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Functions of the central banks
Central banks implement four major functions in the economy: monetary policy implementation; exchange rate supervision; commercial banking supervision; lender of last resort. 1. The first function is to implement monetary policy. There are three ways to do it: a) to print money: coins, banknotes thus controlling the amount of banknotes in circulation. b) to set discount interest rates or minimum rates to control the credit system. A country’s minimum or discount interest rate is the rate at which the central bank makes loans to commercial banks. Banks lend to very large companies at the base rate, or the prime rate; all other borrowers pay more. Lowering the discount rate makes funds cheaper to banks. A lower discount rate could place downward pressure on interest rates in the economy. c) to use open-market operations. Open market operations are the sale or purchase of government securities, such as bonds, in the open market in order to reduce or increase money supply. Open market operations are used mainly in the countries that have highly developed financial markets. 2. The second function is exchange rate supervision exchange rate supervision. In other words, intervention on foreign exchange markets: buying or selling large amounts of the national currency to influence its exchange rate by increasing or decreasing the supply of national currency. The third main task is commercial banking supervision. The purpose is to make sure that the commercial banks have enough liquidity and are solvent. If banks have enough liquidity they avoid a bank run, or bank failure. In this way, central banks try to support the stability of the financial system in the economy. Central banks do this by setting reserve requirements. The forth main task of a central bank is to act as a lender of last resort. In case one of the commercial banks has problems with liquidity and the people who put money in the bank need to get their money back. It is a case when the central bank will be the only lender to the bank facing problems. This eliminates a possible panic in the financial sector, which may destabilize the whole economy. Unit 4.3 Money Creation and a Deposit Multiplier To understand the process of money creation today, let us create a hypothetical system of banks. We will focus on three banks in this system: Bank A, Bank B, and Bank C. Assume that all banks are required to hold reserves equal to 10% of their checkable deposits. The quantity of reserves banks are required to hold is called required reserves. The reserve requirement is expressed as a required reserve ratio; it specifies the ratio of reserves to checkable deposits a bank must maintain. Banks may hold reserves in excess of the required level; such reserves are called excess reserves. Excess reserves plus required reserves equal total reserves. Because banks earn relatively little interest on their reserves held on deposit with the Federal Reserve, we shall assume that they seek to hold no excess reserves. When a bank’s excess reserves equal zero, it is loaned up. Finally, we shall ignore assets other than reserves and loans and deposits other than checkable deposits. To simplify the analysis further, we shall suppose that banks have no net worth; their assets are equal to their liabilities. Let us suppose that every bank in our imaginary system begins with $1,000 in reserves, $9,000 in loans outstanding, and $10,000 in checkable deposit balances held by customers. The balance sheet for one of these banks, Bank A, is shown in Table ‘ A Balance Sheet for Bank A’. Table A Balance Sheet for Bank A Bank A | ||||||
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Assets |
Liabilities | ||||||
| Reserves | $1,000 | Deposits | $10,000 | ||||
| Loans | $9,000 |
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We assume that all banks in a hypothetical system of banks have $1,000 in reserves, $10,000 in checkable deposits, and $9,000 in loans. With a 10% reserve requirement, so the required reserve ratio is 0.1; each bank is loaned up; it has zero excess reserves.
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Bank A, like every other bank in our hypothetical system, initially holds reserves equal to the level of required reserves. Now suppose one of Bank A’s customers deposits $1,000 in cash in a checking account. The money goes into the bank’s vault and thus adds to reserves. The customer now has an additional $1,000 in his or her account. Reserves now equal $2,000 and checkable deposits equal $11,000. With checkable deposits of $11,000 and a 10% reserve requirement, Bank A is required to hold reserves of $1,100. With reserves equaling $2,000, Bank A has $900 in excess reserves.
At this stage, there has been no change in the money supply. When the customer brought in the $1,000 and Bank A put the money in the vault, currency in circulation fell by $1,000. At the same time, the $1,000 was added to the customer’s checking account balance, so the money supply did not change.
