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Korean Monetary Policy and the Financial System

Korean Monetary Policy and the Financial System. Spring 2012. Multiple Deposit Creation & The Money Supply Process. Introduction. • Money supply: total amount of money in circulation in the economy at a given time. .

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Korean Monetary Policy and the Financial System

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  1. Korean Monetary Policy and the Financial System Spring 2012 Multiple Deposit Creation & The Money Supply Process

  2. Introduction • Money supply: total amount of money in circulation in the economy at a given time. • Money supply affects interest rates and the overall health of the economy and thus affects our life. • How do we measure money supply? currency in circulation M1 demand deposits M2 savings deposits, money market deposits other liquid assets M3 large time deposits other less liquid assets

  3. Components of M1 Traveler’s Checks Other Checkable Deposits Demand Deposits Currency ☼Bank deposits account for 46.7%–or almost one-half–of total M1!

  4. Components of M2 MMF Shares (noninstitutional) M1 Small Time Deposits & RPs Savings Deposits & MMDAs

  5. • How is money supply determined? Who controls it? → The money supply process ☞ Since deposits at banks (and other depository institutions) comprise the largest component of the money supply, understanding how these deposits are created is the first step in understanding the money supply process. • There are four types of individuals and institutions involved in the process of creating deposits (and hence in the money supply process)

  6. Money Supply Process: An Overview Money Supply The Central Bank controls the monetary base by “open market operations”. Deposits at Banks Multiple Deposit Creation: When the Central Bank supplies the banking system with additional reserves, deposits increase by a multiple of this amount. Monetary Base Currency in circulation Reserves in the banking system

  7. Four Players in the Money Supply Process ① Central Bank (the Fed): the government agency that oversees the banking system and is responsible for the conduct of monetary policy; the most important player ② Banks (depository institutions): the financial institutions that accept deposits and make loans. ☼In the US, these include commercial banks, savings and loan associations, mutual savings banks, and credit unions. ③ Depositors: the individuals and corporations that hold deposits in banks. ④Borrowers from banks: Individuals and corporations that borrow from banks, along with governments that issue bonds that are purchased by banks.

  8. Fed’s Balance Sheet • Monetary Liabilities Currency in circulation: cash in the hands of the public circulating outside of banks Reserves: vault cash and bank deposits at the Fed • Assets Government securities: holdings by the Fed that affect money supply and earn interest Discount loans: provide reserves to banks and earn the discount rate

  9. Monetary Base • Definition: the monetary liabilities of the monetary authorities (currency-issuing authorities) •Consists of 1) Currency held by individuals and firms 2) Currency held within banks (Vault Cash) 3) Bank reserves on deposit at the central bank ☼1)+2)+3): Gross injection of currency by the central bank 1)+2): Net injection of currency by the central bank ☼Money supply refers to quantity of money that is in circulation. As 2) & 3) are not in circulation, Monetary Base is not considered a measure of money supply. •Under the direct control of the central bank •Used as the vehicle through which the central bank exercises control upon the money supply

  10. US Monetary Base •Being raw material of money creation, also called high-powered money •Other names: Reserve Money, Base Money. ☼In the US, paper currency (the Federal reserve notes) is issued by the Fed while coins are issued by the Treasury Fed’s monetary liabilities = Fed. Reserve notes held by nonbank public (Fed. Reserve notes outstanding) + Fed. Reserve notes held by banks (Reserves) (Bank deposits at Fed + Vault Cash)

  11. •Monetary Base = Fed. Reserve Notes outstanding + Bank Deposits at Fed + Vault Cash + Treasury Currency Outstanding - Coin at Fed Fed’s monetary liabilities Treasury’s monetary liabilities Treasury’s monetary liabilities = Treasury currency in circulation outside both Treasury and Fed = (Total Treasury currency issued – Treasury’s coin holdings) – Fed’s coin holdings = Treasury currency outstanding – Coin at Fed ☼Note “Coin” is an asset item on Fed’s balance sheet

  12. Currency in Circulation(C) Monetary Base = Fed. Reserve Notes outstanding + Treasury Currency Outstanding - Coin at Fed + Vault Cash + Bank Deposits at Fed Currency outside Fed * Reserves (R) … currency supplied by Fed but is now back in bank reserve accounts at Fed * More precisely, ‘Currency outside Fed’ refers to Fed. Reserve notes outside Fed plus coins outside both Fed and Treasury Monetary Base (MB) = Currency in Circulation(C)+ Reserves(R) = Currency in Circulation (C) + Vault Cash + Bank Deposits at Fed = Currency outside Fed + Bank Deposits at Fed

  13. Korean Monetary Base Monetary Base = Currency in Circulation(C) + Vault Cash + Bank Deposits at BOK BOK Notes & Coins Issued Reserves (R) C = Currency in circulation among the nonbank public R = Reserves held by depository corporations in the form of vault cash and deposits at BOK. (BOK’s liabilities to depository corporations) Monetary Base (MB) = C+ R

  14. Monetary Base and Other Measures of Money (2010, period average) trillion won

  15. Composition of Monetary Base (2010, period average, trillion won) Vault Cash Currency in Circulation Depository Corporations’ Reserve at BOK

  16. The Banking System The Fed Liabilities Assets Liabilities Assets Reserves +$100 Securities +$100 Securities −$100 Reserves +$100 Control of the Monetary Base Open Market Operations The Fed’s buying and selling of government securities in the regular (open) market Open Market Purchase from a Bank The Fed buys $100 of securities & pays with a check Net result: Bank reserves have increased by the amount of the open market purchase and the monetary base has also risen by the same amount.

