Satisfied demand for a bank loan

It will have been noted that we have ignored the effect on the RR of the increased deposits of the NBPS: an increase in RR of LCC 10 billion. This leads to an increase in bank indebtedness to the CB, and therefore to a decline on NER. We have done so in the interests of simplicity. We introduce it now with an example of money creation which means bank loans and deposits have increased, which in turn means that the banks have an increased RR situation.

BALANCE SHEET 17: BANKS (LCC BILLIONS)

Liabilities

Loans to NBPS

+ 100

Deposits of NBPS

+ 100

+100

Balance Sheet 17 shows that the banks have made additional loans of LCC 100 billion, and created in the process additional deposits (= money) of the same amount. As we have shown, ARR = ABD x r; therefore in this case the banks are obliged to increase their RR with the CB by:

BALANCE SHEET 18: BANKS (LCC BILLIONS)

Assets Liabilities

Loans to NBPS

+100

Reserves at CB (TR)

+10

Deposits of NBPS

+100

(RR +10)

Loans from CB (BR)

+10

(ER 0)

Total +110 Total +110

We have shown that the banks cannot create CBM; therefore they have no option but to borrow (BR) from the CB in order to comply with the increased reserve requirement. Balance Sheet 18 takes Balance Sheet 17 to its final conclusion, and Balance Sheet 19 shows the changes in the balance sheet of the CB.

BALANCE SHEET 19: CENTRAL BANK (LCC BILLIONS)

Assets Liabilities

Reserves of banks (TR)

+10

Loans to banks (BR)

+10

(RR = +10)

+10

(ER = 0)

Balance Sheet 20 shows the stock balance sheet of the CB (with the relevant items changed from the original one - see Balance Sheet 21). Again, the items that change are indicated in green.

BALANCE SHEET 20: CENTRAL BANK (LCC BILLIONS)

BALANCE SHEET 20: CENTRAL BANK (LCC BILLIONS)

BALANCE SHEET 21: CENTRAL BANK (LCC BILLIONS)

BALANCE SHEET 21: CENTRAL BANK (LCC BILLIONS)

Notable is the fact that the change in NER (-10) brought about by the increase in bank deposits is just one of many factors that can influence NER. In other words the increased reserve requirement is not the driving force in money creation, but a consequence of money creation (this is taken further later again).

As already said, most central banks around the world have the tools to manipulate NER to any level desired / dictated by the monetary policy stance. In most countries the level is always a shade of a negative number and it is often used as an indicator of the stance of monetary policy. And it is always a negative number because - and this is vital - the KIR is only effective if the banks are indebted to the CB.

It is important to note that in this statement, and in the examples presented above, we assumed that the central bank's loan window is always open, and that NER is always negative. As we will show now (and again later), this was not always the case in the past and is not always the case now. In times of crisis central banks have been known to create excess liquidity (ER; a positive NER number) in order to "force" interest rates to levels close to zero in order to stimulate borrowing. As you now know, if you borrow from a bank (T LNBPS) the bank creates a deposit (= T M); underlying this is your increased demand for goods - you borrowed in order to buy goods (T C = T GDE = T GDP).

Surplus liquidity

Some central banks have major surplus liquidity "problems", i.e. a chronically positive NER number. This usually results from donor money (grants in the form of USD / EUR, GBP = forex to the receiving country) which is sold by government to the CB for the local currency for spending. This requires a little elucidation. An example of a positive NER banking system is presented in Balance Sheet 22. The relevant balance sheets items are highlighted; it will be seen that NER = +LCC 200 million (a stock

number) (NER = ER - BR = LCC 200 - LCC 0 = LCC 200).

BALANCE SHEET 22: CENTRAL BANK (LCC MILLIONS)

Assets

Liabilities

A. Notes and coins

1 000

D. Foreign assets

1 600

B. Deposits

1. Government

900

E. Loans to government

1 100

2. Banks' reserve accounts (TR)

700

(RR = 500)

F. Loans to banks (BR) @ KIR

0

(ER = 200)

Total

2 700

C. Foreign loans

Total

100

2 700

As said before, under these conditions the CB loses control over interest rates. Put yourself in the position of the banks that hold the surplus. These balances earn no interest; and the only way to get rid of the surplus is to provide loans cheaply (remember our statement that only the CB can create CBM; by the same token, banks cannot destroy CBM). The extension of new loans creates deposits which carries a reserve requirement. This expansion in lending has to continue up to the point where all the surplus reserves (ER) are "absorbed" into RR. This happens when bank deposits created increases by LCC 2000 million because 10% of this amount is equal to the surplus of LCC 200 million.

As you know, there is an equation for this condition:

This is why the CB loses control - banks drop lending rates in their desperate endeavour to "get rid of" their surplus reserves (ER). This increases the demand for loans, and therefore money (= deposit) growth takes place, but it has to increase by the reciprocal of the r (1/r) in order to have all the ER absorbed into RR.