Figure Bank A, Changes in Balance Sheet and Balance sheet
| Changes in Balance Sheet (in bold) Balance sheet | |||
| Assets | Liabilities | Assets | Liabilities |
| Reserves $1,000 +$1,000 Loans $9,000 | Deposits $10,000 +$1,000 | Reserves +$2,000 Loans $9,000 | Deposits +$11,000 |
| Excess reserves = $900 | |||
Because Bank A earns only a low interest rate on its excess reserves, we assume it will try to loan them out. Suppose Bank A lends the $900 to one of its customers. It will make the loan by crediting the customer’s checking account with $900. Bank A’s outstanding loans and checkable deposits rise by $900. The $900 in checkable deposits is new money; Bank A created it when it issued the $900 loan. Now you know where money comes from – it is created when a bank issues a loan.
Figure Bank A, Changes in Balance Sheet and Balance sheet
| Changes in Balance Sheet Balance sheet | |||
| Assets | Liabilities | Assets | Liabilities |
| Loans $900 | Deposits +$900 | Reserves +$2,000 Loans $9,900 | Deposits +$11,900 |
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Presumably, the customer who borrowed the $900 did so in order to spend it. That customer will write a check to someone else, who is likely to bank at some other bank. Suppose that Bank A’s borrower writes a check to a firm with an account at Bank B Bank. In this set of transactions, Bank A’s checkable deposits fall by $900. The firm that receives the check deposits it in its account at Bank B, increasing that bank’s checkable deposits by $900. Bank B now has a check written on Bank A account. Bank B will submit the check to the Fed, which will reduce Bank A’s deposits with the Fed – its reserves – by $900 and increase Bank B’s reserves by $900.
Notice that Bank A emerges from this round of transactions with $11,000 in checkable deposits and $1,100 in reserves. It has eliminated its excess reserves by issuing the loan for $900; Bank A is now loaned up. Notice also that from Bank A’s point of view, it has not created any money! It merely took in a $1,000 deposit and emerged from the process with $1,000 in additional checkable deposits.
The $900 in new money Bank A when it issued a loan has not vanished – it is now in an account in Bank B. Like the magician who shows the audience that the hat from which the rabbit appeared was empty, Bank A can report that it has not created any money. There is a wonderful irony in the magic of money creation: banks create money when they issue loans, but no one bank ever seems to keep the money it creates. That is because money is created within the banking system, not by a single bank.
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The process of money creation will not end there. Let us go back to Bank B. Its deposits and reserves rose by $900 when the Bank A check was deposited in a Bank B account. The $900 deposit required an increase in required reserves of $90. Because Bank B’s reserves rose by $900, it now has $810 in excess reserves. Just as Bank A lent the amount of its excess reserves, we can expect Bank B to lend this $810. The next set of balance sheets shows this transaction. Bank B’s loans and checkable deposits rise by $810.
Figure Bank B, Changes in Balance Sheet and Balance sheet
| Changes in Balance Sheet Balance sheet | |||
| Assets | Liabilities | Assets | Liabilities |
| Loans $810 | Deposits +$810 | Reserves +$1,900 Loans $9,810 | Deposits +$11,710 |
The $810 that Bank B lent will be spent. Let us suppose it ends up with a customer who banks at Clarkston Bank. Bank B’s checkable deposits fall by $810; Bank C’s rise by the same amount. Bank C submits the check to the Fed, which transfers the money from Bank B’s reserve account to Bank C’s. Notice that Bank C’s deposits rise by $810; Bank C must increase its reserves by $81. But its reserves have risen by $810, so it has excess reserves of $729.
Notice that Bank B is now loaned up. And notice that it can report that it has not created any money either! It took in a $900 deposit, and its checkable deposits have risen by that same $900. The $810 it created when it issued a loan is now at Bank C.
The process will not end there. Bank C will lend the $729 it now has in excess reserves, and the money that has been created will end up at some other bank, which will then have excess reserves – and create still more money. And that process will just keep going as long as there are excess reserves to pass through the banking system in the form of loans. How much will ultimately be created by the system as a whole? With a 10% reserve requirement, each dollar in reserves backs up $10 in checkable deposits. The $1,000 in cash that Bank A’s customer brought in adds $1,000 in reserves to the banking system. It can therefore back up an additional $10,000! In just the three banks we have shown, checkable deposits have risen by $2,710 ($1,000 at Bank A, $900 at Bank B, and $810 at Bank C). Additional banks in the system will continue to create money, up to a maximum of $7,290 among them. Subtracting the original $1,000 that had been a part of currency in circulation, we see that the money supply could rise by as much as $9,000.
