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FPP.1X – MONETARY AND FINANCIAL ACCOUNTS VIDEO 1: Introduction Hello. My name is Luisa Zanforlin. I am a Senior Economist in the Institute for Capacity Development of International Monetary Fund. My role is to guide you through the function and activity of the Monetary and Financial sector, and the ways these are reported in the accounts of the Monetary and Financial Sector. Finally, we will review some of the issues confronting the decisions on monetary policy. Let's first try to understand, what are the main functions of the financial sector and how it operates? One important function of the financial sector is to intermediate the financial flows across the different sectors. It provides the means through which payments can take place. Another very important function of the financial sector is to collect savings generated by income surpluses in some sectors, and then allocate them to sectors that require financing.
In so doing, we say that the financial sector serves as a bridge among different sectors of the economy. Households typically generate savings, while the corporate sector typically requires financing for their investments. The role of the financial sector is to collect savings from the households sector and provide financing to the corporate sector. By converse, it collects the cash balances from the corporations and provides loans, such as mortgages, to households. How does the financial sector provide these services? Financial institutions can provide special instruments. Among the main instruments there are savings vehicles. They allow people to safely store away their earnings and enjoy them at a later date. Savings vehicles are the instruments through which the public can smooth consumption through time and therefore achieve a higher level of welfare through their lifetime. The financial sector also creates credit instruments. These allow the efficient allocation of resources to investment activities. Savings are collected from the general public and allocated to projects of low risk and high expected returns. The financial sector also provides diversified financial instruments that mitigate the income loss arising from unexpected shocks and, therefore, provides the means of smoothing income and consumption over time. Monetary and financial sectors statistics provide information on the balance sheets of the different types of financial intermediaries—
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and therefore, of the different financial instruments that are intermediated in the economy . These statistics are compiled according to the different functions of financial intermediaries and different activities. The financial sector is defined to be the group of agents of the domestic economy that intermediates financial resources. As there are many different ways of combining statistics, it is important to note that this presentation will follow the guidelines of the Manual of Monetary and Financial Statistics of 2001. Why are monetary and financial sector accounts so important? The monetary and financial statistics record the net position of the financial sector, vis a vis the other sectors of the economy. Therefore, they will reveal whether the sectors have been net savers or net users or financial resources. In addition, the monetary accounts are generally available with little delay in most countries. Even where reliable economic data can be scarce, they are among the most reliable of the macroeconomic statistics and therefore useful to policymakers who need to monitor economic developments. Why is the role of the monetary accounts so important? Monetary accounts focus on variables such as money, credit, foreign assets, and liabilities that play a central role in the macroeconomic analysis of an open economy, and are particularly useful for the design of monetary policy.
This lecture will cover two main themes. In the first part, we will review the structure of monetary and financial statistics, the different groups of financial intermediaries, and how different operations are reflected in the accounts. First, we'll take a look at the different types of financial intermediary composing the financial sector and how they're grouped together. Then, we will analyze two-‐sub components—namely, the Central Bank and the other depository corporations. We will see how these two groups come to define a sub-‐sector of intermediaries called the depository corporations sector. This is particularly important for our analyses because, in many countries, this is the largest sub-‐sector among financial intermediaries. We will then discuss how the depositary corporations account are linked to the other accounts that you have been seeing in the other lectures so far. In the second part of this lecture, we will discuss how financial intermediaries create and multiply the amount of money circulating in the system. We will then discuss the main reasons why people demand to hold money and why the stock of money in the economy is an important variable for monetary policy decisions. To conclude, we will review some selected issues in monetary policy analysis. The main objectives of this class are to: (1) identify the main institutions composing the financial corporations sector; (2) to understand the main items in the balance sheets of the depository corporations sector and the consolidation process; (3) to analyze
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how money is created and calculate the growth in the money supply; and finally, (4) to identify the main determinants of the demand for money. VIDEO 2: The Financial Sector Financial Sector Overview. In this section, we will review the different types of financial intermediaries, the main characteristics and how statistics are compiled and consolidated to define monetary aggregates. The financial sector is the broadest group of financial intermediaries for which statistics are collected. In the monetary and financial statistics, we distinguish financial intermediaries on the basis of whether they are allowed or not to collect deposits from the general public for safekeeping. The depository corporations sector provides the means of payments, collects deposits, and channels resources to economic activity. The other financial corporations may not collect deposits and comprises of all those institutions that provide other types of financial services, such as annuities, insurances, and many other types of financial products. It is important to keep in mind that these are the names used in the Statistical Manual, because the common language word is usually not very specific. For example, we commonly refer to the group of deposit-‐
taking corporations as "banks," but the actual category includes a much broader set of intermediaries, such as cooperatives, credit unions, merchant banks, etc. More specifically, the two categories are divided in other subcategories, containing at least one financial intermediary that is somehow different from those contained in the other subcategories. In particular, the depository corporations sector contains the central bank, or a currency board or a public entity with central banking responsibilities, the whole of the commercial banking sector and the money market funds. When we talk about the balance sheet of the depository corporation sector, we refer to the aggregate balance sheet of all these intermediaries. The sector of other financial corporations comprises the pension funds, the insurance sector, the leasing companies, and many other types of financial intermediaries that do not collect deposits but offer financial services. The full accounts of the central bank are called Central Bank Survey. The accounts of the other deposit-‐taking institutions, ODCs, are consolidated in the Other Depository Corporation Survey. When we consolidate the accounts of the central bank with those of the other deposit taking institutions, we obtain the Depository Corporation Survey. In the past, this used to be called the Monetary Survey. The accounts of the other financial intermediaries that do not belong to
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the depository corporations sector are aggregated in the Other Corporations Survey. When the accounts of the depository corporations are consolidated with the accounts of the other financial corporations, we have the Financial Corporations Survey. The consolidated liabilities of the deposit-‐taking institutions will include all the deposits in the system and are structured to present broad money aggregates. A simple scheme can represent the three levels of compilation of monetary and financial statistics. The first and most disaggregated level contains the separate balance sheets for the central banking activities and the rest of the deposit-‐taking activities. The second level consolidates the data for the depository corporation sector. The liabilities of the depository corporations sector represent a measure of the stock of money, which we call broad money, or M2. The third level consolidates the monetary survey and the balance sheets of the other financial corporations into the financial corporations survey. In countries where financial markets are not well developed, the banking system typically accounts for the bulk of an economy's financial assets and liabilities. The statistics present the accounts for each component of the financial sector.
The accounts show the stock of assets and liabilities, or the statement of the financial position of a specific group of intermediary. For monetary analysis, the flow of liabilities is also important. The accounts of the monetary and financial statistics are valued at fair value at the end of the reference period. All entries will be in national currency, or foreign currency for those countries where this is used as a national currency unit. Each account presents gross assets and gross liabilities by residency, by sector of economic counterparty, by type, by maturity. Some items will be presented on a net basis, so that a negative entry for a net asset is interpreted as a net liability. In the course of this lecture, we will be looking at the analytical presentation of the accounts of the different financial intermediaries. This means that the assets and liabilities are aggregated into concepts that are relevant for monetary policy analysis. To summarize, we have learned the financial sector is divided in two main groups of financial intermediaries, depending whether they are allowed or not to collect deposits from the public. The consolidated liabilities of the deposit-‐taking institutions will cover all the deposits in the system and are aggregated to present broad money aggregates. Monetary and financial statistics present the stock value in the accounts at the end of the accounting period and valued at fair value.
