Until 2007 when a serious financial crisis engulfed the financial services sector, the mechanisms through which money circulated in the economy were considered as fully mastered by bankers, particularly central bankers. As such, central banks could effectively control these mechanisms by playing around with monetary control tools.
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On their part, depository institutions and depositors were also considered to play a largely defined role in the money supply. The shattering impact that the financial crisis had on monetary supply led to the need to relook into the traditional roles of these institutions which, together with the changes that have occurred in the way central banks control money supply, are explored in this paper.
The role of central banks in determination of money supply
A Central Bank (referred to as the Federal Reserve Bank in the United States) is the financial institution mandated with the responsibility of controlling a country’s (or an economically unified region’s, like the European Union’s) monetary policy, value of currency, and credit supply. It also serves as banker to the government as well as of financial institutions, issues currency and ensures stability in the financial system of an economy, among other roles.
The central bank in the United Kingdom is the Bank of England. Established in 1684, it served as banker to the government of England until late in the 18th century when its control was expanded to cover the whole of the UK. In regard to its role in determining the amount of money circulating in the economy as well as how the money moves around, the central bank is the sole issuer of national currency (the sterling pound) in England and Wales.
The central bank determines the optimal amount of money that should be circulating in the economy (monetary stability) through several monetary tools. One of the main tools is open market operation where the central bank, on behalf of the government, sets or manipulates the official interest rates on government securities such as Treasury Bills which, in turn, influences financial markets ‘prevailing lending rates.
By setting, for example, the yield of Treasury Bills to be higher than the market rate of lending, the central bank is able to control the amount of money circulating in the economy (in this case the amount of money in circulation is reduced as people are induced to buy and hold short-term government securities which would earn them a decent return in the short-term, unlike cash which does not earn interest) (Adrian and Shin 2009, p.13).
Manipulation of interest rates also helps the central bank to control the rate of inflation in an economy as well as improve the strength of the currency of the country or an integrated monetary region.
Manipulation of overnight lending rates, otherwise referred to as short-term interest rate setting, is yet another important tool through which a central bank is able to effectively control the amount of money circulating in an economy.
As this is the rate of lending in the inter-bank markets, a move to raise it has the consequence of raising the cost of borrowing not only between banks but also for consumers as banks tend to pass down the increase in cost to the final borrowers. Therefore, the borrowing from banks reduces along with the amount of money circulating in an economy.
The discount window is yet another tool which not permits a central bank to set monitory policies but also allows depository institutions – in case they find themselves in shortage of reserve balances – to borrow these from central banks under certain conditions set by the bank and at a specified (usually higher) rate (Brunnermeier, Crockett, Goodhart, Persaud and Shin 2009, p.16).
The discount window has the effect of reducing money supply in the economy; a higher rate of borrowing only increases the cost of borrowing to the banks and subsequently to the final borrowers, which discourages borrowing.
Central banks also require depository institutions to maintain a certain proportion of deposits taken as reserves in the form of cash. This cash is to be kept in their vault or be deposited at the central banks.
Depository institutions and money supply
Deposit institutions such as credit unions, savings banks, savings and loans associations, and more importantly commercial banks, hold a significantly large proportion of a the money stock of a country and, therefore, play a critically important role in the supply of money to the economy, as well as the transmission of monetary policies to the real economy through the financial services markets, depositors/savers, and borrowers (The Federal Reserve Bank of New York n.d, p.1).
Depository institutions hold money in the form of various types of deposits transfer of which they allow to enable payments. Also, one of their core businesses is lending of the funds they hold directly to businesses and direct consumers. These functions, in addition to the banks investing directly in securities, make depository institutions the focal point of money distribution in an economy (Bodie, Kane and Marcus 2008, p.523). As such, they play a critical role in acting as the link between savers and borrowers.
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Commercial banks, in spited of a considerably decline in their share of business, still enjoy the lion’s share of business as well as influence so far as taking of deposits and lending activities are concerned.
Money creation by commercial banks:
The requirement by central banks that depository institutions maintain a minimum reserve for deposits taken brings about the concept of money creation by depository institutions.
Consider a bank with a total of £100,000 in deposits: If, for instance, the central bank requires that 10% of all deposits taken be set aside as minimum reserve, then the commercial bank taking the deposit – ideally speaking – would be left with £90,000 to lend out to borrowers (90% of the deposits).
If the borrower deposits the full amount in the same or another bank, the ten percent minimum reserve rule will apply to the deposit just as in the first deposit, and the bank will have £81,000 to lend out after setting aside £9,000 as minimum reserve.
If, hypothetically, the process continues until the there is no possibility of re-lending the money (the excess amount available for lending out is zero), the accumulated amount from the above chain of multiple deposit expansion would be £1,000,000; £ 900,000 more than the original deposit. Thus, through this process, “money” is said to have been “created” by the depository institution (Baumol and Blinder 2009, p.636). This “excess” amount can similarly be determined using the money multiplayer equation which states;
Money Multiplier = 1/Reserve Requirement
In reality, leakage of money in the banking system occurs because not tall money borrowed in a bank or any other depository institution is re-deposited into a depository institution; leave alone the money being deposited into the bank from which the funds were originally borrowed (Baumol and Blinder 2009, p.637).
