplier will deposit the check with its bank in Chicago • The bank will send the check to the Chicago Fed
10/24/2009 189
Illustration (Cont…)
• The Chicago Fed will send the check to the Boston Fed • The Boston Fed will send the check to the drawer’s bank • The bank will first debit the drawer’s account
– It may then remit funds to the Boston Fed – Or authorize it to debit its reserve account
10/24/2009
190
Illustration (Cont…)
• The funds will be transferred from the Boston Fed to the Chicago Fed • The Chicago Fed will credit the reserve account of the drawee’s bank • The bank will credit the drawee’s account • The net result is a transfer of $100,000 from a party in Boston to a party in Chicago
10/24/2009
191
Illustration (Cont…)
• Checks which are collected and cleared by the Federal Reserve system must be paid in full by the drawer’s bank
– No deduction of fees – To be paid at PAR – The drawee’s bank may recover collection charges from the drawee
10/24/2009
192
Inter District Transfers
• How do funds move from one Federal Reserve Bank to another • To facilitate transfers between two member banks • The 12 banks as a whole maintain a fund in DC called the Inter-District Settlement Fund
– All 12 banks have a share in it
• By way of this fund, money is routinely transferred from one member bank to another
10/24/2009 193
Clearing Balances
• Banks which are not members of the Federal Reserve System may choose to maintain a Clearing Balance with a district bank • When checks drawn on other banks are deposited with it
– Its clearing balance will be credited
• When checks drawn on it are deposited with other banks
– Its clearing balance will be debited
10/24/2009 194
Monetary Aggregates
• When the FED issues currency equivalent to $100
– It adds $100 to the monetary base – The monetary base will remain at this figure
• Whether the amount is held with the public • By a commercial bank • Or by a combination of the two
• But when checking accounts are opened with commercial banks
– M1 and obviously M2 will increase
10/24/2009 195
Aggregates (Cont…)
• When Alfred receives $100 from the government
– Currency in circulation is $100 – Monetary base is also $100
• When Brad receives $100 from Alfred and deposits with the bank
– – – – –
10/24/2009
Currency with the public is reduced by $100 But the magnitude of checking deposits is $100 Bank reserves in the form of vault cash is $100 So the base remains at $100 M1 is also $100
196
Aggregates (Cont…)
• Brad receives a check for $90 from Doug, which is deposited in the bank
– The monetary base remains at $100 – M1 increases to $190
• Eric pays $81 to Charlie by way of a check
– High powered money remains at $100 – M1 is now $271
10/24/2009
197
Investments: An Alternative
• It is not necessary that a bank with excess reserves must make loans • It has the option of buying securities • When Charlie deposits $81 with the bank
– It will have excess reserves of $72.90 (81 - .1x81)
• Assume that it buys $60 worth of securities from a dealer, who has an account with it
10/24/2009
198
Investments (Cont…)
• On the assets side investments will increase by $60 • On the liabilities side the deposits (by the dealer) will increase by $60 • The position of the bank in a T-account format will be as follows.
10/24/2009
199
Balance Sheet of First National
10/24/2009
200
The Treasury’s Accounts
• The Treasury holds a part of its operating cash balances with the Fed • The rest is held with depository institutions across the US
– These are called Treasury Tax and Loan (TT&L) accounts
• All disbursements made by the Treasury are by debits to its account at the Fed
10/24/2009 201
Treasury (Cont…)
• So if the Treasury requires additional funds to cover checks issued by it
– It will transfer funds from its bank account (s) to its account at the Fed – These transfers are termed as calls on TT&L account balances
• How does the Treasury acquire a credit to the TT&L account
– From tax receipts by residents – On account of payments by the buyers of Treasury securities
10/24/2009 202
Treasury (Cont…)
• When a call is made on a TT&L account funds are transferred from the bank in which the account is held to the Treasury’s account at the Fed
– The Fed will debit the reserve account of the bank – And credit the Treasury’s account – So there will be a reduction is reserves equivalent to the full amount of the transaction – However since banks do not have to maintain reserves against TT&L accounts
• There is no reduction in the required reserves
10/24/2009
203
Illustration –The Fed’s Balance Sheet
10/24/2009
204
Treasury (Cont…)
• Charlie has $81 on deposit with First Global • He is required to pay $25 as tax to the Treasury • The Treasury has a TT&L account at First Global
– The bank will debit Charlie’s account and credit the TT&L account
• The transaction will leave the reserves unchanged but will cause the money supply to decline by $25
10/24/2009
205
The Balance Sheet of First Global
10/24/2009
206
Treasury (Cont…)
• Now assume that the Treasury wants to transfer $25 from its account at the bank to its account at the Fed
– First Global will debit the Treasury’s account with $25 – There will be a corresponding decline of $25 its the reserve account.