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VIDEO 3: The Central Bank The Central Bank. The central bank is the national financial institution that exercises control over key aspects of the financial system. What are the main functions? An important function of the central bank is to act as a lender of last resort to the system-‐-‐ LOLR. When financial panic threatens a bank, or even the whole banking system, the central bank will need to take swift action to restore investor confidence. The rationale for using the central bank as a lender of last resort is based on the essentially illiquid nature of the credit system. The liabilities of banks, such as deposits, are typically of very short maturity. However, the loans that comprise the assets have much longer term. If all creditors ask for their cash at the same time, some banks may be pushed into default. If one bank has payment difficulties, depositors across the country may fear for their savings, and they may all rush to claim their deposits from their respective banks. Then, the entire banking system may become illiquid. To prevent financial collapse, the central bank can lend to the problem bank and guarantee payment to its depositors. Therefore,
it will prevent that a confidence crisis in one element of the banking system can spill over to the rest of the sector. The central bank is also in charge of issuing the domestic currency. The central bank creates high-‐powered money, also known as the monetary base, or reserve money, and thus exercises control over the amount of high-‐powered money in the economy. This is the main route through which the central bank controls the money supply in the economy. The monetary base comprises the central bank liabilities toward the rest of the system. And through the monetary base, the central bank controls the supply of money in the economy. Therefore, an analysis of its balance sheet is key to understanding the process of money creation. The central bank creates monetary base whenever it acquires assets from the private sector, because by making a payment, it writes a check against itself. Another important function of the central bank, related to its role as the issuer of the currency, is to conduct monetary policy. In many countries, it would also hold the foreign reserves of the country. Although, there are some countries in which the treasury, or a treasury-‐ controlled stabilization fund, would hold the official reserves. In many countries, it would also act as a banker for the government and generally oversee the soundness of the financial sector.
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Under IMF accounting procedures, the monetary functions of the government are grouped with the accounts of the central bank, so that all the functions of monetary authorities are presented under one accounting unit. It is also important to note that the activities of a central bank can be performed by different types of institutions—an actual central bank, a currency board, or independent currency authorities, or government-‐affiliated agencies that perform central banking activities. The central bank exercises control over the amount of high-‐powered money in the economy. As we mentioned earlier, we use an analytical balance sheet of the central bank to present the aggregate concepts that are relevant for monetary policy analysis. The monetary base represents the liabilities of the central bank. The monetary base is comprised of the currency that is issued and that is held both by the general public and in the banks-‐-‐ also known as cash in vault. The deposits of the other depositary corporations with the central bank are also liabilities of the central bank. And finally, there are liabilities that the central bank has towards the rest of the economy that are included in the national concept of broad money. These will include the deposits of other financial institutions and the non-‐financial private sector, such as private individuals, firms, or foreign currency deposits by residents.
It is important to note that the monetary base excludes the deposits of both the government and the non-‐residents with the central bank. These are netted against the claims of the central bank towards the government and the claims of the central bank towards foreign residents in the asset side of the balance sheet. Now, turning to the asset side, the central bank holds the country's foreign reserves. These are included in the Net Foreign Asset concept. NFA includes official foreign reserves, monetary gold, SDR, and the reserves position in the IMF. While in many countries the net foreign assets of the central bank are equated with a net official international reserves, the definition of net foreign assets is broader than the definition of net official international reserves. Net Domestic Assets of the central bank are usually divided in net domestic credit and other items, which is a residual category usually shown on a net basis. In turn, net domestic credit is comprised of net credit to the rest of the private sector and net claims on the government. The operations between the government and the central bank are shown on a net basis, because the government has easier access to credit than other sectors.
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So its expenditures are not usually constrained by deposits or cash balances. The claims on the other depository corporations represent the lending operation between the central bank and the commercial banking sector. These include all direct credits to banks and the bills of exchange for discount from banks accepted by the central bank. We will see later how both the amount of central bank lending to the ODC and the discount rate, which is the interest rate that the central bank charges on the loans to the banks, are instruments of monetary policy. The claims on the other domestic economic sectors are lending operations to other sectors, which are usually insignificant, but may, at times, be large depending on monetary policy decisions. Finally, the residual category, other items, net, usually includes the central bank capital, the accumulated operating losses or surpluses from the central bank, and the counterpart of valuation changes. VIDEO 4: The Central Bank (continued) An important component of the monetary base is represented by the deposits of the other depositary corporations at the central bank. These are commonly referred to as bank's reserves. The rationale for establishing required reserves will be discussed more at length
later, but, in principle, liquid reserves of banks serve as protection against unexpected depositor withdrawals. Each licensed bank has an account at the central bank where their required reserves are deposited. Required reserves are established by the regulator as a fraction of private sector deposits in the banks. Excess reserves are maintained by banks on a voluntary basis, and depend on the opportunity cost of other investments and the bank's propensity to keep liquid reserves. As we saw, the monetary base is the main liability of the central bank. From the construction of the balance sheet of the central bank, we can see that the monetary base is equal to the sum of net foreign assets and net domestic assets of the central bank. We can write this identity in terms of flows. This implies that, for example, when an overall surplus on the balance of payments adds to the net international reserves of the central bank—all else equal-‐-‐ this will increase the monetary base. The reverse will hold for a deficit in the balance of payments. In a similar way, if the central bank buys government securities or makes loans to banks, this will increase the domestic assets which—all else equal-‐-‐ will result in an increase in the monetary base. We can link the monetary base to the assets of the central bank, and we can now see how the central bank can influence monetary
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conditions through its influence on the monetary base. In effect, all central bank operations which affect net domestic assets, such as lending to the government, open market purchases or sales of government securities, lending to the banks, purchases and sales of foreign exchange, and lending to the rest of the private sector, will lead to an increase in the monetary base. Because when the central bank makes payments to domestic residents, it writes a check against itself. The residents can deposit the money they receive in the form of checks in the banks which, in turn, will deposit them at the central bank. The resulting increase in bank deposits with the central bank will add to the monetary base. No other entity in the economy has this ability. By virtue of being the monopoly supplier of base money, the central bank is the undisputed arbiter of monetary policy. For example, let's see how the central bank can conduct open market operations. These will entail the purchase of securities, either issued by the government or issued by the central bank, and in the secondary market. In so doing, the central bank will change the stock of the monetary base. When the central bank purchases government securities because it is financing the government's deficit, the central bank's holding of
government securities will increase, with a counterpart increase in liabilities, i.e. in the monetary base in the form of the increase of the currency in circulation. When the government finances its deficit by borrowing from the central bank, the claims of the central bank against the government will increase. If the money remains as a government deposit at the central bank, then the net position of the central bank, vis-‐a-‐vis the government, will not change, and therefore, there will be no change in the monetary database. But when the government uses the borrowed money to make a payment to the private sector, the stock of monetary base rises because the government's deposits with the central bank are reduced. When the central bank intervenes in the foreign exchange market, for example, to defend a particular level of the exchange rate or to acquire a desired amount of international reserves, the intervention directly affects base money, as the volume of NFA will change. And hence, it will have a direct impact on overall liquidity in the economy and the stance of monetary policies. The central bank can also influence base money through the quantity and terms of its lending to the domestic banking sector.
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Typically, the central bank lends to the domestic banks through a discount window. The discount mechanism is an instrument of monetary control. The most important of the arrangement is the rate of interest charged. The central bank's credit to the banks is, in practice, the source of base money most directly under its control. An increase in the interest rate the central bank charges signals its intention to tighten monetary conditions. By making such borrowing more costly, it tends to reduce bank borrowing from the central bank while, at the same time, inducing banks to increase their holding of excess reserves. One important thing to note is that the central bank can sterilize its operation to generate an increase in the monetary base by making an offsetting operation. For example, it can offset the purchase of an asset—for example, government securities of foreign exchange—by the selling of another asset. Thus, the monetary base will not change. In this case, we say that the initial action, i.e. the purchase of an asset, has been sterilized, in the sense that its impact on the monetary base and hence on the overall liquidity condition in the economy has been offset.