A fraction of it, for instance, is likely to be held as currency. This leakage diminishes the money multiplier to an amount less than the inverse of the required minimum reserve, thus reducing the amount of money created through the multiple deposit expansion process.
Depositors in the determination of the money supply
The role of depositors in money supply can best be explained by the concept of money creation as discussed in the preceding topic. Through their decision on what proportion of their money to hold in the form of cash and what proportion to deposit as savings in depository institution, depositors tremendously influence the flow of money in an economy.
How the conduct of monetary policy by central banks changed during the recent credit crunch
The financial crisis that began in 2007 highlighted the changing role of financial institutions. Unlike in the past where central banks were in virtually total control of inflation as well as business cycles, deflation – rather than inflation – became a huge source of worry for central banks and economists alike as interest rates tumbled towards zero rate (The Economist 2009, p.1).
In addition, it became extremely hard to do pricing of risks leave alone doing efficient allocation of credit (Adrian and Shin 2009a, p.603). As a result of the financial crisis, central banks have been forced to re-examine the traditional approaches to monetary and fiscal control and have had to reach for other untested monetary as well as fiscal tools.
One of the most important changes in the way of doing business adopted by central banks has been central banks taking on the responsibility of making some of the fundamental judgments about the financial markets previously left to the “rational and efficient” private sector. This was essentially triggered by the significantly huge blow that the traditionally balanced relationship between players in the financial markets suffered at the height of the financial crisis (Drehmann, Sorensen and Stringa 2006, p.4).
Therefore, central banks – through combining more kinds of collateral and credit, as well as credit periods – expanded their lending activities. For instance, the ECB (European Central Bank) began guaranteeing loans taken by commercial banks for a period of up to six months; up from the traditional one week.
In the US, the ‘fed’ decided to begin providing loans to investment banks in dire need of cash, the Bank of Japan took more drastic measures by buying equities in stressed banks. On its part, the central bank in Switzerland, Swiss National Bank, went as far as trying to artificially manipulate the price of its currency.
In regard to the changes that occurred in the way central banks conduct their business, the banks found themselves with no choice but to turn from being lenders of last resort to lenders of both first and last resort after commercial banks could no longer trust each others’ ability to repay loans acquired through inter-bank borrowing (Adrian and Shin 2009b).
Consequent to the above developments, central banks have been given more authority by their home governments to conduct in-depth supervision of financial institutions. This move, although widely seen as largely necessary to tame rouge bankers, comes with some negative implications.
For example, it has the potential of dragging politics into the running of central banks across the world, which challenges a vital element of the pre-2007 consensus about central banking: that central should be separated from politics completely (Levine 2010, p.11). This isolation had effectively managed to repel strong desires by politicians “to play fast and loose” with inflation (The Economist 2009, p.4).
Central banks and depository institutions play a tremendous role in managing the circulation of money in an economy. However, the 2007 financial crisis had a huge impact on the traditional perspectives on how money moves around in an economy.
Serious doubts emerged about the effectiveness of the monetary control approaches and tools traditionally adopted by central bankers in handling tumulus economic times. Thus, central banks have been forced to re-look into the tools they have traditionally adopted in managing the financial services industry. Also, it is recommended that central banks improvise some of the monetary control tools.
Adrian T, and Shin HS (2010) [internet] The Changing Nature of Financial Intermediation and the Financial Crisis of 2007-09, Federal Reserve Bank of New York Staff Report No. 439. Web.
Adrian, T & Shin, HS (2009a) “Money, liquidity and monetary policy” in American Economic Review vol.99, pp.600–605
Adrian, T &Shin HS (2009b) [internet] “Prices and quantities in the monetary policy transmission mechanism” in International Journal of Central Banking vol.5 no.4 [available from https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr396.pdf]
Baumol, WJ, & Blinder, AS (2009) Economics: Principles and Policy. 11th ed. Mason, OH: Cengage Learning
Bodie, Z. Kane, A & Marcus, A (2008) Essentials of Investments 7th ed. New York: McGraw-Hill
Brunnermeier, M, Crockett, A, Goodhart, C, Persaud, A & Shin, H (2009) Fundamental Principles of Financial Regulation London: Centre for Economic Policy Research
Drehmann, M, Sorensen, S & Stringa, M (2006) [internet] “The impact of credit and interest rate risk on banks: an economic value and a capital adequacy perspective’, mimeo, Bank of England [available from https://www.bis.org/bcbs/events/rtf06stringa_etc.pdf]
Levine, R (2010) [internet] “The governance of financial regulation: reform lessons from the recent crisis”, BIS Working Papers No 329 [available from https://www.bis.org/publ/bppdf/bispap55.pdf]
The Economist (Apr 23rd 2009) [internet] The Monetary-Policy Maze [available from https://www.economist.com/briefing/2009/04/23/the-monetary-policy-maze]
The Federal Reserve Bank of New York (n.d) [internet] The Role of Depository institutions. Web.