Note!
Notice that when the banks received new deposits, they could make new loans only up to the amount of their excess reserves, not up to the amount of their deposits and total reserve increases.
The Deposit Multiplier
We can relate the potential increase in the money supply to the change in reserves that created it using the deposit multiplier (m d), which equals the ratio of the maximum possible change in checkable deposits (∆ D) to the change in reserves (∆ R). In our example, the deposit multiplier was 10:
m d = ∆ D / ∆ R = $ 10,000/ $ 1,000 = 10
To see how the deposit multiplier m d is related to the required reserve ratio, we use the fact that if banks in the economy are loaned up, then reserves (R) equal the required reserve ratio (rrr) times checkable deposits (D): R = rrrD
A change in reserves produces a change in loans and a change in checkable deposits. Once banks are fully loaned up, the change in reserves (∆ R ) will equal the required reserve ratio times the change in deposits (∆ D ):
∆ R = rrr ∆ D
Solving for ∆ D, we have Equation 
Dividing both sides by ∆ R, we see that the deposit multiplier, m d = 1/ rrr
1/ rrr = ∆ D/ ∆ R = m d
The deposit multiplier is thus given by the reciprocal of the required reserve ratio.
With a required reserve ratio of 0.1, the deposit multiplier is 10. A required reserve ratio of 0.2 would produce a deposit multiplier of 5. The higher the required reserve ratio, the lower the deposit multiplier.
The entire process of money creation can work in reverse. When you withdraw cash from your bank, you reduce the bank’s reserves. Just as a deposit at Bank A increases the money supply by a multiple of the original deposit, your withdrawal reduces the money supply by a multiple of the amount you withdraw. And just as money is created when banks issue loans, it is destroyed as the loans are repaid. A loan payment reduces checkable deposits; it thus reduces the money supply.
Suppose, for example, that the Bank A customer who borrowed the $900 makes a $100 payment on the loan. Only part of the payment will reduce the loan balance; part will be interest. Suppose $30 of the payment is for interest, while the remaining $70 reduces the loan balance. The effect of the payment on Bank A’s balance sheet is shown below. Checkable deposits fall by $100, loans fall by $70, and net worth rises by the amount of the interest payment, $30.
Similar to the process of money creation, the money reduction process decreases checkable deposits by, at most, the amount of the reduction in deposits times the deposit multiplier.
Figure Changes in Bank A’s Balance Sheet
| Assets | Liabilities and net worth |
| Loans – $70 | Deposits – $100 Net worth + $30 |
Key concepts
· Banks are financial intermediaries that accept deposits, make loans, and provide checking accounts for their customers.
· Bank deposits are insured and banks are heavily regulated.
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· Central banks act as a bank for other banks and for the government. It also regulates banks, sets monetary policy, and maintains the stability of the financial system.
· The central bank sets reserve requirements and the discount rate and conducts open-market operations. Of these tools of monetary policy, open-market operations are the most important.
· Money is created within the banking system when banks issue loans; it is destroyed when the loans are repaid.
· An increase (decrease) in reserves in the banking system can increase (decrease) the money supply. The maximum amount of the increase (decrease) is equal to the deposit multiplier times the change in reserves; the deposit multiplier equals the reciprocal of the required reserve ratio.
A Multiple Choice Test
1. The money supply is shown on the graph as:
a) a horizontal line;
b) a dashed line;
c) a curve with a negative slope;
d) a vertical line.
2. The term ‘discount rate’ means:
a) the level of price reduction for the Central Bank when it buys government securities;
b) the percentage at which the Central Bank provides loans to commercial banks;
c) the degree of pressure exerted by the Central Bank on commercial banks to reduce the volume of loans issued by them;
d) the impact of the Central Bank on the growth of money supply and GNP.