VIDEO 5: CB Balance Sheet Let us take a look at a numerical example of how the central bank can influence the monetary base. As we have seen, the monetary base is equal to the sum of net foreign assets (NFAs) and net domestic assets (NDAs). If the central bank buys 100 worth of government securities in the open market, its claims against the government will increase by an equivalent amount and so will the NDA. The counterpart of this operation will be a payment of 100 for the securities to the banks, which will increase the central bank's liabilities to the ODCs by 100. This will result in an increase of 100 in the monetary base. In the next example, we can see how the purchase of 70 worth of foreign currency from the banks leads to an equivalent increase in the monetary base and in NFAs of the central bank, after the central bank pays the banks for the foreign currency. In this example, the purchase is said to be un-‐sterilized because there is no other counterbalancing action by the central bank. In the third example, we should see the effect of the purchase of 70 of foreign currency from the banks and a concurrent sale of government bonds to the banks—the increase of 70 in foreign assets paid by the central bank and a concurrent sale of government bonds, which will then reduce domestic assets. The deposits of the ODCs will reduce in the equivalent amount and thus the monetary base will then be unchanged. When the central bank conducts operations designed to leave the monetary
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base unchanged, after purchases of foreign currency or government securities, it is said to be "sterilizing" and this operation is "sterilized." Finally, let's look at, how would a revaluation of foreign assets affect the accounts of the central bank? Let's assume in this case that the central bank has an equivalent amount of 50 in NFAs and NDAs of 50. The monetary base will be equal to 100. Let's assume that the revaluation of the domestic currency vis-‐a-‐vis the foreign currency reduces the value of the holdings of the central bank net foreign assets by 10, generating an equivalent valuation loss for the central bank. To account for the reduction in the value of the NFAs, we will need to book an equivalent increase in the revaluation account. This is in the other items, net category of the central bank. The revaluation account will register an increase of 10. This will appear as a reduction of the capital of the central bank because the capital of the central bank is booked as a negative asset and then a loss will actually imply an increase in the capital. NDAs will then be 60. The assets of the central bank are then unchanged. Let's now take a look at an example of central bank accounts. Let's first check for the balance sheet identity. We can see that the monetary base of 2218 is exactly equal to the sum of 2446 and -‐228. The monetary base is composed of currency in circulation and the liabilities to the other depository corporations. As we mention, these will be the deposits that the ODCs will keep at the central
bank because of mandatory requirements or to keep liquidity buffers. The net foreign assets refer to the position vis-‐a-‐vis non-‐residents and net domestic assets refer to the position of the central bank vis-‐à-‐vis residents. The components of the net domestic assets are net claims on the government, the central bank claims on the other depositary corporations and the bonds issued for stabilization purposes. Finally, other items, net will include the capital of the central bank. It's interesting to note that the stabilization bonds issued by the central bank are booked on the asset-‐side, despite the fact that they are actually liabilities of the central bank. The reason for this is, is that they are excluded from the monetary base. The same reasoning applies to the capital account of the central bank, which is also excluded from the concept of high-‐powered money. We can use the statistics to examine what could have been taking place in the last two years in this country. We can check that between 2010 and 2011, the monetary base has expanded by 186, of which 83 corresponds to an increase in NFA and 103 to an increase in NDA. When we look at the breakdown of the NDAs, a large share of the increase is the reflection of a drawdown of government deposits, which reduced by 202 and therefore generates an equivalent increase in net credit to the government. At the same time, there is an increase in claims vis-‐a-‐vis the banking sector, which suggests
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that the central bank has been extending liquidity to the local banking sector. A closer look at the balance sheet of the central bank also reveals that the monetary policy authorities have sought to sterilize the increase in the monetary base by issuing monetary stabilization bonds, as they have increased by 405 over the period. In this particular country, the central bank issues its own liabilities to control the monetary base. We can also note that, most likely, the issuance of its own stabilization bonds is generating a drain on the resources of the central bank, as evidenced by the large increase in the capital position of the central bank, which represents a loss. Let's now summarize what we have seen in this class. We have learned that the central bank is the entity in charge of issuing the currency, regulating the banking sector, and acting as a lender of last resort for financial institutions in distress. We have analyzed the accounts of the central bank and we have noted how the monetary base or high-‐powered money constitutes the liabilities of the central bank. We have noted the balance sheet identity for the central bank, whereby the monetary base is equal to the sum of net foreign assets and net domestic assets. Finally, we have learned how the central bank can take countervailing measures to ensure that the stock of the monetary base remains unchanged, even if it is changing other items in its balance sheet.
Let's now take a break. VIDEO 6: Other Depositary Corporations Other Depository Corporations. The Other Depositary Corporations are deposit-‐taking financial institutions. And we call them "other" because they are financial institutions that collect deposits other than the Central Bank. The ODCs include commercial banks, merchant banks, savings and loans institutions, cooperative banks, that we call in general language words, the banking sector. As we have seen in the introductory class, the ODCs are resident financial intermediaries that collect deposits from the general public. And the deposits of the public, which are liabilities in the balance sheets of the ODCs, are included in the concept of broad money. The ODC sector provides several important services to the local economy. In the first place, they collect deposits from the general public, and keep them safe. They can use the resources they have collected to extend loans to corporations to finance investment projects and thereby support growth in the economy.
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They also transform deposits, which are very short-‐term in nature, into longer term assets, such as securities and loans. The decisions of the ODCs, with respect to the collection of deposits and the extension of loans, influence the amount the liquid resources private sector agents can dispose and thus the overall amount of liquidity circulating in the economy. Because of this, the ODC sector constitutes an important instrument for the transmission of monetary policy to the rest of the economy. The statistics on the ODCs present the accounts for the whole sector on a consolidated basis. The ODC Survey is constructed so that the liability side includes all those liabilities of the ODCs that are included in the concept of broad money. The liabilities of commercial banks are mainly constituted by deposits and they are classified by type of instrument according to their maturity. Demand deposits are deposits which are made readily available to the customers upon demand. All deposits with a maturity less than a year are usually included in the demand deposit category. Time and savings deposits are deposits of the public with a maturity of a year or more. Foreign currency deposits are deposits of the public which will be paid out in foreign currency. All the remainder of the liabilities are liabilities that banks have vis-‐a-‐vis the monetary authority, and other less liquid liabilities.
The assets of commercial banks focus on credit extended to the resident and nonresident sector, just as the Central Bank case. Commercial banks typically hold foreign assets because they finance foreign trade operation and engage in operation with the rest of the world. The position of commercial banks, vis-‐a-‐vis, the non-‐resident sector, is presented on a net basis. The largest share of commercial banks' assets is typically represented by the lending operations, which usually comprise of lending to the government and the rest of the public sector, and lending to the rest of the economy. Because a large share of their liabilities can be called upon at any time by their customers, banks have to hold significant share of their assets in reserves, which will give them immediate access to cash to redeem their deposits. The reserves of the banks are typically held in cash or T-‐bills. Required reserves are the amount which is required to be deposited with the Central Bank. Excess reserves are those held by the banks in excess of the minimum required and they are usually kept for prudential reasons. The amount of excess reserves the bank holds typically depends on the discount rate; that means, how expensive it is to borrow from the Central Bank.
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And also depends on the efficiency of the payment system; therefore, how many liquid reserves banks have to keep for transactional purposes. The last item on the balance sheet of the ODCs is a category that includes all items not elsewhere classified. In particular, it will include long-‐term liabilities, which are not included in the definition of broad money, such as capital. It also will include the valuation accounts, just as in the case of the Central Bank. Let's now take a look at an example of ODC accounts. As in the case for the Central Bank, the assets are broken down by residence and by sector of economic activity. The liabilities are constituted mainly by deposits, which will be broken down by maturity. The assets are mostly composed by the credit to the rest of the private sector. The other important assets are the claims of the ODCs, vis-‐a-‐vis, the Central Bank. These will be currency, mandatory reserve deposits, and excess reserves. If we take a look at what has been happening between 2010 and 2011, we can see a significant accumulation of liabilities vis-‐a-‐vis, the non-‐residents.
This is evidenced by a decline in the NFA of 493. This is evidence of significant foreign capital inflows. We already know, from the balance sheet of the Central Bank, that the Central Bank has been buying some of the inflows and sterilizing the expansion of the NFA by issuing its own bonds. The inflow of foreign capital or, the increase of borrowing from abroad by the domestic banking sector, has been accompanied by a significant expansion of the NDA of the banks and, in particular, a significant increase in credit to the rest of the private sector. This has increased by 1,111. Let's now summarize what we have been seeing in this lecture. We have learned what are the main functions of the ODCs. And that is to collect deposits from the public. The ODCs can use resources collected to extend loans to the rest of the economy. This function influences the degree of liquidity in the economy. We have also seen how the consolidated balance sheets of the ODC assets are broken down by residence and sector of economic activity. We have also learned that deposits are the main liabilities of the consolidated balance sheets of the ODCs and we usually break them down by maturity and by residents. Let's now take a break.
