Money Demand, Creation, and the Role of Central Banks

Posted on Jun 10, 2024 in Economy

Money Demand

People want to have a portion of their cash (money demand) for various reasons, among them:

  • Transactions: To pay for purchases they make. The quantity demanded for this reason mainly depends on the level of income: the higher the income, the more consumption and therefore greater demand for money (and lower income otherwise).
  • Financial Asset: Money has value, and the public may prefer to keep part of their wealth in the form of money, especially in times of uncertainty. Instead of having money in a bank that may fail, or in stocks that can be driven down, in times of crisis, people may prefer to have the money at home.

The demand for money, for one reason or another, has a negative relationship with the interest rate:

  • If rates rise, the opportunity cost of having liquid money and not having it deposited in a bank that accrues interest increases. Therefore, people will try to maintain the minimum required liquid cash.
  • If, however, rates fall, this opportunity cost is reduced, so that people will keep a greater proportion of their savings in cash.

This inverse relationship between interest rates and demand for money can be represented in a graph.

http://www.aulafacil.com/Macro/Lecc-15-1.gif

  • Changes in the interest rate cause movements along the curve.
  • While changes in the level of income cause displacement of the curve:
    • If income increases, consumption will increase, leading people to keep more cash to pay for purchases, the money demand curve shifts to the right (for the same interest rate, people will require more money).
    • If income is low, consumption is reduced, and therefore the need for people to keep money in cash decreases, the money demand curve shifts to the left.

http://www.aulafacil.com/Macro/Lecc-15-2.gif

Monetary and Banking Money

Monetary Aggregates

When it comes to money, we normally refer to notes and coins that are legal tender, but there are other forms that have more or less similar characteristics: value, liquidity, payment method, etc.

The Central Bank, when it comes to controlling the level of liquidity (money) in the system, analyzes various monetary aggregates in terms of the concepts involved.

The aggregates used, ranked from lowest to highest extent, are:

  1. Cash held by the public (Lm): Notes and coins that are legal tender held by the public.
  2. M1: Currency held by the public + demand deposits in banks. M1 is also called the money supply.
  3. M2: M1 + savings deposits in credit institutions.
  4. M3: M2 + time deposits and other bank liabilities.
  5. Liquid assets held by the public (ALP): M3 + other components, among them Treasury bills held by the public, commercial paper, etc.

Bank Money

Financial institutions (banks, savings banks, and cooperatives) receive deposits from their customers in the form of current accounts (which we call money orders). These entities use these deposits to lend.

For example, a bank receives a deposit of $10,000 from a client. Part of this money will address possible cash withdrawals (say $1,000), and the rest is used to grant loans ($9,000).

Part of the amount of these credits returns to financial institutions in the form of new bank deposits.

For example, the company that has been credited with $9,000 uses it to buy machinery. The seller receives the money from these sales and credits their account.

The bank you work with this vendor has a new deposit of $9,000 and, as in the previous case, leaves a portion in reserve (for example, $800) and uses the rest ($8,200) in new lending.

We see that an initial deposit of $10,000 has implemented a mechanism that has led to $19,000 in the banks ($10,000 initial deposit + the $9,000 from the machinery sale). And the process keeps repeating.

In short, the operation of financial institutions leads to a multiplication of the value of deposits (bank money creation).

Commercial bank deposits become a much larger amount of bank money.

http://www.aulafacil.com/Macro/Lecc-11-1.gif

How Much Money Can Banks Create?

To answer this question, we begin by defining the concept of “bank reserve.”

Financial institutions, when they receive a deposit, must leave a percentage of it in cash to meet withdrawals. This percentage is precisely the “bank reserve” or “reserve ratio.”

The Central Bank determines the percentage, i.e., the ratio of public deposits that financial institutions must keep in the form of liquid assets (cash on hand or Central Bank reserves) to meet cash withdrawals.

The total amount of bank money generated by financial institutions is determined by the “banking money multiplier”:

Banking money multiplier = 1 / Reserve Ratio

Continuing the example:

Suppose the reserve ratio is 10%. Then the bank money multiplier is:

Banking money multiplier = 1 / 0.10 = 10

Therefore, financial institutions could generate a volume of bank money 10 times that of the initial deposits: if the initial deposit is $10,000, the bank money that could be generated is $100,000.

This would be the maximum potential amount of deposit money that could be generated, which means it may not actually be generated: the bank may not use the entire amount available in the granting of loans, the loans may not return in full as deposits to financial institutions, etc.

Central Bank

http://www.aulafacil.com/Imagens/gif1x1.gif

a) Functions of the Central Bank

Among the functions performed by a central bank are the following:

  • Issue and circulation (or removal) of legal tender.
  • State Jobs: Receipts and payments made for Public Administration.
  • Bank of banks: Supervising the banking system, keeping the reserves of commercial banks (minimum reserve), acting as lender of last resort (when an entity experiences liquidity strains), and settling payment methods (centralized receipts and payments from lenders).
  • Centralization and management of foreign exchange reserves.
  • Monetary policy: Determines the amount of money in the system to try to control the evolution of the interest rate in the short term.

The ultimate goal of a Central Bank is to achieve price and exchange rate stability, which should allow for sustained growth of output and employment.

b) Balance Sheet

On the asset side of a central bank are the following items:

  • Gold and foreign exchange.
  • Loans to commercial banks.
  • Public sector lending.
  • Portfolio of fixed-income securities (Debt): Securities acquired on a temporary basis in a surgical manner aimed at controlling liquidity in the system.
  • Fixed assets (buildings, facilities, computer systems, etc.).

In its liabilities are listed the following items:

  • Monetary liabilities (also called base currency): Comprised of cash held by the public and bank reserves (cash in hand of financial institutions and deposits that they have in the Central Bank).
  • Non-monetary liability: Equity and public sector deposits.

Monetary Base

http://www.aulafacil.com/Imagens/gif1x1.gif

The monetary base is the sum of cash in public hands (Lm) + bank reserves (cash in the hands of banks and their deposits in the Central Bank).

Monetary Base = Cash held by the public + Bank reserves

The Central Bank determines the monetary base, and from there, the money generated by bank financial intermediaries.

Looking at the balance sheet of a Central Bank, the monetary base equals the total assets less non-monetary liabilities.

Increasing the Monetary Base: Money Creation

  • If the central bank assets increase (increase in foreign exchange reserves, credit growth to the banking system, or the public sector) without increasing non-monetary liabilities, then monetary liabilities have to increase (money creation).
  • If non-monetary liabilities decrease without affecting assets, monetary liabilities necessarily have to increase.

Reducing the Monetary Base: Money Destruction

If the Central Bank’s assets decrease without reducing non-monetary liabilities, it will lead to a decrease in the monetary base.

Autonomous Variations

There are variations in the Central Bank’s balance sheet, thus affecting the monetary base, that it cannot control. These are autonomous:

For example, a deficit (or surplus) in the balance of payments is not controllable by the Central Bank; however, it influences the level of foreign reserves (asset item).

Other changes in the balance of the Central Bank are controllable and will allow it to determine (with some approximation) the amount of the monetary base.

For example, loans to the banking system: If credit increases, the Central Bank’s assets increase, and thus its liabilities increase. If the non-monetary liability does not change, the monetary liabilities necessarily have to increase (increase in the monetary base).

How Does the Central Bank Change the Monetary Base in Practice?

  1. The Discount Rate: The rate at which the central bank is willing to lend money to financial institutions.
    • If the discount rate is raised, loans from the Central Bank to financial institutions will be more expensive, so financial institutions will demand less (contraction of the monetary base).
    • Lowering the discount rate makes these loans cheaper, so financial institutions seek larger amounts (expanding the monetary base).
  2. Open Market Operations: Buying and selling government debt to financial institutions.
    • If the central bank buys government debt, it is increasing liquidity in the system. Financial institutions are replacing fixed-income securities for liquidity that could be used for lending.
    • On the contrary, if the Central Bank sells debt to financial institutions, it replaces these liquid positions on their balance sheets with securities. On the liabilities side of the Central Bank, the deposits of financial institutions will be reduced as some will have to pay for the purchase of these securities.

Money Supply

http://www.aulafacil.com/Imagens/gif1x1.gif

We have seen that M1 is also called the Money Supply:

M1 = Cash held by the public + Demand deposits (bank money)

Central banks try to control the money supply in the system, and with it, the demand for money, which determines the interest rate in the short term.

The interest rate influences the volume of investment, which affects the equilibrium level of production and therefore the level of employment.

Central banks as they try to influence interest rates seek to achieve price stability and exchange rate, requirements for sustained growth in the time of production and employment.

How can central banks influence on money supply?

We will try to explain the relationship between Money Supply (OM) and monetary base (MB):

OM = cash held by the public (Lm) + Demand deposits (Dv)

BM = cash held by the public (Lm) + bank reserves (R)

Dividing the first equation by the second we have:

OM / BM = (Lm + Dv) / (Lm + R)

Then:

OM = ((Lm + Dv) / (Lm + R)) * BM

Now we divide the numerator and denominator of the brackets by Dv:

The quotient “Lm / Dv” will call “x” and represents the proportion of deposits that the public held in cash.

The ratio R / Dv “will call” and “and represents the bank reserves, ie the proportion of deposits that banks must maintain liquid (cash or reserves at the Central Bank) to meet cash withdrawals.