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MGT411 - Money & Banking - Lecture Handout 33

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THE MONETARY BASE

  • 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.
  • Bank Reserves = Vault Cash plus Deposits at the central bank
  • The central bank can control the size of the monetary base and therefore the quantity of money

Changing the Size and Composition of the Balance Sheet

  • The central bank controls the size of its balance sheet. Policymakers can enlarge or reduce their assets and liabilities at will
  • 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.
  • There are four specific types of transactions which can affect the balance sheets of both the central bank and the banking system:
  • An open market operation, in which the central bank buys or sells a security;
  • A foreign exchange intervention, in which the central bank buys or sells foreign currency reserves;
  • The central bank’s extension of a discount loan to a commercial bank;
  • The decision by an individual to withdraw cash from a bank
  • Open market operations, foreign exchange interventions, and discount loans, all affect the size of the central bank’s balance sheet
  • 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
  • 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)

Open Market Operations

  • OMO is when the central bank buys or sells securities in financial markets
  • These purchases and sales have a straightforward impact on the central bank’s balance sheet:
  • Its assets and liabilities increase by the amount of a purchase, and the monetary base increases by the same amount
Table: Change in the Central Bank’s Balance sheet following purchase of a Treasury Bond
Assets Liabilities
Securities(Treasury Bond) +$1billion Reserves +$1billion

 

Table: Change in the Banking system’s balance sheet following the Central Bank’s purchase
of a Treasury Bond
Assets Liabilities
Reserves +$1billion
Securities (U.S. Treasury Bond) -$1billion
 
  • 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
  • For an open market sale, the effects would be the same but in the opposite direction

Foreign Exchange Intervention

  • The impact of a foreign exchange purchase is almost identical to that of an open market purchase:
  • The central bank’s assets and liabilities increase by the same amount, as does the monetary base.
  • If the central bank buys from a commercial bank, the impact again is like the open market purchase, except the assets involved are different.
Table: change in the Central bank’s Balance sheet following purchase of Euro-denominated
German Government Bonds
Assets Liabilities
Foreign exchange reserves +$1billion
(German government bonds in euros)
Reserves +$1billion

 

Table: Change in the Banking system’s Balance sheet following the Central bank’s purchase of
Euro-denominated German Government Bonds
Assets Liabilities
Reserves +$1billion
Securities -$1billion
(German government bonds)
 

Discount Loans

  • The central bank does not force commercial banks to borrow money; the banks ask for loans and must provide collateral, usually a Treasury bond.
  • When the central bank makes a loan it creates an asset and a matching increase in its reserve liabilities.
Table: Change in the Central Bank’s Balance sheet following a Discount Loan
Assets Liabilities
Discount loans +$100million Reserves +$100million

 

Table: Change in the Banking System’s Balance Sheet following a Discount Loan
Assets Liabilities
Reserves +$100million Discount loans +$100million
  • The extension of credit to the banking system raises the level of reserves and expands the monetary base.
  • The banking system balance sheet shows an increase in assets (reserves) and an increase in liabilities (the loan).

Cash Withdrawal

  • Cash withdrawals affect only the composition, not the size, of the monetary base.
  • When people withdraw cash they force a shift from reserves to currency on the central bank’s balance sheet.
Table: Change in the Nonbank Public’s Balance Sheet following a Cash Withdrawal
Assets Liabilities
Currency +$100
Checkable deposits -$100
 
  • 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.
Table: Change in the Banking system’s Balance sheet following a Cash Withdrawal
Assets Liabilities
Reserves -$100 Checkable deposits -$100
  • On the central bank’s balance sheet both currency and reserves are liabilities, so there is just a change between the two with a net effect of zero.
Table: Change in the Central Bank’s Balance Sheet following a Cash Withdrawal
Assets Liabilities
  Currency +$100
Reserves -$100

 

Changes in Size and Composition of Central Bank’s Balance Sheet and Monetary Base
Transaction Initiated by Typical action Impact
Open market
operation
Central bank Purchase of Treasury
bond
Increases reserves, the size of central bank’s
balance sheet and Monetary base
Foreign Exchange
Intervention
Central bank Purchase of foreign
govt. bonds
Increases reserves, the size of central bank’s
balance sheet and Monetary base
Discount Loans Commercial
bank
Extension of loan to
commercial bank
Increases reserves, the size of central bank’s
balance sheet and Monetary base
Cash withdrawals Nonbank public Withdrawal of cash
from ATM
Decreases reserves and increases currency,
leaving size of central bank’s balance sheet
and Monetary base unchanged

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