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VIDEO 7: Depositary Corporations Survey The Depository Corporations Survey. The Depository Corporations Survey is constructed by consolidating the balance sheets of the central bank and that of the other depositary corporations. This DCS allows monitoring the development in the consolidated banking sector. It is designed so that they consolidated liabilities of the central bank and of the commercial banks will present broad money aggregates. The Depository Corporations Survey used to be called the Monetary Survey. It links broad money to the foreign assets and the claims on the domestic economy of the whole depository corporations sector, thereby linking monetary statistics to the BOP and Government Finance Statistics. The main benefits are the consolidated presentation of the accounts of the entire banking system. It presents the evolution of the stock of broad money. And it allows policymakers to adjust monetary policy. To construct the Depository Corporations Survey, we need to consolidate the balance sheets of the central bank and of the ODCs. As with any consolidation, the process requires the netting of offsetting positions across institutions in the DC sector.
Let's take a close look at which would be the position that needs to be netted out between the central bank and the ODCs. In the first place, any loans of the central bank to the banks will have to be netted against the liabilities of the banks to the central bank. They will therefore disappear from the consolidated accounts. In the second place, the liabilities of the central bank to the banks in the form of currency will have to be netted against the holdings of currency of the banks. These will also disappear in consolidation. Finally, the deposits of the banks in the Central Bank and assets for the banks, which are held either for regulatory or voluntary purposes, will have to be netted against the liabilities of the central bank in the form of deposits to the banks. Once off-‐setting positions of depository corporations among each other are netted, we can construct and the consolidated balance sheet for the system. First of all, we break down the assets of the ODCs by sector, namely, in credit to the public sector and to the private sector. We can now sum each of these two categories to their respective category from the central bank.
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In this way, we can compute the total credit provided to the public sector and to the private sector by the depository corporations sector. We are now able to see how much the government and the private sector has been borrowing or saving in the banking sector. Next, we can consolidate the position vis-‐a-‐vis non-‐residents of both the central bank and the commercial banks. This position summarizes the net position of the depository corporations sector vis-‐a-‐vis non-‐residents. A positive net position implies that lending to non-‐residents has been taking place. A negative position indicates a net inflow of foreign resources in the economy through an accumulation of liabilities to non-‐residents. Finally, the "other item, net" category will include the sum of the residual accounts of the central bank and on all of the ODCs, net of any offsetting position, and including any liability of either institution that is excluded from broad money. On the liability side, after the netting of positions, currency in circulation of outside banks will be the most liquid liability of the depository corporations. And then we will be left with the deposits in the banking sector included in broad money. Now we have constructed a depository corporations survey.
Let's summarize what it does. It consolidates the claims of the depository corporations sector on residents It consolidates the claims against non-‐residents. It consolidates the liabilities of the DC sector that constitute broad money. The sum of currency in circulation and transferable deposits will constitute M2, the money supply. The presentation of the accounts of the DCs will be similar to that of its sub-‐components, the central bank and the ODCs, and will have on the liability side overall liquidity generated by the depository corporations sector, or the stock of broad money. This will include all types of liabilities of the whole DC sector, which are transferable, redeemable at no or very little cost and that have a relatively short maturity. Currency, transferable deposits, which will be demand deposits, time and savings as we have seen them before, money market funds, and foreign currency deposits. Other deposits against which it is possible to write checks and other securities which have a relatively short maturity. On the asset side, the depository corporations (survey) will show the claims of the DC sector by residency and net domestic assets by sector of economic activity: lending to the government, lending to the rest of the residents sector.
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The other items net category will represent a consolidated concept of other items net, including capital and valuation accounts, net of inter-‐sectoral flows, and also all those liability items of the depository corporations sector that are not included in the broad money concept. Let's now take a break before we look at an example of the Depository Corporations Survey accounts. VIDEO 8: DCS Example Hello, and welcome back. We are now looking at an example of a Depository Corporations Survey. We can see that in the first place, broad money is composed of currency in circulation, deposits, and other liabilities of the central bank. In particular, we can note that the currency and circulation will be equal to the total currency in circulation issued by the central bank, less what is held in the vaults of the other depository corporations. The deposits of the depository corporations will include the deposits of the ODCs, and the remainder of the liabilities of the central bank.
We can also check that the net foreign asset position will be exactly equal to the sum of the foreign asset position of the other depository corporations and the central bank. Finally, we can check that the net credit to the public and private sector for the Depository Corporation Survey is equal to the sum of the claims on the public sector by the banks and the central bank. We can now see why the DC represents the evolution of the monetary aggregates for the economy as a whole. And we can take a look at what is happening to this economy. We note that the position vis-‐a-‐vis non-‐residents is deteriorating significantly following the strong capital inflows experienced by the banking sector. The accumulation of NFA of the central bank is not sufficient to offset the deterioration in the other depository corporations sector. We also note that the decrease in NFAs has been financing both credit to the public sector and credit to the private sector, which has been growing rapidly between 2010 and 2011. Finally, despite the significant increase in issuance of owned bonds, the central bank has had a limited success in controlling growth of broad money. Let's now turn to the discussion on the money aggregates. As we have seen, the depository corporations survey presents on the liability side the aggregates included in the national definition of
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broad money. However, the broad money stock can be defined in different ways. The most commonly used definitions are referred to as M1 and M2. M1 and M2 are the aggregates the central bank most frequently monitor for monetary policy decisions. M1 includes only the most liquid assets, while M2 includes also some less liquid types of assets, but with still short maturities. In particular, M1, or narrow money, is defined as the sum of currency in circulation and demand deposits. While M2, or broad money, also includes time and savings deposits, money market funds, and foreign currency deposits. We have seen those are those with maturity of one year and more, but still short term. These are usually referred to as "quasi-‐money," so that M2 is equal to M1 plus quasi-‐money aggregates. The identity between assets and liabilities of the depository corporations sector implies that the stock of broad money is identical to the sum of its counterparts, namely net foreign assets valued in domestic currency, and net domestic assets. We can also break down net domestic assets into its components. This will be net credit to the government, net credit to the rest of the private sector, and other items net. This identity will also hold for the flows. An increase in the stock of broad money will have to be reflected in an equivalent increase of net foreign assets and net domestic assets.
And again, we can break down net domestic assets into its components. This implies that an increase in the credit to the government, extended by the depository corporations sector, will increase net domestic assets and, therefore, the outstanding stock of money. By converse, we can interpret an increase in the stock of money as financing the operations of the non-‐resident sector. If the increase in the stock of money finances the general government among the resident sector, then we will also observe an increase in net credit to the government by depository corporations. What is important to understand is how the DC survey is linked to the other sectors of the economy. In the first place, the net position against non-‐residents will have to be related to the balance of the BOP. We know that the change in NFA will be equivalent to the reserve accumulation in the BOP. That, in turn, will be equal to the balance on the current account, the capital account balance, the financial account balance, and net errors and omissions. It is important to keep in mind that the change in the domestic currency of the value of reserves also includes a valuation effect that will be included in the other item's net, as we have seen before.
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The net domestic assets of the Depository Corporations Survey will be linked to the fiscal sector through net credit to the government. This includes the banking system lending to the government to finance its fiscal deficit, and shows how monetization of the fiscal deficit has a direct impact on the money stock. It is also linked to the real sector. On the asset side, credit that the banking system provides to the private sector impacts development and growth. On the liability side, the private sector demand for cash balances is an important determinant of inflation. We can then understand the link between the stock of money in the economy and the financing needs or surpluses of the different sectors. Today, we have learned how the balance sheet of the central bank and the balance sheets of the ODCs are consolidated to generate the Depository Corporation Survey. We have also seen how to consolidated the liabilities of the DCS represents the concept of broad money. Finally, we have seen how the financing flows to and from the other sectors of the economy, reflect in the DC's balance sheet.
VIDEO 9: Money Creation The Money Multiplier. In this part of the lecture, we will cover topics in monetary analysis. To begin, we will explore the process whereby the currency issued by the central bank is transformed in deposits and ultimately grows to become broad money. This process evidences the importance of controlling the monetary base to influence the amount of liquidity in the economy. Let's begin the discussion by analyzing how money gets created in the economy. As we know, the private sector will not keep all of its earnings in the form of currency but will deposit a certain part of them in the commercial banks for safekeeping and savings purposes. We do not usually expect the depositors will demand back all of their savings at once. Therefore, the commercial banks can use part of the amount they receive in the form of deposits to extend loans or purchase assets. In this way, the money deposited in the banks becomes the instrument for lending by the commercial banking sector to the private sector. When banks extend loans using the money in their deposits, they increase the amount of money in circulation. When the loans get spent and generate new earnings, the deposits of the private sector in the banking sector will increase again. The lending activities of the banks increase the amount of money in circulation.
