In Australia in 2008, the actual reserve ratio was about 10.5 per cent. I lowever, since the bank deregulations in the l()80s that changed the banking system from one of the most controlled in the world to one of the least controlled, there have been no legal reserve requirements. While there remains prudential supervision ol the banks, this isn't an aspect of monetary policy.
• 1 caving aside reserves, banks use the remainder of their funds to make loans to firms and consumers or to buy bonds. Loans in Ausiralia today represent roughly 63 per cent of banks non-reserve assets. Bonds of various types account lor the other 37 per cent. The distinction between bonds and loans is unimportant tor our purpose—which is understanding the determination ol the money supply. So. in what follows, we will assume tor simplicity that banks don't make loans, that they hold only reserves and bonds as assets. But the distinction between loans and bonds is important for other purposes, from the possibility ot bank runs' to the role ol federal deposit insurance in the United States. These topics are explored in the focus box 'Bank runs.
Figure 4.6, panel (a> returns to the balance sheet of the central bank, in an economy in which there- are banks. It is very similar to the balance sheet ot the central bank shown in Figure 4.5. The asset side- is the same as before—the assets of the central bank are the bonds it holds. The liabilities ol the central bank are the money it has issued, central bank money. The new feature is that not all central bank money is held as currency by the public. Some is held as reserves by banks.
BANK RUNS
Is bank money (current account deposits that can be used to make payments directly) just as good as central bank money (currency)? To answer, we must look at what banks do with the funds they receive from depositors, and at the distinction between making loans and holding bonds.
Making a loan to a firm and buying a government bond are actions more similar than they may seem. In one case, the bank lends to a firm. In the other, the bank lends to the government.This is why, for simplicity, we have assumed in the text that banks hold only bonds.
But. in one respect, making a loan is very different from buying a bond. Bonds, especially government bonds, are very liquid. In case of need, they can be sold easily in the bond market. Loans are often not liquid at all. Calling them back may be impossible: the firm, which has used the loan to buy inventories or a new machine, no longer has the cash.The bank could, in principle, sell the loan itself to a third party and get cash: but selling the loan may oe very difficult, as potential buyers know little about how reliable the firm is as a borrower.
This fact has one important impiication.Take a healthy bank, a bank with a good portfolio of loans. Suppose rumours start that the bank isn't doing well and some loans won't be repaid. Believing that the bank may fail, people with deposits at the bank will want to close their accounts and withdraw cash. If enough people do so, the bank will run out of reserves. Given that the loans cannot be called back, the bank won't be able to satisfy the demand for cash, and it will have to close.
Conclusion: The belief that a bank may close may lead it to close, even if all its loans are good.The financial history of the United States up to the 1930s is full of such bank runs. In Australia, the 1890s saw many banks collapse, though only three failed during the Great Depression of the 1930s. Since then the Australian financial system has been remarkably stable. Bank runs are occurring even in the modern day. In September 2007, the media was full of stories and pictures from the United Kingdom, where the Northern Rock, one of the country's largest mortgage banks, refused to open its doors to its irate customers. One bank fails for the right reason (that is, it has made bad loans), leading depositors at other banks to become scared and run on their own banks, thus forcing them to close, whether or not their loans are good.You may have seen It's a Wonderful Life, an old movie with James Stewart. Because of the failure of another bank in town, depositors at the savings and loans bank for which James Stewart's character is the manager panic and want to get their money back. It takes all of James Stewart's persuasion to avoid closure.The movie has a happy ending, but in real life most bank runs do not end happily.
What can be done to avoid such runs? The United States has dealt with this problem since 1934 with federal deposit insurance. The US government insures each account up to a ceiling of $100,000. As a result, there is no reason for depositors to panic and to try and get their money out. and healthy banks don't fail.
However, federal deposit insurance leads to problems of its own. A major one is called 'moral hazard'. Depositors who don't have to worry about their deposits no longer look at the activities of the banks in which they have their deposits, and banks may misbehave—for example, making loans they wouldn't have made in the absence of the insurance. (More on this when we discuss the 2008 global financial crisis in Chapter 22.)
There has been no explicit deposit insurance scheme in Australia, until recently. The Reserve Bank regards the stability of the financial system as one of its responsibilities.The RBA is prepared to lend to a licensed financial institution with temporary liquidity difficulties, but only if it believes that the whole system would be at risk. It claims that it doesn't rescue insolvent institutions. In late 2008. the global financial crisis led to the collapse, merger or takeover of many struggling financial institutions. The situation was so bad at the time of writing (October 2008) that governments everywhere were putting in place guarantees for bank deposits. In Australia, the Rudd government assured depositors that their deposits at banks will be fully protected for at least three years.This has happened because of the real fear of bank collapses, which could usher in a deep recession, if not a depression.These problems are discussed in much greater detail in Chapter 22.
