I.
The Role of Financial Intermediaries
1.
As a general rule, indirect finance through financial
intermediaries is much more important than direct finance through the stock and
bond markets.
2.
The reason for this is information; financial
intermediaries exist so that individual lenders don’t have to worry about
getting answers to all of the important questions concerning a loan and a
borrower.
3.
Lending and borrowing involve transactions costs and
information costs, and financial intermediaries exist to reduce these costs.
4.
Financial intermediaries perform five functions:
they pool the resources of small savers; they provide safekeeping and
accounting services as well as access to the payments system; they supply
liquidity; they provide ways to diversify small investments; and they collect
and process information in ways that reduce information costs.
1.
The most straightforward economic function of a
financial intermediary is to pool the resources of many small savers.
1.
Goldsmiths were the original bankers; people asked the
goldsmiths to store gold in their vaults in return for a receipt to prove it was
there.
2.
Today, banks are the places where we put things for
safekeeping; we deposit our paychecks and entrust our savings to a bank or other
financial institution because we believe it will keep our resources safe until
we need them.
3.
Banks also provide other services, like ATMs,
checkbooks, and monthly statements, giving people access to the payments system.
4.
Information is also subject to economies of scale.
1.
Financial intermediaries offer us the ability to
transform assets into money at relatively low cost (ATMs are an example).
2.
By collecting funds from a large number of small
investors, a bank can reduce the cost of their combined investment, offering the
individual investor both liquidity and high rates of return.
1.
Financial intermediaries enable us to diversify our
investments and reduce risk.
2.
Banks mitigate risk by taking deposits from a large
number of individuals and make thousands of loans with them, thus giving each
depositor a small stake in each of the loans.
1.
One of the biggest problems individual savers face is
figuring out which potential borrowers are trustworthy and which are not.
2.
There is an information asymmetry because the borrower
knows whether or not he or she is trustworthy, but the lender faces substantial
costs to obtain the same information.
3.
Financial intermediaries reduce the problems created by
information asymmetries by collecting and processing standardized information.
1.
Asymmetric information poses two obstacles to the smooth
flow of funds from savers to investors:
adverse selection, which involves being able to distinguish good credit
risks from bad before the transaction; and moral hazard, which arises after the
transaction and involves finding out whether borrowers will use the proceeds of
a loan as they claim they will.
1.
Used Cars and the Market for Lemons: In a market in
which there are good cars (“peaches”) and bad cars (“lemons”) for sale, buyers
are willing to pay only the average value of all the cars in the market.
This is less than the sellers of the “peaches” want, so those cars
disappear from the markets and only the “lemons” are left.
a.
To solve this problem caused by asymmetric information,
companies like Consumer Reports provide information about the reliability and
safety of different models, and car dealers will certify the used cars they
sell.
2.
Adverse Selection in Financial Markets:
Information asymmetries can drive good stocks and bonds out of the
financial market.
1.
Disclosure of Information:
Generating more information is one obvious way to solve the problem
created by asymmetric information.
a.
This can be done through government required disclosure
and the private collection and production of information.
b.
However, the accounting scandals of 2001 and 2002 showed
that in spite of such requirements companies can distort the profits and debt
levels published in their financial statements.
c.
Reports from private sources such as Moody’s and Value
Line are often expensive.
2.
Collateral and Net Worth:
Lenders can be compensated even if borrowers default, and if the loan is
so insured then the borrower is not a bad credit risk.
a.
The importance of net worth in reducing adverse
selection is the reason owners of new businesses have so much difficulty
borrowing money.
1.
An insurance policy changes the behavior of the person
who is insured.
2.
Moral hazard plagues both equity and bond financing.
3.
Moral Hazard in Equity Financing:
people who invest in a company by buying its stock do not know that the
funds will be invested in their best interests.
a.
The principal-agent problem, which occurs when owners
and managers are separate people with different interests, may result in the
funds not being used in the best interests of the owners.
4.