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However, there is an important detail in this process. Banks have to keep liquid reserves to meet withdrawal demands of their customers. As we have seen when discussing the accounts of the ODCs, banks will typically hold part of their deposits in reserves. The central bank requires that a fraction of their reserves be deposited at the central bank. Those are known as required reserves and the system by which they are required is known as the fractional reserve system. That means that they are calculated as a proportion of total deposits in the system. The others, which are kept in excess of the central bank regulations, are maintained for the bank's own prudential reasons, to meet withdrawal demands. The amount of excess reserves will depend on how volatile are customer withdrawals? And, most importantly, what is the opportunity cost of keeping resources liquid? Typically, the central bank requires that the bank hold a minimum amount of reserves, but since the reserves at the central bank yield a very little interest, banks will tend to hold very little reserves in excess of mandatory requirements. This process generates a link between the monetary base and the money stock. As we have seen from the balance sheet of the central bank, base money is comprised of reserves and currency outside banks. The total of the currency in circulation plus the deposits determines the stock of money.
By the process we have just discussed, the bank's reserves will tend to be linked to the total amount of deposits in the system. We can therefore see that there will be a relationship between money and reserve money, such that the money stock will be equal to a multiple of reserve money. Let's look at a simple example of how money gets created. In a simplified model, the process starts with an initial supply of base money generated by the central bank. In this case, we assume currency for 100. The initial expansion of the base money by the central bank leads to a subsequent expansion by the commercial banks through the multiplication of resources deposited with them. This is made possible because of each amount deposited only a fraction will need to be kept in reserve, and the rest will be lent out. In this case, part of the money received will be kept in cash form. Since we are making an example that the preference to keep cash balances is 5%, our example will imply that 5 of the 100 they have received is kept in cash. The rest will be deposited in the bank. The bank will hold some of those deposits in reserves. And the rest will be lent out—that will be the amount deposited minus the reserves. The loan will be used to purchase goods and services and eventually will generate another cash holding, this time of 5% of the amount of the loan, and another deposit in the bank.
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Again, the bank will keep a certain amount in reserves and will loan out the rest. Again, the loan will be used for the purchase of goods and services. Again, a part of it will be kept in the form of cash. And again, the rest will be deposited in the bank, and so on. The process will repeat itself after new deposits are created. At the end of the process, the amount of deposits created will be a multiple of the original increase in reserve money. We can see how bank credit is a major link in the monetary policy transmission process. Credit expansion results in the expansion of the money stock. Let's now take a break and then look at an example. VIDEO 10: Money Multiplier Hello and welcome back. Let's start with a simple example of how to compute the money multiplier. In this case, we will use a simplified example. We assume that depositors keep no cash, but they deposit everything they earn in the banks. We assume that banks only hold the required reserves and do not keep any reserves buffers in excess of minimum requirement.
And we assume that the Central Bank buys $100 worth of government bonds through an open market operation. Therefore, the monetary base will grow by 100. Since the reserve requirement is still 10%, as in the last example, we will show how the total amount of money will end up growing by 1000. How precisely does that work? The process goes like this: in purchasing 100 of government bonds, the Central Bank generates an increase in the monetary base of 100. The banks can now extend 100 worth of new credit. After the loans are extended, there will be $100 worth of new deposits in the banking sector. Now the banks will keep 10of such deposits in reserves and then will extend the 90 remaining in new credit. After the credit and the loans have been used, and the goods and services have been purchased, there will be 90 of new deposits generated in the system. And once again the bank will keep required reserves, this time 9, then extend new loans by 81. The process will then continue. We can now show that for an initial increase of 100, the total amount of money will increase by 1000. How do we compute this? Well, in the first place there will be an initial increase in the monetary base of 100. The second time, there will be an increase in deposits, equal to the increase in the monetary base minus the reserve requirement. The third
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time, there will be an increase in deposits equal to the initial increase in the monetary base minus the reserve requirements, twice, and so on, until the process reaches its end iteration. Now, what are we looking at? Well, this looks a lot like a Taylor series expansion. Therefore, we can now write... And finally we know that this is equal to 1 over rr times the initial increase in the money base. In our case, we know that this is 10%, we know this is 100, and therefore, the total increase in this stock of money will be equal to 1000. Let's now try to formally derive the money multiplier. We can start with the definition of the monetary base and the stock of money. We have seen in the previous parts of this lecture how the monetary base generated by the Central Bank is equal to currency plus reserves of the banks. We have also seen that these are typically divided in required reserves and excess reserves. We know that the general public demands for money for transactional purposes, currency and deposits. We have just discussed how we have the relationship between the amount of the monetary base and the stock of money in circulation. In particular, we can express the total amount of money in circulation as a multiple of the monetary base and we will call this multiple the money multiplier. We can then express the money multiplier as the ratio of money to the monetary base, and by the definitions expressed above we can write C plus D over C plus R. We
can express all the terms composing the money multiplier in terms of the ratio to deposits. We can then define as C the ratio of currency to deposits, which denotes the general public preference for holding cash, and then we can write and call R the ratio of total reserves over total deposits that reflects both the mandatory deserves requirement ratio plus the excess reserve requirement ratio. So that now the money multiplier can be expressed as... We can now see how the money multiplier can increase both to an increase in the preference for holding cash or because of the effects of some change in the mandatory reserve requirements. The Central Bank, by increasing or decreasing the required reserves, can affect the total money stock. At the same time, when banks decide how much excess reserves they will hold, they will also be affecting R. Any changes in the behavior of any of the agents with respect to the preference either of holding currency or holding reserves well then affect the stock of money. One final note is that the Central Bank's control over the stock of money that derives from its ability to influence the money multiplier is incomplete, because it can only affect the part of the reserves under regulation. However, it can also influence the preference for currency and the preference for holding excess reserves by influencing the level of the interest rate when it purchases or sells securities in open market operations.
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Let's see how this theory works in a numerical example. VIDEO 11: Money Multiplier – Example Assume R is 15%. That is the ratio of reserves to total deposits. And C -‐-‐ the preference for holding cash —is 5%. The money multiplier, we have just seen, will be C+1 C+R, and therefore, in this case, 5.25. Therefore, if in this case the monetary base increases by 100, the stock of money will be expected to increase by 525. If we want to extend these calculations to M2, the broad money stock, and not just the narrow money definition we have been using to derive the money multiplier, we have to keep in mind that M2 also includes time deposits and money market funds, as well as the components of M1. Therefore, the multiplier for M2 will include the public's preference for having time and savings deposits, which we typically denote as T, and the public's preference for holding money market funds, which we will define as MMF. We can then show that the money multiplier for the broad money stock M2 will be equal to 1 plus the preference for holding currency, the preference for holding time and savings deposit and the preference for holding money market funds over R+C just as in the case of M1. We can now look at the main components of the money multiplier. We have seen that one of the important components are the reserve requirements. They are decided by the Central Bank.
Then, the opportunity cost of holding excess reserves will determine the level of excess reserves by the private banks. That will be determined on the liquidity risk that the banks face vis-‐a-‐vis the level of the interest rates prevailing in the economy, and finally, the private sector opportunity cost of holding cash balances instead of depositing them in the bank. If the value of them on the multiplier is not constant over time, the relationship between reserve money and the money supply will be weak. When the Central Bank estimation show that the money supply is growing too quickly, the Central Bank can intervene by reducing the monetary base. We have seen how these operations work when we were discussing the balance sheet of the Central Bank. It can sell assets through open market operations, it can increase the level of mandatory reserve requirements for the banking sector, and it can also reduce the amount the Central Bank itself lends to the banks. By converse, if the Central Bank believes that the money stock is not growing enough, it can inject liquidity in the system by doing the reverse operations, in this case purchasing assets, lowering reserve requirements and increasing lending to the banking sector. Let's summarize this class by looking at the components of broad money. The monetary base and the money multiplier together generate the size of broad money. We have seen the different components of the money multiplier. We have seen it depends on the mandatory
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reserve requirements and excess reserves of the banks, and on the preference of the public for keeping cash. While the monetary base is composed of those elements we have been seeing in the Central Bank's balance sheets, namely net foreign assets, net claims on government, net claims on the domestic banks, and other items net. All the operations of the Central Bank with the government increase reserve money and via the multiplier the money stock. Let's now take a break. VIDEO 12: Money Demand Money Demand. In this section, we will talk about the demand for money. What does make people hold money? In the first place, money is a medium of exchange. It saves people from having to barter goods and evaluate different quantities of different goods. Therefore, it has to be in some way related to the amount of goods that get exchanged in the economy during a certain period. In addition, it provides an efficient way of expressing the value of each good, and therefore is the unit of account for value. Therefore, it has to be related to the general level of prices in the economy.
Finally, money provides a means whereby people can store their earnings and transfer their purchasing power from the present to the future. Therefore, it has to be related to the relative value of postponing consumption from today to tomorrow. Such a relative value is a function of the rate of return on money, compared with yields on alternative assets. Hence, we expect the nominal money demand—which we will call Md—to depend on income, the level of prices, and the opportunity cost of holding money. The higher is real income, the more goods and services people will buy. And therefore, the more transactions...demand for money increases. Therefore, the higher the price level, the more money you need to buy a given number of things, the more the demand for money increases. The higher the interest rate, or the opportunity cost of holding money, the more attractive other interest-‐bearing assets become as a store of value. Therefore, portfolio demand for money falls. At this point, we need to make a distinction between demand for nominal versus demand for real money balances. Nominal demand is the demand for a given number of specific currency units, for example, dollars.
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Real demand is the demand for money expressed in terms of the goods and services that money can buy. We usually specify the money demand function in real terms because we assume the demand for nominal money balances is proportional to the price level. The price elasticity of nominal money balances is unit. This also implies that people are free from what is called "money illusion". The earliest monetary theory, and one of the most influential, is based on the link between the nominal stock of money, M, and the market value of output that it finances. The so-‐called "quantity equation" equates the stock of money in real terms with real output, with a proportionality factor, k. If k is assumed to be constant, this expression provides the quantity theory of money. This theory postulates a direct link between the stock of money and the price level whenever the economy is assumed to be at full employment. Thus, as long as k remains constant, there is a proportional relation between M and P. We call "v" the inverse of k, which then becomes the number of times M turns over in a given period, financing P*Y. We call v the income velocity of money.
Let's express the money demand equation in logarithmic terms. By taking natural logs, we can write-‐-‐ and then taking derivatives-‐-‐ and then taking derivatives with respect to time, we find a fundamental relationship that links money to prices and goods. As long as the income velocity of money is constant, the growth in the money supply beyond the growth in real incomes will lead to inflation. The higher the growth in the money supply, the higher the inflation rate. Velocity is one of the most studied variables in monetary economics. It is a very useful concept for a policymaker. If v can be predicted with confidence, well, then one can aim at the level of the money supply, which is consistent with the attainment of a desired real growth and inflation rate. A closer examination of v reveals that velocity is not a mechanical link between nominal income and the stock of money, but rather, it is a concept very much linked to the demand for money. And in fact, velocity and money demand are inversely related. What does the quantity theory of money predict? It will predict that the undesired increase in the stock of money will lead to higher inflation in the economy. Do we find this in the data? We can check historical series to see if this relationship holds.
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This graph represents the average change in the stock of broad money over the period 2000 to 2012, as compared with the average change in the Consumer Price Index (CPI) in the same period on the vertical axis for a large sample of countries. Linear interpolation of the data evidences a distinct positive relationship between the change in the money stock and the change in prices, which would support the conclusion of the quantity theory of money. The important conclusions that can be derived from the quantity theory of money are that the increase in prices can be controlled by controlling the stock of money in the economy. In this context, the central bank can control the stock of money. And we have seen that if the money multiplier is stable, the central bank can control the stock of money by controlling the monetary base—then, the central bank will be also able to control inflation in the economy. We have seen how the central back can control the monetary base by limiting growth in net domestic assets and net foreign assets. It also follows from the quantity theory of money that if the central bank is able to control the stock of money, it will also be able to control the growth of credit to the private sector. But is velocity really constant? In recent years, we have been observing that velocity is not such a stable variable as we might imagine. In particular, a number of
factors associated with the development of the financial sector, with the increased access to financial services, and with the expansion of financial instruments, has been affecting the income velocity of money in countries across the world. VIDEO 13: Money Demand (continued) Why do we expect velocity to increase? For example, when demand for money falls. That will happen in a period of high inflation, because people will try to get rid of their cash balances before they depreciate. Or in a period when interest rates are very high, and therefore the opportunity cost of holding money increases. By contrary, we would expect velocity to decline if the economy becomes increasingly monetized because of financial deepening. This will imply an increase in money demand. We can also observe a relative change in the demand for the different components of the stock or money. For example, the increases in the number of banks or technological advances, such as credit cards, cash machines, and electronic transfers, can raise velocity because it becomes easier to convert between money and money substitutes. So money demand for pure cash balances falls.
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The reduction of the demand for cash implies that the velocity of M1 increases, but it is important to note that this shift has generated also an increase in the demand for broad money components, that is, instruments with a longer term. Thus we would observe the velocity of M2 to fall. The liberalization of capital flows has mostly also been associated with a reduction of the domestic level of interest rates and an expansion of the financial assets, so that the effects on velocity of been mixed. The central bank requires an accurate estimation of the demand for money. However, if the velocity of money changes because of structural factors in the economy, the central bank runs the risk of making a mistake. If the central bank underestimates velocity, that means that the demand for money is actually lower, and it generates an excess supply of money in the economy. The excess supply of money will lead to higher inflation or will increase the demand for foreign goods under a fixed exchange rate regime, and eventually will lead to a depletion of foreign exchange reserves. If the central bank over estimates velocity and therefore provides too little money, the tight monetary stance will lead to an increase in interest rates and therefore lower investment and growth in the economy.
After discussing the quantity theory of money, let's discuss what central banks have been doing in practice. Concretely, we can find that central banks across the world seek to make consistent decisions towards the sometimes conflicting objectives of monetary and exchange rate policies. In so doing, they implement four alternative monetary and exchange rates regimes. These can be categorized as: (1) regimes where the central bank targets monetary aggregates, (2) regimes where the central bank targets the exchange rate, (3) regimes where the central bank targets the inflation rate, and (4) eclectic regimes where there is no specific preset target. When a central bank decides to target monetary aggregates, they rely on the notion implied by the quantity theory of money—that is, there is a stable relationship between the amount of money people will require, their nominal income, and the level of interest rates in the economy. Central banks will then seek to ensure that the stock of money in the economy is consistent with the demand for money so as to avoid unwanted increases in prices. We have seen that if the money multiplier is stable, the central bank will aim at controlling the money supply by controlling the monetary base, where mm is the money multiplier and includes the propensity of the public to save, and the level of required reserves established by the central bank.
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We have also seen in the previous part of this lecture how the central bank can do this through open market operations and setting the level of required reserves for banks. If you remember from the first part of this lecture, M2 will be equal to the sum of the NDAs and the NFAs of the depository corporations sector. When targeting monetary aggregates, the central bank can act through open market operations and sterilize any unexpected increases in its own NDAs or NFAs, so as to achieve a monetary base consistent with the desired level of M2 in circulation. This used to be the main for framework for monetary policy operations in the '70s and '80s in industrialized countries, and to these days a number of countries still rely on it. The full list of such countries can be found in the IMF's publication on exchange rate arrangements and exchange restrictions. In exchange rate targeting regimes, the central bank uses the exchange rate as a nominal anchor to achieve price stabilization. In this framework, the central bank will buy and sell foreign reserves to ensure that the exchange rate depreciation is as close as possible to 0. Under fixed exchange rate arrangements, the central bank commits to buy and sell foreign exchange at a targeted exchange rate. Countries that follow this framework are: Denmark, Saudi Arabia, et cetera. As we have seen, the monetary base is equal to the NFA and the NDA of the central bank.
If the central bank buys and sells reserves to achieve a desired level of the exchange rate, it will no longer have control over the NFA part of the balance sheet. This will occur because NFA will fluctuate as much as it is necessary to reach a desired level of the exchange rate. Therefore, the central bank will need to conduct open market operations to sterilize undesired increases in NFA with a decline in NDA, so as to keep the monetary base at the desired level. However, it tends to be often the case that the sterilization operation may not be fully effective. And at times, this will lead to a case of losing fully or partially the control of the monetary base. Exchange rate targeting regimes do not allow central banks to pursue any other policy than exchange rate stabilization because the level of the domestic interest rates can never diverge from that of foreign rates. Central banks that pursue inflation targeting regimes use the inflation forecast as the nominal anchor. They will enact open market operations to ensure that the prevailing level of domestic interest rates is consistent with the pre-‐announced inflation target. Under this regime, the exchange rate is flexible and NFA do not change, 126 00:08:09,945 -‐-‐> 00:08:20,570 but the central bank will target a level of NDAs, and therefore of the monetary base, such
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that they are consistent with achieving the targeted level of the interest rate. Examples of inflation targeting regimes are New Zealand, Chile, the UK, the Czech Republic, Poland, Romania, and many other countries. Finally, there are countries that don't use a specific anchor to achieve price stability, but adjust policy instruments to pursue economic growth and low unemployment. Examples of these are the US, the Euro area, Japan, India, and many others. Historically, countries have been shifting towards inflation targeting and eclectic regimes as capital accounts have been liberalized and central banks have been pursuing policy objectives of growth and unemployment. In particular, we can see that in advanced countries, the incidence of eclectic regimes has increased significantly in recent times, while in emerging market countries it has been the inflation targeting regimes, the one that has experienced the widest increase in countries across the world. What have been the main concepts we have been discussing in this class? In the first place, we have discussed for what purpose people hold money, and established that the level of income, the level of prices, and the level of the interest rates will be important determinants of the demand for money.
Then we derived the equation for the quantity theory of money that establishes that the demand for real money balances will be proportional to the level of income. This predicts that an undesired increase in the stock of money will lead to higher inflation if the income velocity of money is constant. Finally, we have discussed different factors that may change the income velocity of money and the risks the central banks face if they mis-‐estimate the income velocity of money. VIDEO 14: Selected Issues In the last part of this lecture, we will cover specific topics that are relevant for monetary analysis and monetary policy decisions. Namely, these are the presence of seigniorage, foreign-‐capital inflows, and vulnerabilities in the financial sector. The first of our topics is seigniorage. Seigniorage is the rent to the central bank that stems from the privilege of being the sole issuer of the currency. It extends from the fact that the cost of printing currency is lower than the value of the assets of the central bank. This feature has important implications for monetary policy decisions, To explain this property, let's assume that in a country money demand increases at the same rate as GDP, as we would expect from the quantity theory of money.
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Let's assume the GDP grows at 4% per year. So, to maintain the prices stable, the central bank has to increase money supply by 4% per year. Therefore, the central bank can increase the monetary base in the same proportion without generating inflation. Given a stable money multiplier, this implies that the central bank will be expanding its balance sheet by 4% a year at no economic cost beyond that of printing money. The other component of seigniorage is the inflation tax. We typically talk about the inflation tax in the context of financing of the public deficit. If the government requires the central bank to finance its deficit, the central bank will have to print money. And when it does so, according to the quantity theory of money, it will generate an increase in prices. Such inflation will become a tax on the public because by printing money the central bank reduces the value of real money balances of the general public. More in general, inflation reduces the real value of the liabilities of both the government and the central bank. This constitutes revenue for the central bank. For example, if the monetary base is 19.25% of GDP, a 10% inflation rate will reduce liabilities in real terms by 1.9% of GDP. If the velocity of money has not changed, the central bank can now issue 1.9% of GDP in base money. This is the inflation tax collected by the central bank.
The second of our topics is capital inflows. In recent years, capital accounts of countries across the world have been liberalized and capital can freely flow across national frontiers, providing financial intermediation services among countries similar to those that banks provide for savers and investors within the country. Capital flows strengthen the link between domestic economic policies and the balance of payments. As the world capital markets have become increasingly integrated in the past two decades, so have domestic monetary policies and monetary developments in foreign countries. Under perfect capital mobility, the slightest difference between interest rates prevailing in the domestic and foreign capital markets provokes a very large capital flow. Therefore, the tightening of monetary policy stance in a country will induce capital inflows. When countries seek to maintain their exchange rate fixed, the capital inflows following an attempt by the central bank to tighten monetary policy will force the central bank to intervene in the foreign-‐exchange markets in order to prevent the domestic currency from appreciating. The increase in the net foreign assets will offset any initial money contraction, forcing domestic interest rates back down to the level in foreign markets.
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When countries leave their exchange rate to float freely following a tightening of monetary policy, the central bank will not intervene in foreign-‐exchange markets. This implies that the net foreign assets will not change, but the domestic currency will appreciate vis-‐a-‐vis the foreign currency. This will tend to increase the domestic demand for foreign goods and generate a deterioration of the current account deficit which will be financed by the capital flows. In this context, the link between the money supply and the balance of payments is broken and the central bank regains control over money supply. In practice, central banks are often weary of allowing the exchange rate to appreciate too much because of the potential adverse consequences on the external position. In periods of heavy capital inflows, most countries have responded by undertaking a combination of actions. These have involved: (1) a partial intervention to buy some of the capital inflow, but allowing some nominal exchange-‐rate depreciation; (2) a partial sterilization of the increase in net foreign assets so as to offset part of the impact of the increase in NFAs on the monetary base; (3) some increase in the monetary base and inflation and, consequently, some real exchange-‐rate appreciation. Let's now talk briefly about the main vulnerabilities in the financial sector and how these are addressed by the banks.
It is important for central banks making monetary-‐policy decisions to have an assessment of the health of the financial sector, because monetary policy decisions will have a direct effect on the balance sheet of the banks and may weaken banks' financial positions. When we talk about "risks" in the financial sector, we think mainly about four types. In the first place, we find liquidity risk. Liquidity risk the risk that an unexpected shock yields an unanticipated withdrawal of deposits. Liquidity risk is intrinsic to the banking business. It derives from the function of transforming short-‐term liabilities, such as deposits, into long-‐term assets. Therefore at no moment in time can banks repay all of their liabilities. By nature of the banking business, it is based upon the assumption that people will not need to withdraw all of their deposits at once. To guard against such events, banks are required to hold mandatory reserves at the central bank. And in general they also hold extra liquidity buffers, particularly in those countries where liquidity shocks are high and volatile. In the second place, we find exchange rate risk. Exchange rate risk on banks' balance sheets stems from the potential losses deriving from the revaluation of assets and liabilities following a change in the value of the domestic currency vis-‐a-‐vis the foreign currency. As we have seen in the class on the depository corporations sector,
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if the net open position in foreign capital is negative, when the exchange rate depreciates, banks' losses from the revaluation of liabilities will exceed the gains from the revaluation of assets. Therefore balanced net open positions will minimize such risk. Should the exchange rate have a depreciating trend, the banks would benefit from a positive net open position. The third important risk that banks carry on the balance sheet is the risk of losses following the re-‐pricing of banks' assets and liabilities following a change in the interest rates. Remember that banks' assets are typically long-‐term and the income stream can be fixed. By contrary, banks' liabilities are typically short-‐term and generate payments depending on the prevailing level of interest rates in the economy. Therefore banks can suffer losses or gains depending on the interest rate structure of their balance sheets—fixed versus floating. Banks hedge interest rate risk by building portfolios of assets to match the interest rate structure of their liabilities. And finally, the largest risk typically on balance sheets of traditional depository corporations is credit risk. What is credit risk? That is the risk that a loan will not be repaid.
There are number of micro-‐ and macroeconomic factors that influence the probability of repayment of loans. For example, the point of the business cycle which the economy is at and the corresponding level of unemployment. Both will influence the probability that people will be able to repay their loans. There are a number of other factors that also need to be considered. For example, if the debt-‐service burden of the household is very sensitive to the level of interest rates because loans have floating rates, or if they are very sensitive to the level of the exchange rate because loans are denominated in foreign currency. All these factors affect the probability of repayment of bank loans. Banks hedge against credit risk by setting aside provisions to face losses from the occurrence of defaults. The size of the provisions will depend on the likelihood of the loss and the historical loss experience. To summarize, central banks should analyze these risks on balance sheets—liquidity risk, exchange rate risk, interest rate risk, and credit risk—before they make monetary policy decisions because a significant vulnerability the banking sector to one or all of these risks may cause large losses for the banking sector following a decision of the central bank. Let's take a step aside now to review what we've learned in this class. We have learned how to read the balance sheets of the central bank
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and of the other depository corporations. We have also seen how the balance sheets of the central bank and that of the other depository corporations are consolidated to draw analysis on the evolution of the monetary aggregates in the economy. We have discussed how the central bank can control the amount of money in circulation by controlling the monetary base if money multipliers are stable. We have also discussed how the central bank needs to analyze closely money demand before making decisions on monetary policy. In particular, we have seen how, according to the quantity theory of money, an excess supply of money will generate inflation. Finally, we have discussed a set of issues that the central bank will have to take into consideration before making monetary policy decisions, namely, the amount of seigniorage it can extract, the impact of its decision on capital inflows, and the health of the financial sector.