We now demonstrate how donor funds can lead to a positive NER. The starting point is Balance Sheet 23: the banking system is in a liquidity neutral position: NER = 0.

BALANCE SHEET 23: CENTRAL BANK (LCC MILLIONS)

Assets

Liabilities

A. Notes and coins

1 000

D. Foreign assets

1 600

B. Deposits

1. Government

900

E. Loans to government

1 100

2. Banks' reserve accounts (TR)

500

(RR = 500)

F. Loans to banks (BR) @ KIR

0

(ER = 0)

C. Foreign loans

300

Total

2 700

Total

2 700

The government of Developing Country receives a donation of USD 10 million (= LCC 100 million at the prevailing exchange rate USD / LCC 10.0) from the World Development Bank (WDB). It maintains its account at US Bank. The transactions are illustrated in Balance Sheets 24-26.

BALANCE SHEET 24: WDB (USD MILLIONS)

Liabilities

Donation Bank deposits

+10 -10

BALANCE SHEET 25: US BANK (USD MILLIONS)

Liabilities

Deposits of WDB

Deposits of Dev Country govt

-10 +10

BALANCE SHEET 26: GOVT OF DEV COUNTRY (LCC MILLIONS)

Liabilities

Forex (deposit at US Bank)

+ 100

Donation

+ 100

+100

The government requires the local currency, LCC, in order to spend the funds locally on goods. It sells the forex to the CB. The transactions are illustrated in Balance Sheets 27-29.

BALANCE SHEET 27: US BANK (USD MILLIONS)

Deposits of Dev Country govt Deposits of Dev Country CB

-10 +10

BALANCE SHEET 28: GOVT OF DEV COUNTRY (LCC MILLIONS)

Assets

Liabilities

Forex (deposit at US Bank) Deposit at Local Country CB

-100 + 100

0

BALANCE SHEET 29: DEV COUNTRY CENTRAL BANK (LCC MILLIONS)

Assets

Liabilities

Forex (deposit at US Bank)

+ 100

Government deposits

+ 100

+100

The government of Developing Country spends the funds locally on goods. The transactions are illustrated in Balance Sheets 30-33.

BALANCE SHEET 30: GOVT OF DEV COUNTRY (LCC MILLIONS)

Goods

+ 100

Deposits at CB

-100

BALANCE SHEET 31: NBPS (LCC MILLIONS)

Liabilities

Goods

Deposits at banks

-100 + 100

0

BALANCE SHEET 32: BANKS (LCC MILLIONS)

A. Notes and coins

1 000

D. Foreign assets

1 600

B. Deposits

1. Government

900

E. Loans to government

1 100

2. Banks' reserve accounts (TR)

700

(RR = 500)

F. Loans to banks (BR) @ KIR

0

(ER = 200)

2 700

C. Foreign loans

100

BALANCE SHEET 33: CENTRAL BANK (LCC MILLIONS)

Assets Liabilities

Government deposits

-100

Bank reserves (TR)

+ 100

(RR = +10)

(ER = +90)

LCC 100 million reserves (TR) were created by the government selling forex to the CB. LCC 10 million of TR becomes RR because bank deposits increased by LCC 100 million, and the balance of LCC 90 million = ER. The stock balance sheet of the CB changes to Balance Sheet 34 (compare it with original Balance Sheet 35). It shows that ER = LCC 90 million = NER. In terms of changes we have:

The real cause of change in NER was the donation to government in forex which was sold to the CB, and government spent the funds.

BALANCE SHEET 34: CENTRAL BANK (LCC MILLIONS)

Assets

Liabilities

A. Notes and coins

1 000

D. Foreign assets

1 700

B. Deposits

1. Government

900

E. Loans to government

1 100

2. Banks' reserve accounts (TR)

600

(RR = 510)

F. Loans to banks (BR) @ KIR

0

(ER = 90)

C. Foreign loans

300

Total

2 800

Total

2 800

BALANCE SHEET 35: CENTRAL BANK (LCC MILLIONS)

Assets

Liabilities

A. Notes and coins

1 000

D. Foreign assets

1 600

B. Deposits

1. Government

900

E. Loans to government

1 100

2. Banks' reserve accounts (TR)

(RR = 500)

F. Loans to banks (BR) @ KIR

0

(ER = 0)

C. Foreign loans

300

Total

2 700

Total

2 700

The obvious course of action for the CB to take, if it is policy to make the KIR effective, is to undertake an open market sale of government securities to the extent of LCC 100 million or more. However, this is often reluctantly done because it will affect the revenue of the CB. It should be accepted there is a price to pay for the proper execution of monetary policy.135 We will return to this issue again later.

 
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