Principles of Macroeconomics/Monetary Policy and International Trade/Monetary tools/Monetary policy

Money creation: Monetary policy
The purpose of this topic is to outline how banks create money and how this money creation is controlled by the Fed. The various monetary policy tools are investigated and open market operations are identified as the most common.

Banks
Banks exist to receive deposits from individuals and businesses, and to lend these funds. Banks derive their revenue from the interest they charge on loans (as well as from fees for other services). Deposits, withdrawals and payments by check do not change the money stock, but loans do. A portion of deposits are held in reserves.

Banks are private businesses, just as car manufacturers or retail stores. What they offer is a service. That service is making loans from the deposits they receive. For that service they receive an interest which is higher than the interest they have to pay for the deposits they receive from individuals. The difference provides them with profits and keeps them in business.

Check cashing
When a check is drawn and a payment is made by check, the total money stock does not change, only the composition, or distribution of money in its different forms, changes. A payment by check results in a shifting of reserves from one bank to another when the check clears through the Fed.

If I withdraw $100 from my checking account, there are $100 more bank notes in circulation, but, there is $100 less check writing ability. Thus the money stock total does not change. This is also true for a deposit and for a payment by check to another individual.

Money creation
Money is created when a bank makes a loan: the bank accepts a promissory note from the borrower (which is not money) and gives the borrower the ability to make payments in the form of demand deposits up to the amount of the loan. When a loan is repaid money is canceled. In normal circumstances, the volume of new loans exceeds repayment of loans, and thus, the money supply keeps increasing. However, a bank can only loan up to its available excess reserves.

If I take out a car loan for $10,000 and pay the car dealer that amount (plus the down payment) for a new car I just bought, the transaction has created an additional $10,000 which is now going to be circulating. The bank has accepted my promise to repay in exchange for the loan. My promise to repay is not money but the $10,000 is.

Money cancellation
When a loan is repaid money supply is decreased because the borrower must use demand deposits to make the repayment. This takes some cash or demand deposits out of circulation.

A misconception stems from the everyday expression for making a profit as "making money". When banks earn profits by charging an interest on their loans, this profit has nothing to do with money creation. Quite the contrary: a careful analysis would show that the interest charged by the bank has to be paid with money in circulation. Thus, payment of interest on loans cancels money rather than creates money.

Required reserves
Funds held by a bank in its vaults or in its account at the Fed, are its reserves. A proportion of its deposits must be kept in reserves, and only the excess are the excess reserves which can be lend out. The portion of reserves which must be kept by the bank are referred to as required reserves. (Reserves are never part of money supply. They are called "high powered money" because they can permit the creation a multiple of money stock).

The initial purpose of required reserves when they were instituted, was to make sure that banks would have on hand sufficient funds which depositors may withdraw, or at least an adequate proportion. This is no longer true because the required reserves need not be kept on hand. Thus, the purpose of the required reserves is now mostly for monetary policy.

Required reserve ratio
The proportion between required reserves and deposits is the required reserve ratio. There are actually several different ratios according to the degree of permanency of the deposits. The ratios vary from less than 2% to over 15%. They are occasionally changed by the Fed according to economic needs.

The required reserve ratio on different types of deposits depends on how likely the funds will be withdrawn. For instance, the required reserve ratio on checking account deposits is about 12%. But the required reserve ratio on business certificates of deposit (with maturity of at least two years) is only about 3%.

Monetary multiplier
When the proceeds of a loan are used to make a payment, the excess reserves of the first bank are transferred to a second bank. A portion of these funds must remain as required reserves, but the excess reserves can be lent out. Successive relending of the excess reserves cumulates in a total money creation which is several times the initial loan. This monetary multiplier is equal to the inverse of the required reserve ratio.

A dollar of excess reserves can be relent several times by successive banks: that is the monetary multiplier. In a banking situation which would have no required reserves, the relending could go on at infinitum: money creation would be very large. This appears to be true for the Eurodollar accounts balances where reserves are not officially required. However, prudence in Eurodollar banking has kept the monetary multiplier quite low.

