The money identity and the creation of money
BOX 39: CONSOLIDATED BALANCE SHEET OF MBIs (LCC MILLIONS)
Equity and liabilities
A. Notes and coins
D. Foreign assets
E. Claims on government
1. Private sector
F. Loans to private sector
2. Government sector
C. Foreign loans
Bank loan extension is the main BSCoC of the addition to the money stock. There is another: certain activities in the foreign exchange market. In this section we present the money identity, which shows all the BSCoCs. It is derived from consolidated balance sheet of the MBIs (in a consolidation all interbank claims are netted out). The consolidated balance sheet of the MBIs is shown in simplified form in Box 39.
M3 was defined earlier as N&C in circulation (i.e. outside the banking sector) and all NBPS deposits with the MBIs. These are items A and B1 in the consolidated balance sheet. Clearly, because a balance sheet balances [liabilities (plus equity that we include here in liabilities) are equal to assets], items A and B1 = M3 must be equal to items:
It will be evident that certain items are closely related, specifically:
• Item D (foreign assets) and item C (foreign loans).
• Item E (claims on government) and item B2 (government deposits).
If one is trying to "explain" changes in M3 it makes sense to deduct the liability items mentioned from their asset counterparts. Having done this, we now arrive at the balance sheet identity.
This can be verbalized as:
We can make the identity even simpler by grouping NCG and LPS and calling it domestic loan extension (DLE - in the examples we presented earlier "Loans to..." should be seen as DLE). Now:
Thus the BSCoCs in M3 are changes in NFA and changes in DLE:
As we have said before, the actual causes of changes are the dynamics that underlie the changes in NFA and DLE. This analysis requires more elaboration, but a space limit thwarts it.
Role of the central bank in money creation
The role of the CB in money creation also requires much consideration; again we are limited. As a conclusion to this text we present a brief discussion on the role of the CB in money creation (in this and the next section). We touched upon this earlier and endeavour to cement it here.
In much of the developed world monetary policy is conducted through an operational variable: interest rates. Following is a summary of the KIR's transmission path to the banks' lending rates [prime rate (PR) is the benchmark; all lending rates are related to PR], inflation and economic growth:
• The CB, through open market operations (OMO) creates a liquidity shortage (LS) and, in most countries in normal circumstances, maintains it permanently. This means it "forces" the banks to borrow from it at all times. The borrowing term is short (usually 1 day to 7 days).
• It levies its KIR on these borrowed reserves.
• The bank-to-bank interbank rate (b2b IBM, the market in which banks settle interbank claims on one another) takes its cue from the KIR.
• The b2b IBM rate has a major impact on the banks' deposit rates (wholesale call money rates in the first instance and other short-term deposit rates in the second, and so on).
• As the banks maintain a steady margin, deposit rates impact on bank lending rates.
• Thus the KIR impacts on the banks' PR (in one country the correlation coefficient between the KIR and PR for the period 1960 to the present = 0.99).
• The level of PR (especially in real terms) influences the NBPS's demand for bank loans (governments tend to be interest rate insensitive).
• Interest rate changes also have a major impact on asset prices which through the "wealth effect" influence consumption and investment (C + I = GDE) behaviour.
• ADLE is the main counterpart of AM3.
• The growth rate in demand (AGDE), financed to a large degree by ADLE and reflected in AM3, has a major impact on price developments (inflation).
• The inflation rate is a major input in business decisions
• Business decisions impact on economic growth and employment.
Figure 5: monetary policy
The above is a brief synopsis of monetary policy and of part of the so-called monetary policy transmission mechanism (MPTM). The MPTM may be depicted minimally as in Figure 5.
How does a central bank maintain a bank liquidity shortage?
In the previous section we stated that "The CB, through open market operations (OMO) creates a LS and maintains it permanently." This is a significant and interesting topic and will be covered here in brief.
Box 40 presents the balance sheet of the central bank in simplified form (we have left out unimportant items such as other assets, other liabilities and capital and reserves). From this balance sheet we can create what can be called a money market identity as follows:
On the left of the identity we have the net excess reserves (NER) of the banking sector, an indicator of bank liquidity (as far as CBM is concerned). This is made up of the ER of the banking sector (item B2b)28 less the extent of loans to the banking sector (at the KIR), i.e. the LS (item F, also called borrowed reserves - BR):
BOX 40: CENTRAL BANK (LCC MILLIONS)
On the right hand side of the identity we have all the remaining liability and asset items (the BSCs); thus:
If we group the related liability and asset items we have:
It will also be evident that:
Thus, a change in the NER (and the LS which is its main component) of the banking system is caused by changes in the BSCs (i.e. the BSCoC):
A(E - C) = net foreign assets (NFA)
+ A (F - B1) = net claims on government (NCG)
- AA = notes and coins in circulation
- AB2a = required reserves (RR)
- AD = central bank securities (CBS).
The actual causes of change are the transactions that underlie the BSCoC. It will be evident that the instruments of OMO are NFA (usually forex swaps), NCG (purchases / sales of government securities in the main) and CBS (issues) and that RR can also be used (and is at times) to manipulate bank liquidity (NER). For example, the sale of forex to a bank (a forex swap) will decrease NER (increase the LS). The BSCoC is a decrease in NFA. Similarly the sale of TBs to the banks will decrease NER (increase the LS). The BSCoC is a decrease in NCG. Thus, the CB has total control over bank liquidity (assuming efficient markets).
The above illustrates that bank liquidity is firmly under the control of the CB, and that the RR is just one of the many factors that influences bank liquidity. Most countries' monetary policy approach rests on creating and maintaining a liquidity shortage (in normal circumstances) in order to make the KIR effective. Thus, to maintain that money creation revolves around the RR is misleading. In fact, because it takes time for banks to compile their statements of assets and liabilities, they, in most countries, are required to top up their RR up to 7 weeks after deposit increases29.
This exposition does not ignore the existence of a loan / credit / money multiplier (maximum deposit increase = ER / r), i.e. the CB is able to create ER and force the multiplier on banks. However, this implies quantitative restriction and interest rate freedom, the consequence of which is extremely volatile interest rates. Central banks and the business sector do not like this state of affairs. Rather, they like stable interest rates and use them (the PR in particular - via making KIR effective) to manipulate the demand for loans. New bank loans create new bank deposits (money).
It is a fine system, provided new loan / money creation (which to a large degree reflects AC + I) is congruent with economic output elasticity.