A useful defence against bank runs is to have high-quality bank supervision by the government. Since 1998. the supervision of a broad range of financial institutions in Australia (Australian and foreign-owned banks, building societies, credit unions, insurance companies, superannuation funds, and so on) has been handled by the Australian Prudential Regulation Authority (APRA). Its duty is to ensure that these licensed financial institutions follow best practice in risk management.The idea is that depositors will then feel confident that their deposits are safe, thus reducing the likelihood of bank runs. The banking system in Australia was in very good shape in 2008. with less than I per cent of loans considered as problems, down from 6 per cent in 1991. (Contrast this with Japan's 8 per cent in 2002, and the United States in 2008 struggling with about 6 per cent delinquency of all its mortgages, mostly sub-prime ones, which are loans to people with a high risk of default.) Nevertheless, in the terrible crisis of confidence in global financial markets in 2008, the Australian government decided to guarantee for three years all deposits of banks supervised by APRA.
An alternative solution to bank runs, which has been often proposed but never implemented, is narrow banking. Narrow banking would restrict banks to holding liquid, safe, government bonds, such as T-bills. It would eliminate bank runs, as well as the need for federal insurance. Loans to firms would have to be made by other financial intermediaries, who would then have to be more carefully regulated that they are at present.
The supply of and demand for central bank money
Tlic easiest way to think about the determination ol the interest rate in this economy is to think in terms of the supply of and demand for central bank money:
• The demand lor central bank money is equal to the demand lor currency plus the demand lor reserves by banks.
• The supply ol central bank money is under the direct control of the central bank.
• The equilibrium interes: rate is such that the demand for and the supply ot central bank money arc- equal.
Remember, though, that the central bank could just as well decide what interest rate it would like, and vary the supply of central bank money so that the supply equalled the demand lor central bank money at that interest rate. Indeed, most central banks do this all the time.
Figure 4.7 shows the structure of demand and supply in more detail. (Look only at the top part ol the figure lor the moment. The bottom part shows how the equations we will derive later relate to the various boxes in the figure.
Start from the left side. The demand lor money is a demand lor both current account deposits and currency. Banks have to hold reserves against deposits. The demand lor deposits leads to a demand lor reserves by banks. The demand lor central bank money is equal to the demand lor reserves by banks plus the demand for currency. Now go to the right side. The supply ol central bank money is determined by the central bank. The interest rate nuist be such that the demand and the supply arc- equal.
We now go through each of the boxes in Figure 4.7 and ask:
• What determines the demand lor current account deposits and the demand lor currency?
• What determines the demand for reserves by banks?
• How does the condition that the demand and the supply ot central bank money be equal determine the interest rate?
The demand for money
When people can hold both currency and current account deposits, the demand lor money involves two decisions. First, people must decide how much money to hold. Second, they must decide how much of this money to hold in currency and how much to hold in deposits.
Md
4.3)
It is reasonable to assume that the overall demand lor money (currency plus deposits) is given by the same factors as before. People will hold more money the higher the level ol transactions and the lower the interest rate on bonds. So, we can assume that overall money demand is given by the same- equation That brings us to the second decision. How do people decide how much to hold in currency, and how much in deposits? Currency is more convenient lor small transactions. I It is also more convenient lor illegal transactions:? Cheques and EFTPOS arc more convenient lor large transactions. Holding money in your account is saler than holding it in cash.
(4.4) (4.51
Let us simply assume that people hold a lixed proportion of their money in currency—call this proportion <"—and, by implication, a fixed proportion 11 — c) in current account deposits. In Australia in 2008, people held 19 per cent of their money (Ml) in the lorm of currency, thus с = 0.19. Call the demand lor currency CU* (CU for currency, and il for demand !. Call the demand for currcnt account deposits D"' i D tor deposits, and d lor demand). The two demands are given by
CUd = cMd D1' = (I - c)Md
where M'! is given in equation (4.3). Equation (4.4i gives the lirst component of the demand for central bank money, the demand for currency by the public. Equation '4.5) gives the demand lor current account deposits.
We now have a description of the behaviour in the first box column, entitled Demand for money, in Figure 4.7. Equation (4.3) gives the overall demand lor money,- equations (4.4) and 14.5) give the demand lor current account deposits and the demand for currency, respectively. The three demand equations arc written in the bottom part ol the box in the figure.
The demand lor current account deposits leads to a demand by banks lor reserves, the second component ol the demand for central bank money. To see how, let us turn to the behaviour ol banks.