Government securities
Banks have a strong preference for government securities because of the safety (as well as liquidity) they offer as compared to loans to private businesses. Excess reserves are often held in government securities. When a bank buys a government security from an individual, the transaction is equivalent to a loan and increases money supply. The Fed holds a large stock of government securities and is responsible for their issuance and redemption.

The U.S. Treasury Bills (or T.B.'s for short) are considered very safe and held by many U.S. and foreign entities. They are also very liquid: easy to convert into cash. Some of these T.B.'s are redeemed or rolled-over (at the option of the owner) every 90 days. Banks like this safe and liquid type of loan to the government.

Monetary policy tools
The tools of monetary policy are those available to the Fed to control the excess reserves of banks. They include open market operations, changes in required reserve ratios and changes in the discount rate. Changes in required reserve ratios affect reserves directly but are too authoritarian and not used often. Changes in the discount rate make bank borrowing from the Fed more or less difficult, but the volume of bank borrowing is very small.

It is normal to believe that control over the physical printing of bank notes is the essence of monetary policy, but that is not entirely correct. Since the monetary multiplier shows that banks have the ability to create most of the money, control over reserves which banks can lend, is the real focus of monetary policy.

Open market operations
Open market operations consist of buying and selling of government securities by the Fed. It is the most common and most potent tool of monetary policy because it is flexible, subtle and effective.

The Bank Act of 1935 established the Federal Open Market Committee in the United States. This Committee is composed of the seven governors of the Federal Reserve Board of Governors, plus several regional Federal Reserve Bank presidents. This Committee is responsible for setting the monetary policy of the Fed. This underscores the importance of open market operations as a tool of monetary policy.

Discount rate
The discount rate is the interest charged by the Fed on loans to member banks. The amount of such loans is very small. When a change in the discount rate occurs it is most often a reflection of changing conditions rather than an intended monetary policy action. However, such change contains a strong message about the direction of monetary policy.

In the Fall of 1988, the discount rate was raised from 6% to 6.5%. This change followed a period of rising interest rates with a moderate increase in inflation. It is not sure, therefore, whether the change in the discount rate is a policy action or merely an adjustment reflecting prevailing market rates.

In 2001, the Fed lowered the discount rate a record of seven consecutive times to force lower interest rates and renewed loans. The lowering of the discount rate was widely publicized in the press.

Tight money policy
A tight money policy consists in reducing the excess reserves of banks and, thus, their money creation ability. This is done by selling government securities to banks in the open free market for government securities. Banks are eager to put some of their excess reserves in government securities because of their safety. Tight money policy can also be carried out by increasing the required reserve ratios or the discount rate.

In 1979, Paul Volker was appointed chairman of the Fed. Money growth was very rapid at the time. In 1981, a variety of tight money policy tools were implemented to successfully bring credit expansion growth under control.

Easy money policy
An easy money policy is intended to increase the excess reserves of banks and, thus, make money creation by banks more possible. This is accomplished by purchasing government securities from banks (since banks commonly hold a large proportion of them). An easy money policy can also be carried out by lowering the required reserve ratios or the discount rate.

In 1982, Paul Volker switched to an easier monetary policy allowing slightly faster money growth (in order to avoid chocking off investment and economic growth).

In 2001, Fed's chairman Alan Greenspan applied a forceful easy money policy to thwart the oncoming recession.

Minor monetary policy tools
In addition to open market operations, changes in required reserves ratios and the discount rate, the Fed may also affect the money supply by changing margin requirements (the proportion which must be present in a securities dealer account for transactions), consumer credit terms such as the downpayment or the length of car loans. Another, less common, method is to persuade banks to adopt some desirable conduct; this is called moral suasion.

In many countries of the world, monetary policy is carried out by direct contact between the central bank and the banking community (i.e. moral suasion, as it is known in the U.S.). For instance, this is true in Canada where there are seven major banking institutions only. Such process is not possible in the United States, because of the large number of private banks.