Solving the Moral Hazard Problem in Equity Financing:
The problem can be solved by if owners can fire managers and by requiring
managers to own a significant stake in their own firm.
5.
Moral Hazard in Debt Finance:
Debt goes a long way toward eliminating the moral hazard problem, but it
doesn’t finish the job; debt contracts allow owners to keep all the profits in
excess of the loan payments and so encourage risk taking.
6.
Solving the Moral Hazard Problem in Debt Finance:
To some degree, a good legal contract with restrictive covenants can
solve the moral hazard problem in debt finance.
III.
Financial Intermediaries and Information Costs
1.
Borrowers must fill out a loan application that includes
information that can be provided to a company that collects and analyzes credit
information and which provides a summary in the form of a credit score.
2.
Your personal credit score tells a lender how likely you
are to repay a loan; the higher your score the more likely you are to get a
loan.
3.
Banks collect additional information about borrowers
because they can observe the pattern of deposits and withdrawals, as well as the
use of credit and debit cards.
4.
Financial intermediaries’ superior ability to screen and
certify borrowers extends beyond loan making to the issuance of bonds and
equity.
5.
Underwriting represents screening and certifying because
investors feel that if a well-known investment bank is willing to sell a bond or
stock then it must be a high-quality investment.
1.
Intermediaries monitor both the firms that issue bonds
and those that issue stocks.
2.
Banks will monitor borrowers to make sure that the funds
are being used as intended.
3.
Financial intermediaries that hold shares in individual
firms monitor their activities, in some cases placing a representative on a
company’s board of directors.
4.
In the case of new firms, a financial intermediary
called a venture capital firm does the monitoring.
5.
The threat of a takeover helps to persuade managers to
act in the interest of the stock and bondholders.
6.
In the end, the vast majority of firm finance comes from
internal sources, suggesting that information problems are problems too big for
even financial intermediaries to solve.
I.
The Balance Sheet of Commercial Banks
A.
Assets:
Uses of Funds
1.
The asset side of a bank’s balance sheet includes cash,
securities, loans, and all other assets (which includes mostly buildings and
equipment).
2.
Cash Items:
The three types of cash assets are reserves (which includes cash in the bank’s
vault as well as its deposits at the Federal Reserve); cash items in the process
of collections (uncollected funds the bank expects to receive); and the balances
of accounts that banks hold at other banks (correspondent banking).
3.
Securities:
The second largest component of bank assets; includes U.S. Treasury securities
and state and local government bonds.
Securities are sometimes called secondary reserves because they are
highly liquid and can be sold quickly if the bank needs cash.
4.
Loans: The
primary asset of modern commercial banks; includes business loans (commercial
and industrial loans), real estate loans, consumer loans, interbank loans, and
loans for the purchase of other securities.
The primary difference among the various types of depository institutions
is in the composition of their loan portfolios.
B.
Liabilities: Sources of Funds
1.
Banks need funds to finance their operations; they get
them from savers and from borrowing in the financial markets.
2.
There are two types of deposit accounts, transactions
(checkable deposits) and nontransactions.
3.
Checkable deposits: A
typical bank will offer 6 or more types of checking accounts.
In recent decades these deposits have declined because the accounts pay
low interest rates.
4.
Nontransactions Deposits:
These include savings and time deposits and account for nearly two-thirds
of all commercial bank liabilities.
Certificates of deposit can be small ($100,000 or less) or large (more than
$100,000), and the large ones can be bought and sold in financial markets.
5.
Borrowings:
The second most important source of bank funds; banks borrow from the Federal
Reserve or from other banks in the federal funds market.
Banks can also borrow by using a repurchase agreement or repo, which is a
short-term collateralized loan in which a security is exchanged for cash, with
the agreement that the parties will reverse the transaction on a specific future
date (might be as soon as the next day).
C.
Bank Capital
and Profitability
1.
The net worth of banks is called bank capital; it is the
owners’ stake in the bank.
2.
