A policy on money: now

Introduction

We know that banks create money by extending loans, and that CB management of the growth rate of money creation is a critical issue. There are three methods or models of monetary policy implementation: (1) the firm required reserves model, (2) the firm borrowed reserves model and (3) the interbank rate model. The first one was flirted with in the past (and even a few central banks do today). The second and last models are about CB control of bank liquidity through open market operations and through this making the CB lending rate to banks effective. The first impact is on the b2b interbank rate. The interbank rate has a major impact on bank deposit rates and, through the margin that banks endeavour to maintain (in the interests of profit maximisation), on bank lending rates. Bank lending rates impact on the behaviour of the NBPS and therefore on the demand for loans; the latter is largely the counterpart of money creation.

Modern monetary policy (modern being from the last quarter of the twentieth century) revolves around the same elements as the Bank of England identified and it was maturing: the reserve requirement (the amount of which we call the RR, and the ratio the r), the central bank's lending rate to the banks (the KIR), and open market operations (OMO), which is used to make the KIR effective, through ensuring that the banks are indebted to the CB at all times.

We hasten to add that while this is the norm, it is not followed to the T by all central banks as we shall see. For example, we will show that not all central banks in this modern age have a reserve requirement (which does not mean that they cannot make loans). Similarly, not all central banks keep the banks in the red at all times; the mere threat of them being forced to borrow from the CB is enough to ensure that the banks' interbank rates (think: Fedfunds market) are closely aligned with the central bank's KIR.

We also hasten to add that in some countries, as Zimbabwe in 2008 / 2009, monetary policy has been conducted in a bewilderingly irresponsible manner. Generally, this can be ascribed to the lack of independence of the CB. Independence from government is a critical factor in the success of monetary policy. As we saw earlier, the co-ordination between monetary and fiscal policies needs to be in place. Ideally, government's deficit should not be financed by the banking sector (= money creation); neither should government borrow in the NBPS (which is mainly the retirement funds and insurers, where money is not created) to such an extent that the private sector's requirements for equity finance are "crowded out". Ideally, government and the CB need to collaborate closely in these matters, and if this is not the case, the CB should be able to carry out a restrictive monetary policy freely.

In this modern age there are essentially three methods (models) of monetary policy. We like to call them: (1) the firm required reserves model (firm-RR model), (2) the firm borrowed reserves model (firm-BR model) and (3) the interbank rate model (IBR model). The latter model is only slightly different to the firm-BR model as you will see.

Firm required reserves model

Let's commence with the first model: the firm-RR model. Note here that we assume that N&C do not rank as reserves. Where N&C do rank as reserves (in text books it is called the "monetary base model") it is a minor part of the story, and its inclusion would only serves to mask the principles.

As you now know, in real life the causation path of money creation runs from bank loans (= bank asset) to money (= bank liability). The RR comes into play in that as deposits (= money) increase, as a result of new bank loans extended or the purchase of newly issued securities (= bank loans), the amount of RR to be held with the CB increases. But, the banks can get the additional reserves required only by borrowing from the CB.

The previous example of government borrowing and spending is a true life example. Here we provide another (see Balance Sheets 2-5); it is the same as the one presented earlier but with the RR and the CB included.

BALANCE SHEET 2: COMPANY A (NBPS) (LCC MILLIONS)

Assets

Liabilities

Goods

Deposit at bank

-100 + 100

Total

Total

BALANCE SHEET 3: COMPANY B (NBPS) (LCC MILLIONS)

Goods

+ 100

Loans from bank

+ 100

BALANCE SHEET 4: BANK (LCC MILLIONS)

Loans to Company B Reserves at CB (TR) (RR = +10)

+ 100 + 10

Deposits of Company A Loan from CB @ KIR

+ 100 +10

Total +110 Total +110

BALANCE SHEET 5: CENTRAL BANK (LCC MILLIONS)

Assets

Liabilities

Loans to banks (BR) @ KIR

+ 10

Bank reserves (TR) (RR = +10)

+10

Total

We emphasize here again that no bank can create CBM (reserves); only the CB can. Therefore what happens in the above case? The simple answer is that it cannot, unless the CB allows it to come about by providing the reserves (note that +BR = +RR). You will recall that where a reserve requirement exists, which applies to bank deposits, there is a fixed relationship between RR and bank deposits (BD):

Thus if BD = LCC 100 million and r = 10%, we have:

This means that the banks cannot supply any further loans unless the CB supplies BR. So, without the CB supplying BR, the banking system comes to a halt in terms of new loans, and therefore money creation. It will be evident that in such a system, assuming the existence of a demand for loans, interest rates (prime rate - PR) will rise up to a point where new projects are rendered non-viable. Recall that companies need to have an expected return on the project for which borrowing is required, which is higher the cost of borrowing (PR).

Clearly this is the extreme case, which we present here to make a point. The central banks that operate this model (few161 do) provide reserves to the extent that is consistent with their money growth target. The calculation is simple. If the banking system is in balance (= no BR and no ER) and the money stock in the form of BD is LCC 100 billion, and the CB would like the money stock in this form to grow by 12% over the next twelve months (to LCC 112 billion), it will supply additional reserves to the extent of LCC 1.2 billion, which will be used by the banking sector as the "backing" for money stock growth of LCC 12 billion.

How does the CB achieve this? The answer is OMO purchases of government securities (bonds) to the extent of LCC 1.2 billion. We assume these are forthcoming from the banks (they will offer them at a tender). The CB will do this in stages, to avoid a sharp drop in interest rates that accompanies the creation of ER. For the sake of clear illustration we assume it is done in one go (see Balance Sheets 6-7).

BALANCE SHEET 6: CENTRAL BANK (LCC MILLIONS)

Assets

Liabilities

Government bonds

+ 1 200

Bank reserves (TR) (RR = +0) (ER = +1 200)

+ 1 200

Total

+1 200

BALANCE SHEET 7: BANKS (LCC MILLIONS)

As noted, the banks will over time be able to meet new demand or loans; the final outcome is presented in Balance Sheets 8-9.

BALANCE SHEET 8: CENTRAL BANK (LCC MILLIONS)

Assets

Liabilities

Total

Bank reserves (TR) (RR = +1 200) (ER = -1 200)

Total

0

BALANCE SHEET 9: BANKS (LCC MILLIONS)

Reserves at CB (TR)

0

(RR = +1 200) (ER = -1 200)

Deposits of NBPS

+ 12 000

Loans to NBPS

+12 000

The money stock has increased by LCC 12 billion and ER has shifted to RR. It will be quite evident by now that once the banking system has expanded to the point where all its ER shifted into RR, it cannot expand any further. Interest rates in this system are free to find their own levels, and will now reflect the quantitative constraint on money growth. The lending rate of the banks (PR) will increase sharply.

As the scholars of money and banking will know, essentially this is a theoretical money "supply" model. Some of the world's large central banks flirted with this model in the past but rejected it because the profound consequence of the quantitative control of bank reserves was extremely volatile interest rates. As noted, in some parts of the developing world this model is imposed on the central banks as part of developmental programmers that includes donor funds.

A final word: you will understand that the RR has replaced the gold coin / bullion holdings of the banks / central banks of old, which were held against deposits and bank notes issued. Because the deposits / bank notes were convertible to gold, the bankers could not afford to allow the gold reserves to drop too low in relation to deposits / notes. This represented the brake on the system.

 
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