intervention, sterilization, and money concepts and exemplification
Post on 19-Dec-2015
223 Views
Preview:
TRANSCRIPT
Intervention, Sterilization, and Money
Concepts and exemplification
Objective
Explain what happens to the domestic money supply when central banks intervene in foreign exchange markets
Outline
• The Monetary Base
• The Money Supply
• The link between MB and M (the money multiplier, m)
• Foreign exchange interventions
• The concept of sterilization
A nation’s monetary base
Domestic credit (DC)
Foreign exchange reserves (FXR)
Monetary base (MB)
Assets Liabilities
Currency (CURR)
Bank reserves (BRES)
Monetary base (MB)
A nation’s monetary base
MB = DC + FXR = CURR + BRES
A nation’s money supply (stock)
The money supply is generally comprised of currency in circulation and transaction deposits
M = CURR + TrD
The effect of open-market transactions
Open market transactions change the money stock
that is,
Open market transactions increase or decrease the size of the money supply
The effect of open-market transactions: Exemplification
Assume the Fed purchases $1 m of securities from a dealer in Chicago.
What happens?
• The Fed wires the payment and creates a $1 m deposit for the dealer with a Chicago bank.
• The Chicago bank keeps 10% in bank reserves with the central bank, and lends out $0.9 m
• The borrower of this $0.9 m spends the money, which ends up as a new deposit in a New York bank
• The New York bank keeps 10% in bank reserves and lends the remaining $0.810 m
• Etc.
The effect of open-market transactions: Consequences
DC increases by $1 m
Bank reserves and currency increases by a combined $ 1m
The monetary base increases by $ 1m
Transaction deposits and currency in circulation increase by $0.9 m + $0.810 m + …+ etc.
The money supply increases by more than $1 m
The concept of money multiplier
The magnitude of the change in the money supply as a result of a change in the monetary base
m = (increase in M)/(increase in MB)
If m = 4, the money supply has increased by $4 m.
The relationship between the monetary base and the money stock
M = m(MB)
or
M = m(MB)
An open market purchase of securities will increase the money supply by a factor of m
An open market sale of securities will decrease the money supply by a factor of m
Side note
Any change in the monetary base will have a ripple effect in the economy.
A central bank cannot really control the money supply unless it knows the value of m
Foreign exchange transactions: Exemplification
Assume the Fed buys £1 m from a foreign exchange dealer in New York
Also assume that:
mUS = 2.6
mUK = 2.1
s = $1.6/ £
Foreign exchange transactions: Effect on US money supply
The Fed pays the dealer by creating a $1.6 m deposit with the dealer’s bank.
The Fed’s foreign reserves increases.
The Us monetary base increases
Foreign exchange transactions: Effect on US money supply
Domestic credit (DC)
Foreign exchange reserves (FXR) + $1.6 m
Monetary base (MB) + $1.6 m
Assets Liabilities
Currency (CURR)
Bank reserves (BRES)
+ $1.6 m
Monetary base (MB) + $1.6 m
Foreign exchange transactions: Effect on UK money supply
The Fed has £1 m claim on the Bank of England,
Bank of England reserves are now reduced by £1 m
The UK monetary base is, hence, reduced
Foreign exchange transactions: Effect on UK money supply
Domestic credit (DC)
Foreign exchange reserves (FXR) - £1 m
Monetary base (MB) - £1 m
Assets Liabilities
Currency (CURR)
Bank reserves (BRES) - £1 m
Monetary base (MB) - £1 m
What if the Fed is committed to a stable money supply and is worried about inflation?
Foreign exchange transaction (like buying £1 m) increase the monetary base and, therefore, the money supply.
Increase in US money supply = ($1.6 m)(2.6) = $4.16 m
To keep the money supply unchanged the Fed would have to sterilize the foreign exchange purchase.
Sterilization
Open-market interventions to offset changes in the money supply resulting from foreign exchange transactions.
The Fed would have to sell $1.6 m worth of securities to reduce MB by $1.6 m
Sterilization
The Bank of England would have to purchase £1 m of securities if it wants to sterilize the foreign exchange transaction.
Summary
A purchase of foreign currency will increase the domestic money supply, unless offset by a domestic sale of securities.
A sale of foreign currency will decrease the money supply, unless offset by a domestic purchase of securities
top related