Capital is the cushion that banks have against a sudden
drop in the value of their assets or an unexpected withdrawal of liabilities.
3.
An important component of bank capital is loan loss
reserves, an amount the bank sets aside to cover potential losses from defaulted
loans.
4.
There are several basic measures of bank profitability:
return on assets (a bank’s net profit after taxes divided by its total
assets) and return on equity (a bank’s net profit after taxes divided by its
capital).
5.
Net interest income is another measure of profitability;
it is the difference between the interest the bank pays and what it receives.
6.
Net interest income can also be expressed as a
percentage of total assets; that is called net interest margin, or the bank’s
interest rate spread.
7.
Net interest margin is an indicator of future
profitability as well as current profitability.
D.
Off-Balance-Sheet Activities
1.
Banks engage in these activities in order to generate
fee income; these activities include providing trusted customers with lines of
credit.
2.
Letters of credit are another important
off-balance-sheet activity; they guarantee that a customer will be able to make
a promised payment. In so doing, the
bank, in exchange for a fee, substitutes its own guarantee for that of the
customer and enables a transaction to go forward.
3.
A standby letter of credit is a form of insurance; the
bank promises that it will repay the lender should the borrower default.
4.
Off-balance-sheet activities create risk for financial
institutions and so have come under increasing scrutiny in recent years.
1.
Liquidity risk is the risk of a sudden demand for funds
and it can come from both sides of a bank’s balance sheet (deposit withdrawal on
one side and the funds needed for its off-balance sheet activities on the
liabilities side).
2.
If a bank cannot meet customers’ requests for immediate
funds it runs the risk of failure; even with a positive net worth, illiquidity
can drive it out of business.
3.
One way to manage liquidity risk is to hold sufficient
excess reserves (beyond the required reserves mandated by the Federal Reserve)
to accommodate customers’ withdrawals.
However, this is expensive (interest is foregone).
4.
Two other ways to manage liquidity risk are adjusting
assets or adjusting liabilities.
5.
A bank can adjust its assets by selling a portion of its
securities portfolio, or by selling some of its loans, or by refusing to renew a
customer loan that has come due.
6.
Banks do not like to meet their deposit outflows by
contracting the asset side of the balance sheet because doing so shrinks the
size of the bank.
7.
Banks can use liability management to obtain additional
funds by borrowing (from the Federal Reserve or from another bank) or by
attracting additional deposits (by issuing large CDs).
1.
This is the risk that loans will not be repaid and it
can be managed through diversification and credit-risk analysis.
2.
Diversification can be difficult for banks, especially
those that focus on certain kinds of lending.
3.
Credit-risk analysis produces information that is very
similar to the bond-rating systems and is done using a combination of
statistical models and information specific to the loan applicant.
4.
Lending is plagued by adverse selection and moral
hazard, and financial institutions use a variety of methods to mitigate these
problems.
1.
The two sides of a bank’s balance sheet often do not
match up because liabilities tend to be short-term while assets tend to be
long-term; this creates interest-rate risk.
2.
In order to manage interest-rate risk, the bank must
determine how sensitive its balance sheet is to a change in interest rates; gap
analysis highlights the gap or difference between the yield on interest
sensitive assets and the yield on interest-sensitive liabilities.
3.
Multiplying the gap by the projected change in the
interest rate yields the change in the bank’s profit.
4.
Gap analysis can be further refined to take account of
differences in the maturity of assets and liabilities.
5.
Banks can manage interest-rate risk by matching the
interest-rate sensitivity of assets with the interest-rate sensitivity of
liabilities, but this approach increases credit risk.
6.
Bankers can use derivatives, like interest-rate swaps,
to manage interest-rate risk.
1.
Banks today hire traders to actively buy and sell
securities, loans, and derivatives using a portion of the bank’s capital in the
hope of making additional profits.
2.
However, trading such instruments is risky (the price
may go down instead of up); this is called trading risk or market risk.
3.