• After the transaction, the balance sheet will look as follows
10/24/2009 207
Treasury (Cont…)
10/24/2009
208
Treasury (Cont…)
• The Fed will
– Debit First Global’s reserve account by $25 – It will credit the Treasury’s account with $25 – As a consequence the reserves held by the banking system will decline by $25
• The balance sheet of the Fed after the transaction will look as depicted
10/24/2009
209
The Fed’s Balance Sheet
10/24/2009
210
Treasury (Cont…)
• The Treasury will typically spend this income by issuing checks
– Assume it gives a check for $20 to Larry – Larry deposits the check with First Global
• First Global will credit Larry’s account with $20 • It will gain $20 in reserves • The Fed will debit the Treasury’s checking account with $20 and credit the bank’s reserve account
10/24/2009 211
The Fed’s Balance Sheet
10/24/2009
212
Balance Sheet of First Global
10/24/2009
213
Treasury (Cont…)
• The Treasury keeps its funds in TT&L accounts until needed
– The required amounts are transferred to the Fed only when they have to be disbursed
• What is the reason?
– Income for the Treasury by way of taxes and bond issues is lumpy – Disbursements are steady
• Salaries, wages, pensions, fuel bills
10/24/2009 214
Treasury (Cont…)
• When a call is made on a TT&L account, there is a drain of reserves from the banking system • The reserves are restored, at least partially, when the Treasury makes a payment from its checking account at the Fed • If the Treasury were to make calls as and when funds are received it will lead to a significant and sharp decline in reserves
– Restoration obviously will not be at the same pace
10/24/2009 215
Treasury (Cont…)
• Thus the banking system will experience a substantial reduction in reserves if and when a large call is made on a TT&L account
– This has implications for the ability of banks to make loans – This can therefore lead to a recession – Thus the Treasury draws on its TT&L balances only on a JIT basis
10/24/2009
216
Deposit Contraction
• Assume that Brad has $190 on deposit with First National while Charlie has $81 on deposit with First Global • First National has reserves of $19 which is required by law
– $15 in vault cash and $4 at the Fed
• First Global has reserves of $81
– 8.1 is required by law – Consequently it has excess reserves of $72.90
10/24/2009 217
Contraction (Cont…)
• First National has made
– a loan of $90 to Doug – And $81 to Eric
• The positions of the two banks are as depicted
10/24/2009
218
Balance Sheet of First National
10/24/2009
219
Balance Sheet of First Global
10/24/2009
220
Contraction (Cont…)
• Let us consider various possibilities • Assume Charlie withdraws $40 from his account • The bank will ask the Fed to issue $40 to it in the form of currency bills • It will debit Charlie’s account by $40 and its reserve account at the Fed will be debited with $40
10/24/2009 221
Balance Sheet of First Global
10/24/2009
222
The Fed’s Balance Sheet
10/24/2009
223
Contraction (Cont…)
• The aggregate reserves held by the two banks, including vault cash = 15 + 4 + 6 + 35 = $60 • The reserves have therefore contracted by $60 • There is no change in the monetary base
– Reserves + currency = 60 + 40 = $100
• Take another case where Brad wants to withdraw $40 in cash from First National
– The bank has no excess reserves – It will have to borrow from First Global
10/24/2009 224
Contraction (Cont…)
• The Fed will
– Debit First Global’s reserve account – And credit First National’s reserve account – It will then issue $40 in currency to facilitate the withdrawal by Brad
• And in the process will debit First National’s reserve account by an equivalent amount.
10/24/2009
225
The Fed’s Balance Sheet
10/24/2009
226
Balance Sheet of First National
10/24/2009
227
Balance Sheet of First Global
10/24/2009
228
Contraction (Cont…)
• Once again the sum of vault cash and reserve balances of the two banks stands reduced from $100 to $60 • Now let us consider the following situation
– – – – – Charlie deposits $81 with First Global The bank invests $22.90 in government securities It makes loans worth $500 It keeps vault cash of $6 The balance is kept at the Fed
10/24/2009
229
Contraction (Cont...)
• Assume that the securities were bought from the Treasury
– The bank will credit the Treasury’s TT&L account with $22.90
• The bank’s balance sheet will look as follows
10/24/2009
230
Balance Sheet of First Global
10/24/2009
231
Contraction (Cont…)
• The bank is required to maintain reserves worth .10 x 581 = $58.10
– Thus it has excess reserves of $22.90
• Now assume that Charlie withdraws $40 as cash
– The excess reserves are inadequate – The bank will have to sell securities – Or else recall loans
10/24/2009 232
Contraction (Cont…)
• Borrowing of reserves is ruled out
– First National is the only other bank in the system – It has no excess reserves
• Assume First Global sells securities
– The amount to be sold may be computed as follows. If $X worth of securities is sold: 41 + 500 + 22.90 = (22.90-X)+500+0.10x(41+500) ? X = $13.10
10/24/2009 233
Contraction (Cont…)
• The securities will be sold to the Fed, which will credit the bank’s reserve account with $13.10.
10/24/2009
234
Balance Sheet of First Global
10/24/2009
235
Analysis
• • • • • The bank had $22.90 as excess reserves A withdrawal of $40 reduced the required reserves by $4 So to fund $40 the bank can rely on its reserves of $26.90 The balance of $13.10 is obtained by selling securities The reserve balance at the Fed (assuming that vault cash is maintained at $6) is 48.10
48.10 = 75 – 26.90
• Vault cash + reserve balance at the Fed = 6 + 48.10 = 54.10 = 0.10 x 541
– Remember banks do not have to maintain reserves against TT&L accounts
10/24/2009
236
Contraction (Cont…)
• The other option is to recall loans • If $X worth of loans is recalled then from the balance sheet equation 41+(500-X)+22.90=22.90+(500-X)+.1x(41+500-X) ?X = $131 • The bank’s balance sheet will appear as follows.
