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2 Modern Banking

The Central Bank

Modern money in almost all economies is fiat money controlled by a central bank and backed in law by a government.

The monetary objective of the central bank should be to maintain the value of the currency at a level beneficial to the political domain it is attached to and possibly the world, keeping inflation down etc. It does this through lending, borrowing and open market operations as described below.

The central bank does not as such posses a limited amount of money in its own currency. It can print or burn its own currency as it determines necessary. However there are rules about how currency leaves or enters a central bank which if not followed can lead to failing monetary objectives and possible collapse of the currency.

The central bank has a balance sheet and any money it creates "out of thin air" is marked as a liability on that balance sheet. Against this are its assets, foreign currency reserves, gold and what it is owed by the government and other banks.

The central bank can;
  • Print or burn its own currency. (Adjusting its balance sheet accordingly.)
  • Swap/trade foreign currency, gold or other financial assets, in its reserves. (These are called open market operations.) The central bank may also buy and sell financial instruments such as bonds, shares, foreign currencies etc. or precious metals for money, thus also changing the amount of narrow money in the economy. This is known as open market operations.
  • Trade government bonds, these are promises the government will pay the owner of the bond at a future date. The government sells bonds as a way of borrowing money.
  • Lend money to or hold deposits for other banks at interest rates it determines. (Holding deposits could be considered to be money borrowed from other banks.)  The central bank may lend the money to the other banks and charge interest on those loans at a rate it determines. Other banks may also put money into the central bank and receive interest according to their deposits.
  • Regulating and supervising the banking industry.

Narrow Money


Any money issued by the central bank to other institutions is either handed out physically as coins and notes (cash) or credited to the other institution's account at the central bank and convertible to coins and notes. Similarly any money returned to the central bank is either handed in physically as coins and notes or debited from the other institution’s account at the central bank.

The amount of money issued by the central bank less that returned, is the narrow money supply. The central bank issues money when it;
  1. buys gold, foreign currency reserves and other assets in open market operations, (i.e. trading on the financial markets)
  2. to buys bonds in particular government bonds. Bonds are promises to pay an amount at some time in the future. (i.e. the government sells for money a promise to pay back money in the future. )
  3. pays interest on institutional accounts that are in credit at rates it determines.
The central bank returns money when it;
  1. sells gold, foreign currency reserves and other assets in open market operations,
  2. sells bonds in particular government bonds.
  3. charges interest on institutional accounts that are in debt at rates it determines.
The central bank borrows ends money in a number of ways at varying interest rates one of which is publicised as the base rate.

The central bank controls the narrow money supply by setting the interest rates and by open market operations. 

  • Money goes out of the bank in three ways, as loans (i.e. mostly bond purchases) as interest payments and for purchases in open market operations.
  • Money comes into the bank in three ways, as repayments, as interest receipts and for sales in open market operations.   

Other Banks

The primary type of institutions dealing with the central bank are the other banks. The other banks may lend money to each other and to people, and charge interest on those loans and people may deposit money with those other banks and receive interest.

People that have borrowed money may spend that money and the people that receive it may in turn, deposit the money in the bank and receive interest for it.

Fractional Reserve Banking

Of the money deposited at the bank the bank must retain a fraction in reserve but may lend the rest and receive interest for it. The central bank determines the fraction that other banks must keep in reserve. This is fractional reserve banking. See Wikipedia: The History of Fractional Reserve Banking

If the fraction that can be loaned out is X, the reserve fraction is (1 - X). This loan cycle happens many times so it turns out that for each unit of narrow money from the central bank there can be a further X+X2+X3+.... units of money borrowed from the other banks. So the total money in circulation per unit of narrow money becomes;

1+X+X2+X3+.... which with some maths,

is equal to 1/(1-X)

Broad Money

1/(1-X) determines the amount of broad money in the economy, known as the broad money supply, as a multiple of the amount of narrow money. So if the reserve requirement was 20% then the amount of broad money can be as much as 5 times the amount of narrow money. If the reserve requirement was 10% then the amount of broad money is 10 times the amount of narrow money.

The central bank may limit the broad money in the economy by setting the reserve requirements for other banks. However the central bank can only control lending but cannot control whether the lending is responsible or not that is the duty of other banks.

Capital Requirements


Another limit on other bank lending is capital adequacy. The bank is required to hold capital assets with a risk adjusted value of X% of its total liabilities.

For international banks, including the 55 member central banks of the Bank for International Settlements, the threshold is 8% (see the Basel Capital Accords)

This is on top of the fractional reserve above. These assets can be sold if necessary to pay off liabilities i.e. pay people back who have put money in the bank. 

The Economy and the Interest Rate

Ultimately the price of borrowing, usually expressed as the interest rate is determined by the offers to lend and the bids to borrow in the market. However one player, the central bank, can always lend below the market price or borrow above the market price because it does not have a limited amount of money in its account.

When it lends below the market price then it undercuts lenders and may cause a surplus of borrowed money in the economy. Money will be borrowed from the central bank, faster than it is lent to the central bank. Interest payments will remove un-borrowed money from the economy.

When it borrows above the market price it overcuts borrowers and may cause a shortage of lent money in the economy. Money will be lent to the central bank, faster than it is borrowed from the central bank. Interest payments will add un-borrowed money to the economy.

There will always be a fraction of the narrow money which is borrowed from the central bank and a fraction which is not. This may have little influence, in that broad money borrowed from the other banks is a far larger proportion of the total money supply.

Borrowing from the Central Bank

When money is borrowed from the central bank it makes more money available temporarily but then even less money available in the future when the money is paid back with interest. This may cause inflation then deflation.

If the borrowing facilitated the creation of;
  • consumable value - the economy may have a temporary reduction in prices for these types of consumable.
  • capital value - the economy may have a permanent reduction in prices for these types of capital asset.
Deflation is a problem for those in debt.

Lending to the Central Bank

When money is lent to the central bank it makes less money available temporarily but then even more money available in the future when the money is paid back with interest. This may cause deflation then inflation.

Inflation is a problem for those in credit.

Inflation and Deflation

This subject is dealt with fully here  but summarised below.

Prices are raised due to competition amongst buyers and lowered due to competition amongst sellers. It is the things on offer for sale and the money in bids to buy that will directly determine price. These are connected but not necessarily determined by the total money supply and the amount of tradable things in the economy as a whole.

Clearly;
  • if the amount of money bid increases or the amount of things offered decreases there will be market shortages or price inflation,
  • if the amount of money bid decreases or the amount of things offered increases there will be market surpluses or price deflation.
Market shortages or market surpluses can be created when prices resist market conditions otherwise they are corrected by inflation or deflation.

There is a very important distinction between market shortages and surpluses, and real physical shortages and surpluses. See Markets_and_Reality

Conclusion

Central banks strive to meet inflation targets by controlling the money supply through setting interest rates, open market operations and setting reserve requirements.

They can control the money supply but they cannot control the things on offer for sale and the money in bids to buy that will directly determine price, and thus inflation, they can only influence it.



(C)2010 Tom de Havas. The information under this section is my own work it may be reproduced without modification but must include this notice.