Managing trading risk is a major concern for today’s
banks, and bank risk managers place limits on the amount of risk any individual
trader is allowed to assume.
4.
Banks also need to hold more capital if there is more
risk in their portfolio.
1.
Banks that operate internationally will face foreign
exchange risk (the risk from unfavorable moves in the exchange rate) and
sovereign risk (the risk from a government prohibiting the repayment of loans).
2.
Banks manage their foreign exchange risk by attracting
deposits denominated in the same currency as the loans and by using foreign
exchange futures and swaps to hedge the risk.
3.
Banks manage sovereign risk by diversification, by
refusing to do business in a particular country or set of countries, and by
using derivatives to hedge the risk.
4.
Banks also face operational risk, the risk that their
computer system may fail or that their buildings may burn down.
5.
To manage operational risk the bank must make sure that
its computer systems and buildings are sufficiently robust to withstand
potential disasters.
1.
The most important day-to-day jobs of the central bank
are to:
b.
manage the payments system (settles interbank payments).
c.
oversee commercial banks and the financial system
(handles the sensitive information about institutions without conflicts of
interest).
2.
By ensuring that sound banks and financial
intermediaries can continue to operate, the central bank makes the whole
financial system more stable.
3.
Central banks are the biggest and most powerful players
in a country’s financial and economic system and are supposed to use this power
to stabilize the economy, making us all better off.
1.
When left on their own economic and financial systems
are prone to episodes of extreme volatility; central bankers work to reduce that
volatility.
2.
Central bankers pursue five specific objectives:
a.
low and stable inflation
b.
high and stable real growth, together with high
employment
c.
stable financial markets and institutions
d.
stable interest rates
e.
a stable exchange rate
1.
Many central banks take as their primary job the
maintenance of price stability; they strive to eliminate inflation.
2.
The rationale for keeping the economy inflation-free is
that money’s usefulness as a unit of account and as a store of value is enhanced
when its purchasing power is maintained.
3.
Inflation degrades the information content of prices and
impedes the market’s function of allocating resources to their best uses.
1.
Central bankers work to dampen the fluctuations of the
business cycle; booms are popular but recessions are not.
2.
Central bankers work to moderate these cycles and
stabilize growth and employment by adjusting interest rates.
3.
Monetary policymakers can moderate recessions by
lowering interest rates and can moderate booms by raising them (to keep growth
at a sustainable level).
1.
Financial system stability is an integral part of every
modern central banker’s job.
2.
The possibility of a severe disruption in the financial
markets is a type of systematic risk that central banks must control.
1.
Interest rate stability and exchange rate stability are
a means for achieving the ultimate goal of stabilizing the economy; they are not
ends unto themselves.
2.
Interest rate volatility is a problem because:
a.
it makes output unstable as borrowing and expenditure
fluctuate with changing rates.
b.
it means higher risk and a higher risk premium and makes
financial decisions more difficult.
1.
The idea that central banks should be independent of
political pressure is a new one, because central banks originated as the
governments’ banks.
2.
3.
Successful monetary policy requires a long time horizon,
which is inconsistent with the need of politicians to focus on short-term goals.
4.
Given a choice, most politicians will choose monetary
policies that are too accommodative, keeping interest rates low and money growth
rates high. While this raises output
and employment in the near term it may result in inflation over the longer term.
5.
To insulate policymakers from the daily pressures faced
by politicians, governments have given central banks control of their own
budgets, authority to make irreversible decisions, and appointed them to long
terms.
1.
Central bank independence is inconsistent with
representative democracy.
2.
To solve this problem, politicians have established a
set of goals and require the policymakers to report their progress in pursuing
these goals.
3.
Explicit goals foster accountability and disclosure
requirements create transparency.
4.
The institutional means for assuring accountability and
transparency differ from one country to the next; in some cases the government
sets an explicit numerical target for inflation, while in others the central
bank defines the target.
5.
Similar differences exist in the timing and content of
information made public by central banks.
6.