10/24/2009
237
Balance Sheet of First Global
10/24/2009
238
Analysis
• The bank had excess reserves of $26.90 • It thus required $40 - $26.90 = $13.10 • To acquire 13.10 in reserves, it has to recall loans worth $131, since the reserve ratio is 10% • The excess reserves of $26.90 were completely used up • The $13.10 in reserves that was freed due to the loan recall was also completely used up
10/24/2009 239
Analysis (Cont…)
• The amount with the Fed, assuming that $6 is held as vault cash is $35
– $35 = $75 - $40
• The sum of the vault cash and the reserve deposit is $41, which is 10% of the deposits
10/24/2009
240
Contraction (Cont…)
• A deposit of currency has a multiplier effect • If the required reserve ratio is 10% a deposit of $100 can lead to total deposits of $1,000 • Similarly the withdrawal of currency will lead to a contraction of deposits • In our case, the withdrawal of $40 prevented the deposit base from expanding to $1,000
10/24/2009
241
Contraction (Cont…)
• In the first case, after Charlie withdrew $40 the total reserves held by the banking system was: 19 + 6 + 48.10 = $73.10 • Prior to the withdrawal it was $100 • To meet the drain of cash the bank needed to release $40 in reserves • The Fed injected extra reserves of $13.10 into the banking system by acquiring securities
10/24/2009 242
Contraction (Cont…)
• Consequently the post withdrawal reserve balance was: 100 + 13.10 – 40 = $73.10 • This was just adequate to support a deposit base of $731 • In the second case, after loans worth $131 were recalled the reserves available were: 100 - 40 = $60 • Thus the banking system could support a deposit base of only $600
10/24/2009 243
Contraction (Cont…)
• In both cases theory predicted that a withdrawal of $40 would lead to reduction of $400 in the deposit base • In the first case this was precluded by an injection of $13.10 in reserves by The Fed
– As a consequence total deposits contracted to $731
• In the second case no additional reserves were injected and the deposit base shrank to $600
10/24/2009
244
Contraction (Cont…)
• There is therefore a critical difference between deposit expansion and deposit contraction • Leakage or slack loan demand may lead to a deposit expansion that is less than what theory would predict • However, unless the withdrawal is accompanied by a simultaneous injection of reserves, contraction must take place to the extent predicted by theory
10/24/2009 245
Borrowing by the Treasury
• In the first illustration we assumed that the Fed creates currency of $100 by buying a bond from the Treasury • In principle the federal government can borrow from the central bank
– But this is not the practice in the US – In the US the Treasury borrows to a limited extent by issuing debt securities to banks – And to a large extent by issuing such securities to the public
10/24/2009 246
Borrowing (Cont…)
• Let us consider a case where the Treasury borrows directly from the Fed by issuing government securities worth $100 • The Fed’s balance sheet would look as shown below.
10/24/2009
247
Borrowing (Cont…)
10/24/2009
248
Borrowing (Cont…)
• Assume that the Treasury spends the money by giving a check to Larry, who deposits it with First National Bank. • The Fed will debit the Treasury’s account and credit the reserve account of First National • The Fed’s balance sheet and the bank’s balance sheet would look as follows.
10/24/2009
249
Borrowing (Cont…)
10/24/2009
250
Borrowing (Cont…)
10/24/2009
251
Analysis
• High-powered money has gone up by $100
– For bank reserves have increased by $100
• M1 has increased by $100
– Transactions deposits have gone up by $100
• Thus if the Treasury were to spend the proceeds of an issue of $X worth of securities to the Fed
– Both H and M1 will increase by $X
10/24/2009 252
Borrowing (Cont…)
• What would happen if the Treasury were to directly issue securities worth $X to the bank
– Its TT&L balance would increase by $X – If it were to spend the money by issuing a check to Larry, M1 will increase by $X – However there will be no change in H
10/24/2009
253
Borrowing (Cont…)
• Finally consider a situation where the Treasury issues $X worth of securities to a dealer named Joe
– He makes payment by issuing a check on First National – The bank will debit his account and credit the TT&L A/c – Thus M1 stands reduced by $X
10/24/2009
254
Borrowing (Cont…)
• The Treasury will at some point transfer the funds to its account at the Fed
– This will reduce H by $X
• If the Treasury were to then make a payment of $X to Larry
– High powered money will be restored to its former level – M1 will be restored to its earlier level
10/24/2009 255
Analysis
• The expending of $X by the Treasury after obtaining funds by directly issuing bonds to the Fed
– Will increase both H and M1 by $X
• However if the Treasury were to issue bonds to a bank
– M1 will increase by $X, H would be unaffected
• Finally if the Treasury were to directly issue bonds to the public and spend the resources
– There will be no impact on either H or M1
10/24/2009 256
Putting Money in Circulation
• When coins or currency are produced by the Mint or the BEP – they are sold by the Treasury to the Federal Reserve Banks • Coins are sold for their face value • Notes are sold for their cost of production • Each of the 12 districts FR banks will keep the newly minted coins and notes in their storage vaults
10/24/2009 257
Money (Cont…)
• But this currency does not immediately become a part of M1 • For coins and notes to be counted as M1 they must pass into the hands of the public
– That is they must leave the possession of the Fed and the banking system
• So how does newly generated cash enter into circulation?
