Paul Bernd Spahn, Goethe-Universität Frankfurt/Main1 Lecture 8 DETERMINANTS OF THE MONEY SUPPLY, AND THE TOOLS OF CENTRAL BANKS (2)

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main2 ESCB monetary policy instruments In order to achieve its objectives, the ESCB has at its disposal a set of monetary policy instruments. The ESCB –conducts open market operations, –offers standing facilities and –requires credit institutions to hold minimum reserves on accounts with the ESCB.

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main3 Money supply process In order to understand the money supply process, we have to come back to the ECB’s balance sheet and the monetary base (or high-powered money). The assets of the CB constitute the sources of the base. The liabilities of the CB constitute the uses of the base.

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main4 Schematic central bank balance AssetsLiabilities Bank notes Gold and SDR Forex Securities Bank lending Bank reserves

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main5 Bundesbank, Balance sheet st of December, in bill. €

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main6 The control of the monetary base The quantity-oriented approach to monetary policy purports that the central bank can control the monetary base. It is basically effected via open market operations with commercial banks. The ECB can control OMOs more effectively than foreign reserves, but she can also use interventions in forex markets to change the monetary base.

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main7 Controlling the money supply Under fixed exchange rates controlling the money supply is more difficult. In this case the central bank has to “sterilize” inflows or outflows of foreign exchange. It renders interest rates endogenous, i.e. they vary in response to sterilizing interventions. Forex interventions will be discussed later.

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main8 Forex inflows with sterilization AssetsLiabilities Base money remains fixed Gold Forex Securities

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main9 Forex inflows with sterilization AssetsLiabilities Base money remains fixed Gold Forex Securities

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main10 OMOs Among the OMOs, the main refinancing operations (MROs) are the most important, playing a pivotal role in steering liquidity and signaling the stance of monetary policy. Three quarters of liquidity is provided by MROs. MROs were conducted as fixed rate and variable rate tenders with a minimum bid rate. The MROs are regular, liquidity providing, reverse transactions, conducted as standard tenders, with a weekly frequency and normally a maturity of two weeks.

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main11 Longer-term refinancing (LTROs) Longer-term refinancing operations (LTROs) are carried out through monthly standard tenders and have a maturity of three months. LTROs are regular open market operations executed by the Eurosystem also in the form of a reverse transaction. On average over the year, LTROs provided about one quarter of the total refinancing of banks.

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main12 Reserve requirements of banks The Eurosystem requires banks to hold minimum reserves equal to 2% of certain short-term liabilities. It is part of base money. The purpose is the stabilization of short-term interest rates and the enlargement of the structural liquidity deficit of banks. Reserve requirements bear interest, and must only be fulfilled on average over a one-month reserve maintenance period. It has a significant smoothing effect on the behavior of short-term interest rates.

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main13 Short-term liquidity policy The monetary base is also affected when a central bank makes a discount loan to a bank. The ECB does not use this instrument however. There are two standing facilities offered by the Eurosystem –the marginal lending facility and –the deposit facility, These instruments provide and absorb overnight liquidity, signal the stance of monetary policy and set an upper and lower limit for the overnight market interest rate.

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main14 The use of the standing facility

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main15 Key ECB interest rates The key ECB interest rates are at present –the minimum bid rate on the main refinancing operations, –the interest rate on the marginal lending facility –and the interest rate on the deposit facility.

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main16 ECB interest rates EONIA (euro overnight index average):

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main17 Interest rate policy in Europe and the US

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main18 The notion: quantity of money In addition to the central bank, commercial banks do also supply credit money. We assume that there is a fixed relationship between central bank money (base money) and credit money. Then the quantity of money M equals M = m  B = multiplier  base money. We assume the ECB controls B, then she also controls M.

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main19 Money creation through bank credit Credit money is created (destroyed) if the sum of demand deposits of non- banks at commercial banks increases (declines) In the case of a credit to a customer by a bank, the bank creates „book money“. As this credit is redeemed, money is destroyed.

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main20 Money creation by a commercial bank Example: A commercial bank receives a cash deposit of € 1 Mill. and uses it for a loan to a firm of € 1 Mill.. Cash deposit + € 1 mill. Loan + € 1 mill. Liability + € 1 mill. Bank Firm A L L A Outlays + € 1 mill. Demand deposit + €1 mill. Loan + € 1 mill. Liability + € 1 mill. Outlays etc. Demand deposit etc.

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main21 Money creation by banks: is it limited? Yes, money creation by banks is not infinite! Central banks require commercial banks to maintain minimum reserves to be held on accounts of the central bank. These reserve requirements are calculated as a percentage of demand, savings and time deposits. Demand deposits represent a claim on central bank money, which commercial banks cannot create themselves.

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main22 Multiple money creation: An example Mr. K. puts € 10,000 into his acount at A-Bank. The central bank requires minimum reserves of 20% of the deposit (  =1/5). There remains an excess reserve of € 8,000. A-Bank grants a loan to Mr. L. for the purchase of a car. The amount of the loan can only be € 8,000.

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main23 Example, continued Mr. L. transfers this amount to an account of the car dealer at B-Bank. At B-Bank it creates excess reserves of €8,000 minus €1,600 minimum reserves required (= € 6,400). These excess reserves can be used for a loan, etc.....

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main24 Example, continued It is best to imagine this process in terms of “rounds” of credit creation:

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main25 The money creation multiplier The money creation multiplier is obtained as a result of an infinite geometric series. In the example: 10, , , = 50,000 From an initial excess reserves of € 10,000 an an additional credit volume of € can be derived.

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main26 By subtracting R2 from R1 it is obtained: [1 - (1-  ) ]  Cr = [{1-  } 1 - {1-  }  +1 ] ER   Cr = {1-  } ER =  Cr=ER ({1-  } /  ) or in this case: ({1-.2} /.2 ) = 4 The credit multiplier

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main27 Critique of the simple model Supply of credit must meet a demand! Banks do not extend their lending to the maximum because of insolvency risks. Lending is limited by capital adequacy ratios (Basel I and II). But there are refinancing possibilities –through the ESCB, and –through the interbank market.

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main28 An example: The Eurodollar market The Eurodollar market (better: xeno market) is an off-shore market for the US dollar (more generally: any hard currency). It is characterized by the absence of mandatory reserve requirements for commercial banks. The experience has shown that this market had avoided “credit explosion”.