Today it is understood that secrecy damages both the
policymakers and the economies they are trying to manage, and that policymakers
need to be as clear as possible about what they are trying to achieve and how
they are going to achieve it.
1.
The Federal Reserve Bank of
2.
The geographical lines that define the Banks’ districts
were drawn in 1914 and represent the population density at the time and the
decision that no district should coincide with a single state.
3.
This arrangement has two purposes:
to ensure that every district contains as broad a mixture of economic
interests as possible and that no person or group can obtain preferential
treatment from the Reserve Bank.
4.
Reserve Banks are part public and part private; they are
owned by the commercial banks in their districts and are overseen by the Board
of Governors.
5.
The Board of Directors of each bank is comprised of
representatives of banking, other business leaders, and those who represent the
public interest. Of the nine members on each board, six are elected by the
commercial bank members and three are appointed by the Board of Governors.
6.
Each Reserve Bank has a President who is appointed for a
five-year term by the Bank’s Board of Directors (with the approval of the Board
of Governors).
7.
The Reserve Banks conduct the day-to-day business of the
central bank, serving as both the government’s bank and the bankers’ bank.
8.
As the bank for the
9.
As the bankers’ bank they hold deposits for the banks in
their districts, operate and ensure the integrity of a payments network, make
funds available to commercial banks in the district through “discount loans,”
supervise and regulate financial institutions in the district, and collect and
make data available on business conditions.
10.
In addition to these duties the Federal Reserve Bank of
11.
Finally, the Reserve Banks play an important part in
formulating monetary policy, both through their responsibilities on the FOMC and
through their participation in setting the discount rate.
1.
The seven members of the Board are appointed by the
President and confirmed by the U.S. Senate for 14-year terms, which are
staggered (typically one new member is appointed every two years).
2.
These long terms are intended to protect the Board from
political pressure, as is the fact that the terms are staggered so that one
begins every two years.
3.
The Board has a Chairman and a Vice Chairman, appointed
by the President from among the seven governors for four-year renewable terms.
4.
The duties of the Board are to:
set the reserve requirement, approve or disapprove the discount rate
recommendations made by the Federal Reserve Banks, administer consumer credit
protection laws, approve bank mergers, supervise and regulate the regional
Reserve Banks, regulate and supervise the banking system (along with the Reserve
Banks), analyze financial and economic conditions, and collect and publish
statistics about the system’s activities and the economy at large.
1.
The FOMC is the group that sets interest rates to
control the availability of money and credit to the economy.
2.
Made up of the seven Governors, the President of the NY
Fed, and four Reserve Bank Presidents, it is chaired by the Chairman of the
Board of Governors.
3.
The FOMC controls the federal funds rate, the rate banks
charge each other on overnight loans of excess deposits at the Fed.
4.
The FOMC meets eight times a year, although in
extraordinary times it can meet more often.
5.
The primary purpose of a meeting is to decide on the
target interest rate and produce a policy directive, which tells the NY Fed how
to conduct purchases and sales of Treasury securities in order to meet the
FOMC’s goals.
6.
Prior to each meeting participants receive the beige
book (a compilation of anecdotal information about current business activity),
the green book (the Board staff’s economic forecast for the next few years) and
the blue book (a discussion of financial markets and current policy options).
7.
An FOMC meeting is a formal proceeding that can be
divided into three parts: reports by the staff, and two rounds of discussion by
the meeting participants.
8.
Reports by the staff include presentations by the System
Open Market Account Manager (reporting on financial market conditions and
actions taken to maintain the target interest rate since the last meeting); the
Director of the Division of International Finance (commenting on recent
international economic developments); and the Director of the Division of
Research and Statistics at the Federal Reserve Board (presenting the staff’s
forecast from the green book).
9.
The ensuing round of discussion is called the economic
go-round. One at a time committee
members describe their view of the economic outlook, and then the Chair speaks
at the end.
10.
Next, the Director of Monetary Affairs describes the
policy options (from the blue book).
