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Money and Banking

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Money & Banking ­ MGT411
VU
Lesson 33
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
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Money & Banking ­ MGT411
VU
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  Reserves
+$1billion
(German government bonds in euros)
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.
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Money & Banking ­ MGT411
VU
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
Central bank
Purchase of Treasury Increases reserves, the size of central bank's
operation
bond
balance sheet and Monetary base
Foreign Exchange
Central bank
Purchase of foreign Increases reserves, the size of central bank's
Intervention
govt. bonds
balance sheet and Monetary base
Discount Loans
Commercial
Extension of loan to Increases reserves, the size of central bank's
bank
commercial bank
balance sheet and Monetary base
Cash withdrawals
Nonbank public Withdrawal of cash
Decreases reserves and increases currency,
from ATM
leaving size of central bank's balance sheet
and Monetary base unchanged
104
Table of Contents:
  1. TEXT AND REFERENCE MATERIAL & FIVE PARTS OF THE FINANCIAL SYSTEM
  2. FIVE CORE PRINCIPLES OF MONEY AND BANKING:Time has Value
  3. MONEY & THE PAYMENT SYSTEM:Distinctions among Money, Wealth, and Income
  4. OTHER FORMS OF PAYMENTS:Electronic Funds Transfer, E-money
  5. FINANCIAL INTERMEDIARIES:Indirect Finance, Financial and Economic Development
  6. FINANCIAL INSTRUMENTS & FINANCIAL MARKETS:Primarily Stores of Value
  7. FINANCIAL INSTITUTIONS:The structure of the financial industry
  8. TIME VALUE OF MONEY:Future Value, Present Value
  9. APPLICATION OF PRESENT VALUE CONCEPTS:Compound Annual Rates
  10. BOND PRICING & RISK:Valuing the Principal Payment, Risk
  11. MEASURING RISK:Variance, Standard Deviation, Value at Risk, Risk Aversion
  12. EVALUATING RISK:Deciding if a risk is worth taking, Sources of Risk
  13. BONDS & BONDS PRICING:Zero-Coupon Bonds, Fixed Payment Loans
  14. YIELD TO MATURIRY:Current Yield, Holding Period Returns
  15. SHIFTS IN EQUILIBRIUM IN THE BOND MARKET & RISK
  16. BONDS & SOURCES OF BOND RISK:Inflation Risk, Bond Ratings
  17. TAX EFFECT & TERM STRUCTURE OF INTEREST RATE:Expectations Hypothesis
  18. THE LIQUIDITY PREMIUM THEORY:Essential Characteristics of Common Stock
  19. VALUING STOCKS:Fundamental Value and the Dividend-Discount Model
  20. RISK AND VALUE OF STOCKS:The Theory of Efficient Markets
  21. ROLE OF FINANCIAL INTERMEDIARIES:Pooling Savings
  22. ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED):Providing Liquidity
  23. BANKING:The Balance Sheet of Commercial Banks, Assets: Uses of Funds
  24. BALANCE SHEET OF COMMERCIAL BANKS:Bank Capital and Profitability
  25. BANK RISK:Liquidity Risk, Credit Risk, Interest-Rate Risk
  26. INTEREST RATE RISK:Trading Risk, Other Risks, The Globalization of Banking
  27. NON- DEPOSITORY INSTITUTIONS:Insurance Companies, Securities Firms
  28. SECURITIES FIRMS (Continued):Finance Companies, Banking Crisis
  29. THE GOVERNMENT SAFETY NET:Supervision and Examination
  30. THE GOVERNMENT'S BANK:The Bankers' Bank, Low, Stable Inflation
  31. LOW, STABLE INFLATION:High, Stable Real Growth
  32. MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK
  33. THE MONETARY BASE:Changing the Size and Composition of the Balance Sheet
  34. DEPOSIT CREATION IN A SINGLE BANK:Types of Reserves
  35. MONEY MULTIPLIER:The Quantity of Money (M) Depends on
  36. TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION
  37. WHY DO WE CARE ABOUT MONETARY AGGREGATES?The Facts about Velocity
  38. THE FACTS ABOUT VELOCITY:Money Growth + Velocity Growth = Inflation + Real Growth
  39. THE PORTFOLIO DEMAND FOR MONEY:Output and Inflation in the Long Run
  40. MONEY GROWTH, INFLATION, AND AGGREGATE DEMAND
  41. DERIVING THE MONETARY POLICY REACTION CURVE
  42. THE AGGREGATE DEMAND CURVE:Shifting the Aggregate Demand Curve
  43. THE AGGREGATE SUPPLY CURVE:Inflation Shocks
  44. EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION
  45. SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY