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