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)17 less the extent of loans to the banking sector (at the KIR), i.e. the LS (item G):
NER = B2b - G.
BOX 40: CENTRAL BANK (LCC MILLIONS)
Equity and liabilities
A. Notes and coins
E. Foreign assets
F. Government securities (claims on gout)
G. Loans to banks (MMS)
1. Government 2.Banks (TR)
C. Foreign loans
D. Central bank securities
On the right hand side of the identity we have all the remaining liability and asset items (the BSCs); thus:
NER = B2b - G = (E + F) - (A + B1 + B2a + C + D). If we group the related liability and asset items we have:
NER = B2b - G = (E - C) + (F - B1) - A - B2a - D. It will also be evident that:
ANER = A(E - C) + A(F - B1) - AA - AB2a - AD.
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 = RR
- AD = central bank securities (CBS).
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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 increases18.
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.
Faure, AP, 1977. A money market analysis. South African Reserve Bank Quarterly Bulletin, September. Pretoria: South African Reserve Bank.
Van Staden, B, 1966. A new monetary analysis for South Africa. South African Reserve Bank Quarterly Bulletin, March. Pretoria: South African Reserve Bank.