10/24/2009 258
Money (Cont…)
• For cash to enter circulation there must be a demand for cash from bank customers • If the banks do not have enough vault cash to satisfy this demand they will ask the Fed for additional supplies • The Fed will debit the reserve account of the bank and transfer cash • The bank will debit the account of the customer
– Thus newly minted cash starts its circulation
10/24/2009 259
Money (Cont...)
• There is no impact on the on M1
– Checking account balances are reduced – But there is more money in circulation with the public
• There is no impact on H
– Reserves stand depleted – But money in circulation is more
10/24/2009
260
Money (Cont…)
• The reduction in bank reserves has implications for its ability to make additional loans
– So a bank will seek to shore up reserves
• One option is to sell Treasury securities to the Fed • The purchase and sale of Treasury securities by the Fed is termed as OPEN MARKET OPERATIONS
10/24/2009 261
Money (Cont…)
• The Fed will credit the bank’s reserve account with an equivalent amount • Thus high powered money increases
10/24/2009
262
Fed’s Balance Sheet
10/24/2009
263
First National’s Balance Sheet
10/24/2009
264
Money (Cont…)
• Assume that there is no money in circulation with the public
– H = $200 – M1 = $250
• A customer called Brad approaches the bank seeking $25 in cash • The Fed will issue the cash to facilitate the withdrawal
10/24/2009 265
Fed’s Balance Sheet
10/24/2009
266
Balance Sheet of First National
10/24/2009
267
Money (Cont…)
• • • • High powered money = 175 + 25 = $200 M1 = 225 + 25 = $250 So the transaction has had no impact on H or M1 But bank reserves have declined by $25 it has implications for the bank’s ability to make loans • One way to restore reserves is by selling securities worth $25 to the Fed
10/24/2009 268
Fed’s Balance Sheet
10/24/2009
269
Balance Sheet of First National
10/24/2009
270
Money (Cont…)
• • • • • H = 200 + 25 = $225 M1 = 225 + 25 = $250 M1 is unaffected H has increased by $25 Thus the injection of $25 into the public domain has lead to the acquisition of Treasury securities worth $25 by the Fed
10/24/2009
271
Money (Cont…)
• The Treasury has to pay interest on all outstanding securities including those held by the Fed • The Fed, unlike private parties, will return such income to the Treasury at the end of the year • Thus the injection of new money leads to the retirement of an equivalent amount of securities
10/24/2009 272
Money (Cont…)
• Thus the income from the issue of currency is the interest saved by the Treasury
– Which would have otherwise been paid to the security holders
10/24/2009
273
Seigniorage
• What is Seigniorage • It is the net revenue earned by issuing coins or bank notes • There is always a difference between the face value of a coin or note and the costs entailed in production and distribution
10/24/2009
274
The Canadian Evidence
• It costs the Royal Canadian Mint about 12 cents to produce and distribute a one dollar coin • Thus the government makes a profit of 88 cents for every coin that is sold at face value. • Coins unlike notes are not redeemed by the government • So the seigniorage is generated at the time of sale
10/24/2009 275
Canada (Cont…)
• The Bank of Canada issues currency notes • Their lifespan is short
– Ranging from about 2 years for $5 and $10 notes to 7 years for $100 notes
• Institutions can redeem their surplus notes to the central bank for payment • The accounting process for the revenues and costs associated with note issuance differs from that for coins
10/24/2009 276
Canada (Cont…)
• When the central bank issues a note, which is a liability for it, it subsequently acquires interest bearing securities via open market operations.
– These may be short-term in nature (Bills) – Or medium to long term (Notes and Bonds)
• Seigniorage in the case of currency notes is the difference between the interest earned on government securities and the cost of production and distribution.