Committee members again comment on the options, with the Chair speaking last.
11.
Finally there is a vote taken, with the Chair voting
first, the Vice Chair second, and then the committee members (in alphabetical
order).
12.
The Chair of the Federal Reserve is the FOMC’s most
powerful member; to have an impact on policy, governors or Reserve Bank
presidents must build support for their positions through their statements at
the meeting and in public speeches.
13.
However, while the Chair is very powerful, the committee
structure does provide an important check on that person’s power.
I.
The Central Bank’s Balance Sheet
1.
The central bank engages in numerous financial
transactions, all of which cause changes in its balance sheet.
1.
The central bank’s balance sheet shows three basic
assets: securities, foreign exchange
reserves, and loans.
2.
Securities: the primary assets of most central banks;
independent central banks determine the quantity of securities that they
purchase. For the U.S. Federal
Reserve, these are primarily U.S. Treasury securities.
3.
Foreign Exchange Reserves: the central bank’s and
government’s balances of foreign currency and are held as bonds issued by
foreign governments. These reserves
are used in foreign exchange market interventions.
4.
Loans are extended to commercial banks. There are
several kinds. Discount loans are the loans the Fed makes when commercial banks
need short-term cash.
5.
Through its holdings of U.S. Treasury securities the Fed
controls the federal funds rate and the availability of money and credit.
1.
There are three major liabilities:
currency, the government’s deposit account, and the deposit accounts of
the commercial banks.
2.
The first two items represent the central bank in its
role as the government’s bank, and the third shows it as the bankers’ bank.
3.
Currency:
nearly all central banks have a monopoly on the issuance of currency, and
currency is the principal liability of the Fed.
4.
Government’s account:
the central bank provides the government with an account into which it
deposits funds (primarily tax revenues) and from which it writes checks and
makes electronic payments.
5.
Reserves:
Commercial bank reserves consist of cash in the bank’s own vault and deposits at
the Fed, which function like the commercial bank’s checking account.
6.
Central banks run their monetary policy operations
through changes in banking system reserves.
1.
The balance sheet published by the central bank is
probably the most important information that it makes public; it is an essential
aspect of central bank transparency.
1.
Currency in the hands of the public and the reserves of
the banking system are the two components of the monetary base, also called
high-powered money.
2.
The central bank can control the size of the monetary
base and therefore the quantity of money.
II.
Changing the Size and Composition of the Balance Sheet
1.
The central bank controls the size of its balance sheet.
Policymakers can enlarge or reduce their assets and liabilities at will.
2.
The central bank can buy things, like a bond, and create
liabilities to pay for them. It can increase the size of its balance sheet as
much as it wants.
3.
There are four specific types of transactions which can
affect the balance sheets of both the central bank and the banking system:
(1) an open market operation, in which
the central bank buys or sells a security; (2) a foreign exchange intervention,
in which the central bank buys or sells foreign currency reserves; (3) the
central bank’s extension of a discount loan to a commercial bank; and (4) the
decision by an individual to withdraw cash from a bank.
4.
Open market operations, foreign exchange interventions,
and discount loans all affect the size of the central bank’s balance sheet and
they change the size of the monetary base; cash withdrawals by the public create
shifts among the different components of the monetary base, changing the
composition of the central bank’s balance sheet but leaving its size unaffected.
5.
One simple rule will help in understanding the impact of
each of these four transactions on the central bank’s balance sheet:
When the value of an asset on the balance sheet increases, either the
value of another asset decreases (so that the net change is zero) or the value
of a liability rises by the same amount (and similarly for an increase in
liabilities).
1.
OMO is when the Fed buys or sells securities in
financial markets.
2.
These purchases and sales have a straightforward impact
on the Fed’s balance sheet: its
assets and liabilities increase by the amount of a purchase, and the monetary
base increases by the same amount.
3.
In terms of the banking system’s balance sheet, the
purchase has no effect on the liabilities, and results in two counterbalancing
changes on the asset side, so the net effect there is zero.