COUNTRY CASE VIDEO 1 In the next and following set of questions you will be working on the survey of financial corporations for Macronia. And actually in the set of questions that immediately follow this tutorial video, you will only work on the balance sheet of the central bank and that of other depository corporations. We will then see how to consolidate the two to obtain the survey of financial corporations in the next tutorial video. So let's go back to the central bank and let's now start to complete the balance sheet of the central bank. Let's start from the liability side. Actually, to complete the table and answer the following questions, we suggest that you follow exactly the order in which those questions are posed. So let's now start from, as I suggested, computing the liabilities. Well, the monetary base is simply equal to the currency in circulation plus liabilities to other depository corporations which gives a value of 2,218. In general, information about net foreign assets are obtained fairly easily. In most cases to obtain net domestic asset, if you look at a balance sheet of the central bank you might need to do some rearrangement. So it's generally easy to compute this simply as the value of the
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liabilities. So, I'm sorry. Set it equal to the values of the liabilities minus the values of net foreign assets. Why are we doing this? Simply because let's remember the sum of net foreign assets and net domestic assets is equal to the liabilities, so the monetary base. So if you have the monetary base and net foreign asset, it is very straightforward to compute net domestic asset. As a next step, you would compute all of these components of net domestic assets. In particular, let's compute the net claims on the public sector. And these are equal simply to the net claims on the general government plus the net claims on the rest of the public sector. OK? And the result here is minus 86. Now to compute other items, net, you may actually follow two ways. You can either compute either items net as a sum of its sub components, shares and other equities plus other items, net. Or you basically might use the fact that net domestic asset must be a summation of all of its sub components so that you can compute other items net simply as net domestic asset, minus net claims on the public sector, minus the claims on other depository
corporations, minus the claims on the rest of the private sector, minus the monetary stabilization bonds. And this would deliver, indeed, the same number that you obtained before. For the balance sheet of other depository corporations you would do exactly the same thing. So you would start from computing your total deposit as the sum of transferrable deposits and other deposits. You now move to the asset side and you will compute the net domestic assets as the difference between deposits and net foreign assets. And finally, again, you can compute other items, net in two ways. You can compute it—well, let's start from the second way as net domestic asset, minus net claims on the general government, minus net claims on the—the central bank, minus net claims on the public sector, minus the claims on the rest of the private sector. And you would obtain minus 3,442. And actually let's notice that this is, if you highlight all of the three cells below, this is—and you find it down below here—exactly the sum of these three numbers. So of course this is a balance sheet, so numbers and summations should all square.
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COUNTRY CASE VIDEO 2 In the following set of questions, you will still be working with the table "Macronia: Survey of Financial Corporations," the one you have been working with in the previous questions. But you will now switch to the bottom of the table and be asked to complete the survey of financial corporations. So as usual, to do that, let me start by demonstrating how you would do the same questions that you have to do for 2012, but for 2011. Let's start by completing the survey of financial corporations. And let's start by computing broad money. So let me delete all of these numbers and reconstruct them. So let's start by the components of broad money. Currency in circulation would be equal to, if you go up above, the currency in circulation from the central bank balance sheet, 743, of course, minus any currency which other depository corporations are holding. This currency, this 197, is actually within the broad set of financial corporations. So it is not counted as currency outside of the financial corporations of that set. Deposits is simply equal to the deposits of other depository corporations.
And once you have these two elements, you can simply sum up the three sub-‐components of broad money. So currency in circulation, plus deposits, plus other central bank liabilities accounted as broad money, which has been provided directly to you. You don't have to bother computing that. And you can obtain broad money. Let's now move to the upper part of this table. And let's compute, reconstruct, all of the assets of the financial corporations. Let's start from net foreign assets. Net foreign assets would simply be equal to the sum of the net foreign assets of the central bank plus the net foreign assets of other depository corporations. Once you have done that, you can now compute net domestic assets. And again, the strategy here would be simply to compute net domestic assets as the difference between broad money and net foreign assets. At this point we can start building up all of the sub-‐components of net domestic credit. In particular, let's start from net claims on the public sector.
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And let's start from these two sub-‐components of it, the net claims on the general government, which would be the sum of the net claims on the general government from the central bank, plus the net claims on the general government of other depository corporations. Similarly, we can compute the net claims of the entire set of financial corporations as the sum of net claims on the rest of the public sector by the central bank, plus the claims on the rest of the public sector of other depository corporations. And we obtain 98. If we now sum these two, we can obtain the net claims on the public sector, 943. At this point, we can compute the claims on the rest of the private sector. And these, again, would be those claims on the rest of the private sector from the central bank, plus those claims on the rest of the private sector of other depository corporations. And so we would obtain 1,072. If we now sum up the net claims on the public sector and the claims on the rest of the private sector, we will obtain net domestic credit. At this point, again, there are two ways in which you can compute other items, net. One would be simply by taking the net domestic assets and subtracting the net domestic credits. The other one would simply be to sum up the sub-‐components. Let's actually construct these components and simply check that the sum of the sub-‐components is equal to other items, net that we have just calculated.
So for shares and other equity, we'd actually take those of the other depository corporations, plus those shares and other equity of the central bank. And we obtain minus 117. For other liabilities excluded from broad money, we would take these items simply from that of other depository corporations. And we can now see that the sum of these three is exactly minus 2,597. In this way, we have reconstructed the entire survey of financial corporations. COUNTRY CASE VIDEO 3 You will now be constructing some indicators from the monetary accounts. So you would be working with the table called "Macronia Monetary Accounts Indicators." In this table, you are asked basically to compute the first set of indicators, which simply relate to the growth of the money aggregates. For the growth of money aggregates, that is actually fairly simple. You would have to take—let me construct that growth for net foreign assets—you would actually have to compute the percent of change, for example, in this specific case in net foreign assets.
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So you take—I'm sorry, I forgot to put here equal to; you might also want to open a parentheses—this would be equal to the net foreign assets at the end of the year divided by the net foreign assets at the end of the previous year minus 1. All of that multiplied by 100. And you will be able to reconstruct minus 18%. So the calculations for all of the other rate of growth is the same. Let me now maybe illustrate how to compute the contribution to the growth of broad money of some of these specific aggregates. So let's compute how the growth in net foreign asset contributed to the growth of broad money. In this case, we would basically have to compute the difference in net foreign asset. Again, net foreign asset at the end of the year minus net foreign asset at the end of the previous year, all of that within parentheses, divided by the stock of broad money at the end of the previous period, all of that multiplied by 100. And you will be able to reconstruct this minus 4.3%. Let me illustrate that again for another aggregate, which is net domestic credit. Again, that would be the difference in net domestic credit within two consecutive end of years, divided by the stock of broad money at the end of the previous period, all of that multiplied by 100. And you obtain here 14.1%. Finally, you will be asked to compute other selected indicators.
Some of them are fairly easy. For example, monetary base to GDP. For others, let's suppose credit to deposit, you simply have to take the relevant variable, in this case this would be net claims on the private sector, and divide it by, in this case, deposits, and then you multiply everything by 100, and you are able to reconstruct this 118.9. Maybe another interesting variable that you might want to compute is velocity. And to compute velocity, you would actually take nominal GDP. And you divide it. So you divide and open a parentheses, maybe open two parentheses, by the average broad money. You can compute the average broad money simply by taking broad money at the end the current year, plus broad money at the end of the previous year, close parentheses, and divide by 2. That's an approximation, of course, but it's a fairly valid one. And you are able to compute velocity as 2.