10/24/2009 277
Canada (Cont…)
• Since the banks hold such securities over a period of time, note related seigniorage is collected in installments over a number of years • Take the $20 Canadian bill • At an average interest rate of 5% is generates a revenue of $1 per year that it is in circulation which is about 3 years
10/24/2009 278
Canada (Cont…)
• The production cost of such notes is about six cents
– Works out to 2 cents per year if we amortize it
• The average annual distribution cost is about 2 cents • Thus the total annual production and distribution cost is 4 cents • Thus the annual net revenue for the central bank is about 96 cents
10/24/2009 279
Canada (Cont…)
• The interest revenue for the Bank of Canada has ranged between $1.7 billion to $2.2 billion • The Bank has used about $130 MM to finance its general operating expenses • The remainder is paid to the government • Thus seigniorage allows the government to finance a part of its expenditure without having to levy taxes
10/24/2009 280
The U.S. Evidence
• The currency bills issued by the Fed have a finite lifespan • The average life of bills in the US is given in the table below
10/24/2009
281
US (Cont…)
10/24/2009
282
US (Cont…)
• Take the $20 bill • Assume that it stays in circulation for exactly 2 years • At the end of 2 years, a depositor will return it to a bank • The bank will return it to the Fed and have its reserve account credited. • The Fed will retire the note from circulation • To offset the increase in reserves the Fed will sell securities to the bank • And debit its reserve account
10/24/2009 283
US (Cont…)
• So for 2 years the Fed earns interest on $20 • If we assume an interest rate of 6%, the annual income is $1.20 • The Fed pays 5 cents to acquire the note from the Treasury • If we assume that this is the only cost then the net income from the bill over 2 years is $2.35 • This is the seigniorage income from the bill
10/24/2009 284
US (Cont…)
• The Fed transfers the profits obtained by it to the Treasury • Thus the ultimate beneficiary of seigniorage is the Treasury
10/24/2009
285
Assets & Liabilities
• Federal reserve notes in circulation are the largest liabilities of the Fed • Treasury securities are the biggest assets of the Fed • In practice the Fed arrives at a forecast of the amount of currency required to meet the demand in a year
– It will then submit an order to the BEP
10/24/2009 286
Assets & Liabilities (Cont…)
• The BEP establishes a billing rate for the cost of manufacturing currency notes
– The cost has to be borne by the Fed
• However unlike currency notes coins are not liabilities of the Fed • The annual output of coins is determined by the Mint
– It monitors the stock held by the Fed to identify trends in the demand
10/24/2009 287
Coins & Currency
• In 2002 the Mint sold 15 billion coins
– With a face value of $1.4 billion – The production cost was $436 million
• The BEP produced 7 billion notes
– With a face value of $103.50 billion – The production cost was 384 million
• The Fed spent $30 million to process the coins • And $342 million to process the notes
10/24/2009 288
Coins & Currency (Cont…)
• In 2002 the mint transferred $1 bn in seigniorage from coins • The Fed transferred about $24.50 bn in excess earnings
– These arise mainly from the holding of government securities – And are attributable in part to the value of currency in circulation
10/24/2009
289
Credit & Debit Cards
• Are credit and debit cards money • Consider credit cards
– They represent a revolving line of credit offered by the issuer to the holder – He can use it to acquire goods and services up to a pre-defined limit – Each time he repays in part or in full his ability to make further transactions will be restored by the extent of payment made
10/24/2009 290
Credit Cards (Cont…)
• Credit cards are referred to as Plastic Money • But they are not money • When money is used in the form of currency or as a checking account balance to acquire a good or a service
– We are exchanging one asset for another
• But if the same transaction is done with a card
– A liability is created
10/24/2009 291
Credit Cards (Cont…)
• When one makes a card based payment
– The issuer will make a transfer of funds to the merchant’s bank account – This is a monetary transaction – The issuer will send a bill for the transaction – The holder will respond in the form of installments or as a bullet payment – Such payments are normally made by check – This too is a monetary transaction
10/24/2009 292