4.
For an open market sale the effects would be the same
but in the opposite direction.
1.
The impact of a foreign exchange purchase is almost
identical to that of an open market purchase:
the Fed’s assets and liabilities increase by the same amount, as does the
monetary base.
2.
If the Fed buys from a commercial bank, the impact again
is like the open market purchase, except the assets involved are different.
1.
The Fed does not force commercial banks to borrow money;
the banks ask for loans and must provide collateral, usually a U.S. Treasury
bond.
2.
When the Fed makes a loan it creates an asset and a
matching increase in its reserve liabilities.
3.
The extension of credit to the banking system raises the
level of reserves and expands the monetary base.
4.
The banking system balance sheet shows an increase in
assets (reserves) and an increase in liabilities (the loan).
1.
Cash withdrawals affect only the composition, not the
size, of the monetary base.
2.
When people withdraw cash they force a shift from
reserves to currency on the Fed’s balance sheet.
3.
The withdrawal reduces the banking system’s reserves,
which is a decrease in its assets, and if the funds come from a checking
account, there is a matching decrease in liabilities.
4.
On the Fed’s balance sheet both currency and reserves
are liabilities, so there is just a change between the two with a net effect of
zero.
III. The Deposit Expansion Multiplier
1.
If the Fed buys a security from a bank, the bank has
excess reserves, which it will seek to lend.
2.
The loan replaces the securities as an asset on the
bank’s balance sheet.
1.
However, the loan that the bank made was spent and as
the checks cleared, reserves were transferred to other banks.
2.
The banks that receive the reserves will seek to lend
their excess reserves, and the process continues until all of the funds have
ended up in required reserves.
3.
Assuming no excess reserves are held and that there are
no changes in the amount of currency held by the public, the change in deposits
will be the inverse of the required deposit reserve ratio (rD) times
the change in required reserves, or ∆D = (1/rD) ∆RR
4.
The term (1/rD) represents the simple deposit
expansion multiplier.
5.
A decrease in reserves will generate a deposit
contraction in a multiple amount too.
IV. The Monetary Base and the Money Supply
1.
The simple deposit expansion multiplier was derived
assuming no excess reserves are held and that there is no change in currency
holdings by the public. These
assumptions are now relaxed.
2.
The desire of banks to hold excess reserves and the
desire of account holders to withdraw cash both reduce the impact of a given
change in reserves on the total deposits in the system; the two factors operate
in the same way as an increase in the reserve requirement.
1.
The amount of excess reserves a bank holds depends on
the costs and benefits of holding them, where the cost is the interest foregone
and the benefit is the safety from having the reserves in case there is an
increase in withdrawals.
2.
The higher the interest rate, the lower banks’ excess
reserves will be; the greater the concern over possible deposit withdrawals, the
higher the excess reserves will be.
3.
Similarly, the decision of how much currency to hold
depends on the costs and benefits, where the cost is the interest foregone and
the benefit is the lower risk and greater liquidity of currency.
4.
As interest rates rise cash becomes less desirable, but
if the riskiness of alternative holdings rises or liquidity falls, then it
becomes more desirable.
5.
Deriving the money multiplier tells us that the quantity
of money in the economy depends on the monetary base, the reserve requirement,
the desire by banks to hold excess reserve and the desire by the public to hold
currency.
6.
The quantity of money changes directly with the base,
and for a given amount of the base, an increase in either the reserve
requirement or the holdings of excess reserves will decrease the quantity of
money.
7.
But currency holdings affect both the numerator and the
denominator of the multiplier, so the effect is not immediately obvious.
Logic tells us that an increase in currency decreases reserves and so
decreases the money supply.
1.
There is no tight link between the monetary base and the
quantity of money.
2.
In places like the
3.
The problem is that the money multiplier is too
variable.
4.
Therefore, modern central banks keep an eye on trends in
money growth since that is what ultimately determines inflation. For short-run
policy, interest rates have become the monetary policy tool of choice.