Intervention sterilization and money
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Intervention, Sterilization, and Money. Concepts and exemplification. Objective. Explain what happens to the domestic money supply when central banks intervene in foreign exchange markets. Outline. The Monetary Base The Money Supply The link between MB and M (the money multiplier, m )

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Intervention sterilization and money

Intervention, Sterilization, and Money

Concepts and exemplification


Objective
Objective

Explain what happens to the domestic money supply when central banks intervene in foreign exchange markets


Outline
Outline

  • The Monetary Base

  • The Money Supply

  • The link between MB and M (the money multiplier, m)

  • Foreign exchange interventions

  • The concept of sterilization


A nation s monetary base

Assets

Liabilities

A nation’s monetary base

Currency (CURR)

Bank reserves (BRES)

Monetary base (MB)

Domestic credit (DC)

Foreign exchange reserves (FXR)

Monetary base (MB)


A nation s monetary base1
A nation’s monetary base

MB = DC + FXR = CURR + BRES


A nation s money supply stock
A nation’s money supply (stock)

The money supply is generally comprised of currency in circulation and transaction deposits

M = CURR + TrD


The effect of open market transactions
The effect of open-market transactions

Open market transactions change the money stock

that is,

Open market transactions increase or decrease the size of the money supply


The effect of open market transactions exemplification
The effect of open-market transactions: Exemplification

Assume the Fed purchases $1 m of securities from a dealer in Chicago.

What happens?

  • The Fed wires the payment and creates a $1 m deposit for the dealer with a Chicago bank.

  • The Chicago bank keeps 10% in bank reserves with the central bank, and lends out $0.9 m

  • The borrower of this $0.9 m spends the money, which ends up as a new deposit in a New York bank

  • The New York bank keeps 10% in bank reserves and lends the remaining $0.810 m

  • Etc.


The effect of open market transactions consequences
The effect of open-market transactions: Consequences

DC increases by $1 m

Bank reserves and currency increases by a combined $ 1m

The monetary base increases by $ 1m

Transaction deposits and currency in circulation increase by $0.9 m + $0.810 m + …+ etc.

The money supply increases by more than $1 m


The concept of money multiplier
The concept of money multiplier

The magnitude of the change in the money supply as a result of a change in the monetary base

m = (increase in M)/(increase in MB)

If m = 4, the money supply has increased by $4 m.


The relationship between the monetary base and the money stock
The relationship between the monetary base and the money stock

M = m(MB)

or

M = m(MB)

An open market purchase of securities will increase the money supply by a factor of m

An open market sale of securities will decrease the money supply by a factor of m


Side note
Side note stock

Any change in the monetary base will have a ripple effect in the economy.

A central bank cannot really control the money supply unless it knows the value of m


Foreign exchange transactions exemplification
Foreign exchange transactions: Exemplification stock

Assume the Fed buys £1 m from a foreign exchange dealer in New York

Also assume that:

mUS = 2.6

mUK = 2.1

s = $1.6/ £


Foreign exchange transactions effect on us money supply
Foreign exchange transactions: Effect on US money supply stock

The Fed pays the dealer by creating a $1.6 m deposit with the dealer’s bank.

The Fed’s foreign reserves increases.

The Us monetary base increases


Foreign exchange transactions effect on us money supply1

Assets stock

Liabilities

Foreign exchange transactions: Effect on US money supply

Currency (CURR)

Bank reserves (BRES)

+ $1.6 m

Monetary base (MB) + $1.6 m

Domestic credit (DC)

Foreign exchange reserves (FXR) + $1.6 m

Monetary base (MB) + $1.6 m


Foreign exchange transactions effect on uk money supply
Foreign exchange transactions: Effect on UK money supply stock

The Fed has £1 m claim on the Bank of England,

Bank of England reserves are now reduced by £1 m

The UK monetary base is, hence, reduced


Foreign exchange transactions effect on uk money supply1

Assets stock

Liabilities

Foreign exchange transactions: Effect on UK money supply

Currency (CURR)

Bank reserves (BRES) - £1 m

Monetary base (MB) - £1 m

Domestic credit (DC)

Foreign exchange reserves (FXR) - £1 m

Monetary base (MB) - £1 m


What if the fed is committed to a stable money supply and is worried about inflation
What if the Fed is committed to a stable money supply and is worried about inflation?

Foreign exchange transaction (like buying £1 m) increase the monetary base and, therefore, the money supply.

Increase in US money supply = ($1.6 m)(2.6) = $4.16 m

To keep the money supply unchanged the Fed would have to sterilize the foreign exchange purchase.


Sterilization
Sterilization worried about inflation?

Open-market interventions to offset changes in the money supply resulting from foreign exchange transactions.

The Fed would have to sell $1.6 m worth of securities to reduce MB by $1.6 m


Sterilization1
Sterilization worried about inflation?

The Bank of England would have to purchase £1 m of securities if it wants to sterilize the foreign exchange transaction.


Summary
Summary worried about inflation?

A purchase of foreign currency will increase the domestic money supply, unless offset by a domestic sale of securities.

A sale of foreign currency will decrease the money supply, unless offset by a domestic purchase of securities


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