Credit Cards (Cont…)
• The transaction that created the liability is not money • It is merely an extension of credit on the part of the issuer • One may argue that most checking account balances arise on account of loans from banks • However the loan itself is not money • Money is created when the borrower deposits the loan amount in a checking account thereby creating an asset for himself
10/24/2009 293
Credit Cards (Cont…)
10/24/2009
294
Credit Cards (Cont…)
• Now assume that the bank makes a loan of $100 to Mark who deposits it with First Global • When the check clears the balance sheet of the two banks will be as depicted below
10/24/2009
295
Credit Cards (Cont…)
10/24/2009
296
Credit Cards (Cont…)
10/24/2009
297
Credit Cards (Cont…)
• M1 = $300 • Now assume First Global gives Mark a revolving line of credit of $50 in the form of a credit card • He will use it only if he wants to buy a good or a service • Assume he buys $50 worth of goods from Brad
10/24/2009 298
Credit Cards (Cont…)
• When First Global pays Brad
– The Fed will debit its reserve account by $50 – And credit First National’s reserve account by $50
• The two balance sheets will look as follows
10/24/2009
299
Credit Cards (Cont…)
10/24/2009
300
Credit Cards (Cont…)
10/24/2009
301
Credit Cards (Cont…)
• M1 has increased to $350 • Now assume that Mark repays the outstanding on his card
10/24/2009
302
Credit Cards (Cont…)
10/24/2009
303
Credit Cards (Cont…)
• M1 is back to $300 • A card based transaction has monetary implications on two occasions
– First when the issuer pays the merchant – The second is when the cardholder repays the issuer – The card based transaction by itself just creates a liability
10/24/2009 304
Debit Cards
• These are an alternative to checks • When such a card is used
– Funds are immediately transferred by a debit to the holder’s account and a credit to the merchant’s
• In a check based transaction
– It is not the check that represents money – It is the balance in the checking account which backs the check which is treated as money
10/24/2009 305
Debit Cards (Cont…)
• The checking account balances are a part of M1 and M2 • Thus withdrawal limits on debit cards do not represent any addition to the amount of money in circulation
10/24/2009
306
The Money Multiplier
• The deposit multiplier is the reciprocal of the required reserve ratio • The monetary base is equal to the sum of
– Currency held by the public – Total reserves in the banking system
10/24/2009
307
The Money Multiplier (Cont…)
• We will use the following symbols
– H ? high powered money – C ? currency held by the public – TR ? total reserves in the banking system – D ? level of transactions deposits in the banking system – RR?? required reserves – ER ? excess reserves – r ? required reserve ratio
10/24/2009 308
The Money Multiplier (Cont…)
• If there are no excess reserves in the system
D = TR/r ? TR = rD
• Assume that the currency held by the public may be expressed as cD, where `c’ is the desired currency ratio • So: H = C+TR = cD + rD = (c+r)D • So the level of high-powered money is equal to the sum of the required reserve ratio and the desired currency ratio multiplied by the amount of deposits held in the banking system
10/24/2009 309
Money Multiplier (Cont…)
• M1 = C + D • Thus M1 = cD + D = (1+c)D • Thus the quantum of liquid money in the economy is equal to one plus the desired currency ratio multiplied by the amount of transactions deposits • M1 = (1+c)D = (1+c) x H ________ (r+c)
10/24/2009 310
Money Multiplier (Cont…)
• So for a given level of high-powered money, the amount of money in the economy as measured by M1 is a function of
– The required reserve ratio – The desired currency ratio
• If these ratios are constant then ?M1 = (1+c) x ?H _____ (r+c)
10/24/2009 311
Money Multiplier (Cont…)
• Thus a dollar’s increase in high-powered money will increase M1 by (1+c)/(r+c) • Since r is less than 1.0, this factor will always be greater than 1.0 • This factor is known as the MONEY MULTIPLIER
10/24/2009
312
Money Multiplier (Cont…)
• If the desired currency ratio is zero then the Money Multiplier = Deposit Multiplier • However if the desired currency ratio is > 0, which is normally the case Money Multiplier < Deposit Multiplier • This is because
–
•
Every time a bank makes a loan or an investment there will be a leakage
That is some money will exit the banking system
•
So the ability of banks to expand the money supply by making additional loans or investments is reduced.