The demand for reserves
The larger the amount of bank deposits, the larger the amount of reserves the banks must hold, either for precautionary or for legal reasons. Let в (the Creek lowercase theta) be the reserve ratio, the amount of reserves banks hold per dollar ol deposits. Let R denote the reserves ot banks. Let D denote the dollar amount of bank deposits. Then, by the definition ol в, the following relation holds between R and D:
R = вО (4.6)
We saw earlier that, in Australia today, the reserve ratio is equal to 10.5 per cent. Thus, в is equal to 0.105.
If people want to hold DJ in currcnt account deposits, then from equation (4.61 banks must hold 0D'1 in reserves. Combining equations (4.5) and 4.6 , the second component of the demand for central bank money—the demand for reserves by banks—is given by
R
The demand for central bank money
Call Hthe demand lor central bank money. This demand is equal to the sum of the demand lor currency and the demand for reserves by banks:
Hd = CU* + Rd (4.8)
Replace CU'! and Rd by their expressions from equations 14.4) and (4.7) to get
Hd = cMd + 0(1 — c)Md = [c +• 0(1 — c)]Md
finally, replace the overall demand for money, ,VI" by its expression from equation (4.3) to get
A Federal Reserve study ► suggests that more wan half of US currency is held abroad! It is a reasonable guess that part of these foreign holdings of US currency is associated with illegal transactions, and that US currency is the currency of choice for illegal transactions around the world. The US dollar is also used as an alternative to the local currency in high-inflation
HJ = [c + 01 I - с)]$УШ) (4.9)
This gives us the equation corresponding to the third box column, Demand lor central bank money', in Figure 4.7.
The determination of the interest rate
We arc now ready to characterise the equilibrium. Let H be the supply ol central bank money. H is directly controlled by the central bank; just as in the previous section, the central bank can change the amount ol H through open-market operations. We call it H because sometimes economists describe it as high-powered money. The equilibrium condition is that the supply of central bank money be equal to the demand lor central bank money:
H = Hd (4.10)
Or, using equation (4.9):
H = [c t 0(1 - c)]$VL(i) (4.11)
The supply ol central bank money (the lelt side of equation [4.11]) is equal to the demand for central bank money (the right side ot equation 4.11 ]), which is itself equal to the term in brackets times the overall demand for money.
Look at the term in brackets more closely. Assume that people held only currency, so с = I. Then, the term in brackets would be equal to I, and the equation would be exactly the same as equation (4.2) in Section 4.2 (with the letter II replacing the letter M on the left side, but H and Ai both stand lor the supply of central bank money). In this case, people would hold only currency, and banks would play no role in the supply ol money. We would be hack to the case we looked at in Section 4.2.
Assume instead that people don't hold currency at all. hut hold only current account deposits. In this case, г 0, and the term in brackets is equal to в. Suppose, lor example, that в - 0.1, so that the term in brackets is equal to 0.1. Then, the demand for central bank money is equal to one-tenth ol the overall demand for money. This is easy to understand—people hold only deposits. For every dollar they want to hold, banks need to have 10 cents in reserves. The demand for reserves is one-tenth ol the overall demand for money.
Leaving aside these two extreme cases note that, as long as people hold some deposits (so that с < I), the term in brackets is less than I. The demand for central bank money is less than the overall demand for money. This comes from the fact that the demand tor reserves by banks is only a Iraction of the demand for deposits.
We can represent the equilibrium condition, equation (4.11), graphically, and we do this in Figure 4.8. The ligurc looks the same as Figure 4.2, but with central bank money rather than money on the horizontal axis. The interest rate is measured on the vertical axis. The demand tor central bank money, CU'1 + RJ, is drawn for a given level of nominal income. A higher interest rate implies a lower demand tor central bank money, for two reasons: the demand for currency goes down,- and the demand for bank deposits also goes down, leading to a decrease in the demand for reserves by banks. The supply of money is fixed, and is represented by a vertical line at II. Equilibrium is at point A, with interest rate i.
The ellects of either changes in nominal income or changes in the supply of central bank money are qualitatively the same as ir. the previous section. In particular, an increase in the supply ol central bank money leads to a shilt in the vertical supply line to the right. This leads to a lower interest rate. As bclore, an increase in central bank money leads to a decrease in the interest rate,- symmetrically, a decrease in central bank money leads to an increase in the interest rate.
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4.4 TWO ALTERNATIVE WAYS TO THINK ABOUT THE EQUILIBRIUM
Demand for central bank money
Hd = CUd + Rd
Figure 4.8 Equilibrium in the market for central bank money, and the determination of the interest rate
H
Central bank money, H
The equilibrium interest rate is such that the supply of central bank money is equal to the demand for central bank money.
all equivalent, each provides a different way ol thinking about the equilibrium, and going through each will strengthen your understanding.
The interbank overnight cash market and the cash rate
Instead of thinking in terms of the supply ol and demand for central bank money, we can think in terms of the supply ol and demand lor bank reserves.
The supply of reserves is equal to the supply of central bank money II, minus the demand for currency by the public, CU1'. The demand for reserves by banks is R". So, the equilibrium condition that the supply of and demand for bank reserves be equal is given by
H - CUJ = R'1
Note that, if we move CU" from the left side to the right side, and use the fact that the demand lor central hank money, Hi is given by Hd = + R'1, then this equation is equivalent to II = //''. In other words, looking at the equilibrium in terms of the supply of and demand for reserves is equivalent lo looking ai the equilibrium in terms ol the supply of and demand for central bank money—lhe approach followed in Section 4.3.
Nevertheless, this alternative way ot looking at the equilibrium is attractive because, in Australia (as in most other modern economies), there is indeed a market tor bank reserves, in which the interest rate moves so the supply ol and demand for reserves arc equal. This market is called the overnight interbank cash market in Australia (and the federal funds market in the United States). The accounts in which banks keep their reserves at the central bank are called exchange settlement accounts in Australia. It is essential for banks to hold these accounts at the RBA, in order to clear any transactions involving the government. In effect, banks that have excess reserves at the end ot the day lend them to
banks that have insufficient reserves. In overnight equilibrium, the interbank market clears, and the total demand lor exchange settlement reserves by all banks, R* must be equal to the supply ol these reserves to the market, H - CU'1, the equilibrium condition stated above. The interest rate determined in the market is called the cash rate in Australia (and the federal funds rate in the United States). Because the central bank—the Reserve Bank of Australia (or the federal Reserve in the United States)—can choose the cash interest rate it wants by appropriately changing the supply ol central bank money, II. the cash rate is typically thought ol as an indicator of Australian monetary policy, reflecting what the RBA wants the interest rate to be. This is why, when we looked in Chapter I at the sharp decline in the cash rate and the federal funds rate during 2008, we interpreted the decline as reflecting the decision by the RBA and the Fed to decrease the interest rate in order to stimulate economic activity. In fact, in subsequent chapters, we will describe central bank monetary policy in modern, well-behaved economies as choosing a preferred interest rate. To achieve and maintain their desired interest rate, the central bank has to be prepared at all times to appropriate!}/ buy and sell H for bonds in its open-market operations. We will work this out in detail in Chapter 5.
The supply of money, the demand for money and the money multiplier
Instead of thinking in terms ol the supply ol and demand for central bank money, we can look at the equilibrium in terms ol the overall supply ot and overall demand lor money (currency and deposits).
To derive an equilibrium condition in terms ol the overall supply ol and overall demand for money, take the equilibrium condition (4.111 and divide both sides by |r + 0( I — c)]:
7 -7 TH - $YL(i) (4.12)
[c + 0( 1 - r)]
The right side of the equation gives the overall demand lor money (currency plus deposits.) The left side gives the overall supply of money (currency plus deposits). Condition -112) therefore says that, in equilibrium, the overall supply ol and overall demand lor money must be equal.
• If you compare equation 4.12) with equation (4.2). the equation characterising the equilibrium in an economy without banks, you will see that the only difference is that the overall supply ot money isn't equal just to central bank money but to central bank money times a constant term \/[c +0(1— c)].
• Note also that, because fr + 0 (1 — f)] is less than one. its inverse—the constant term on the left of ;4.I2)—is greater than one. For this reason, this constant term is called the money multiplier. The overall supply of money is thcrclorc equal to central bank money times the money multiplier. II the money multiplier is 4, for example, then the overall supply ol money is equal to four times the supply of central bank money.
• To reflect the fact that the overall supply ol money depends in the end on the amount of central bank money, central bank money, H. is often called high-powered money, or the monetary base. The term high-powered reflects the fact that increases in H lead to more than one-for-one increases in the overall money supply, and are therefore 'high-powered'. In the same way, the term monetary base rellects the tact that the overall money supply depends ultimately on a 'base'—the amount of central bank money in the economy.
The presence ol a multiplier in equation 4.12 implies that a given change in central bank money has a larger effect on the money supply—and, in turn, a larger effect on the interest rate—in an economy with banks than in an economy without banks. To understand why, it is useful to return to the description of open-market operations, this time in an economy with banks.
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