313
10/24/2009
Excess Reserves
• Thus far we have assumed that there are no excess reserves in the banking system • That is TR = RR • In other words the banks are fully loaned up • In practice most banks keep excess reserves
– One reason is to facilitate larger than anticipated withdrawals – Or to deal with a sudden loan request
10/24/2009 314
Excess Reserves (Cont…)
• What would happen if there are no excess reserves
– A bank can borrow reserve funds in the FED Funds market – It can borrow directly from the FED at its discount window – Or recall loans made to borrowers – Or sell securities from its investment portfolio
10/24/2009
315
Excess Reserves (Cont…)
• TR = RR + ER • ? H = C + TR = c + RR + ER • Assume that the banks want to hold a fraction `e’ of their deposit liabilities as excess reserves ? ER = eD • Thus H = cD + rD + eD = (c+r+e)D • M1 = cD + D + (1+c)D = (1+c) x H _________ (c+r+e)
10/24/2009 316
Excess Reserves (Cont…)
• Thus in the presence of excess reserves the money multiplier is (1+c)/(r+e+c) • Thus the higher the level of excess reserves, the smaller will be the money multiplier
10/24/2009
317
Illustration
• Alfred receives a $100 bill which he deposits in a bank. • The required reserve ratio is 10% • Bob then receives a loan of $90 from the bank.
– He withdraws $25 as cash and deposits the balance $65 with the bank.
• The bank lends the money deposited by Bob to other parties till it has no excess reserves
– That is, the deposit base multiplies till it reaches the limit
10/24/2009 318
Illustration (Cont…)
• The total deposits in the banking system will be:
100 + 65/0.10 = $750
• The amount of cash with the public is $25 • The reserves in the banking system is $75 • Thus the amount of high-powered money is $100 while M1 = 25 + 750 = 775
10/24/2009
319
Illustration (Cont…)
• The cash to deposit ratio is 25/750 = 1/30 • The money multiplier is: (1 + 1/30)/(1/10 + 1/30) = 31/4 = 7.75 • Thus M1 = 775 = 7.75 x 100 = m x H
10/24/2009
320
Illustration (Cont…)
• Now assume that when Bob deposits $65 with the bank the bank decides to hold $15 as excess reserves • Thus the next borrower gets only $43.50 • If we assume no further leakages the deposit will get multiplied to $435 • The high powered money in the economy continues to be $100 • However M1 = 100 + 25 + 65 + 435 = $625
10/24/2009 321
Illustration (Cont…)
• The cash to deposit ratio is 25/600 = 1/24 • The excess reserves to deposit ratio is 15/600 = 1/40 • The money multiplier is: (1+1/24)/(4/40 + 1/40 + 1/24) = 25/4 = 6.25 • Thus M1 = 625 6.25 x 100 = m X H
10/24/2009 322
The Credit Multiplier
• When a bank receives a deposit
– It will maintain a portion as reserves
• Perhaps a combination of required and excess reserves
– And use the balance to make loans and investments
• The magnitude of loans and investments or the level of credit offered by the bank is: D – RR – ER = (1 – r – e)D
10/24/2009 323
The Credit Multiplier (Cont…)
• D = H/(r+c+e) • Thus the credit multiplier is • [(1-r-e)/(c+r+e)] x H
10/24/2009
324
Illustration
• • • • • The monetary base is $100 The required reserve ratio is 0.10 The cash to deposit ratio is 1/24 The excess reserves ratio is 1/40 The credit multiplier is: [(120-12-3)/120]/[(12+5+3)/120] = 5.25 • The amount of credit offered by the banking system is 5.25 x 100 = 525
10/24/2009 325
doc_191683280.pptx