  17. Nonbank Public The Fed Liabilities Assets Liabilities Assets The Banking System Reserves +$100 Securities +$100 Securities −$100 Checkable Deposits +$100 Liabilities Assets Reserves +$100 Checkable Deposits +$100 Open Market Purchase from a Nonbank Public (Two Possible Cases) 1) The non-bank public deposits the Fed’s check in a bank Net result: Same as before; Reserves increase by the amount of the open market purchase and the monetary base increases by the same amount.

  18. Nonbank Public The Fed Liabilities Assets Liabilities Assets Currency +$100 Securities +$100 Securities −$100 Currency +$100 2) The non-bank public cashes the Fed’s check for currency Net result: Currency in circulation increases by the amount of the open market purchase and the monetary base increases by the same amount. Unlike before, reserves do not change.

  19. The Banking System The Fed Liabilities Assets Liabilities Assets Reserves −$100 Securities −$100 Securities +$100 Reserves −$100 Open Market Sale to a Bank Suppose the Fed sells $100 of securities Net result: Reserves have decreased by the amount of the open market purchase and the monetary base has also fallen by the same amount.

  20. Nonbank Public The Fed Liabilities Assets Liabilities Assets The Banking System Reserves −$100 Securities −$100 Securities +$100 Checkable Deposits −$100 Liabilities Assets Reserves −$100 Checkable Deposits −$100 Open Market Sale to the Nonbank Public (Two Possible Cases) 1) The nonbank public pays with a check Net result: Same as above; Reserves decrease by the amount of the open market sale the monetary base decreases by the same amount

  21. Nonbank Public The Fed Liabilities Assets Liabilities Assets Currency in Circulation −$100 Securities −$100 Securities +$100 Currency −$100 2) The nonbank public pays with currency Net result: Currency in circulation decreases by the amount of the open market sale and the monetary base decreases by the same amount. Unlike 1), reserves do not change. Conclusion: The effect of open market operations on the monetary base is much more certain than the effect on reserves. That is, the Fed can control the monetary base more effectively than it can control reserves.

  22. 15-22 Nonblank Public Liabilities Assets The Fed The Banking System Checkable Deposits −$100 Currency +$100 Liabilities Assets Liabilities Assets Currency in Circulation +$100 Reserves −$100 Reserves −$100 Checkable Deposits − $100 Shifts from Deposits into Currency A shift from deposits into currency will affect reserves but not the monetary base Random fluctuations of reserves can occur as a result of random shifts into currency and out of deposits, and vice versa. The same, however, is not true for the monetary base, making it a more stable variable.

  23. The Fed Liabilities Assets The Banking System Reserves +$100 Discount Loans +$100 Liabilities Assets Reserves +$100 Discount Loans +$100 Discount Loans Suppose Jamestown National Bank finds itself short of reserves, and asks the Fed for a $100 discount loan. When the Fed makes this discount loan, it credits the bank’s account at the Fed with an additional $100. This example shows how the Fed can provide additional reserves to Jamestown National Bank, and hence to the banking system as a whole, by making discount loans. An increase in discount loans will increase reserves and the monetary base and vice versa.

  24. BOK’s Flow of Open Market Operations Source: Monetary Policy in Korea, second edition, BOK, 2008 http://www.bok.or.kr/contents/total/eng/boardView.action

  25. The Process of BOK’s Practical RPTransactions

  26. The Bidding Process for the Issuance of MSBs

  27. Multiple Deposit Creation: A Simple Model When the Fed supplies the banking system with additional reserves, deposits increase by a multiple of this amount Assumptions 1. Banks keep zero excess reserves 2. No proceeds are withdrawn as cash 3. Required reserve ratio(r) = 10% on checkable deposits •Suppose the Fed buys a $100 bond from the First National Bank (i.e., it injects reserves of $100 into the banking system via an open market purchase of securities) ☞ This lowers the bank’s securities by $100 and raises the amount of excess reserves by $100. (As there’s no change in checkable deposits, there’s no change in required reserves)

  28. First National Bank First National Bank Assets Liabilities Assets Liabilities Securities – $100 Loans + $100 Securities – $100 Reserves + $100 ΔR • Since the bank does not want to hold excess reserves, they will make a loan for $100. The increase in reserves of $100 has been converted into additional loans of $100 at the First National, which will find their way, as shown next, to other banks in the form of checking deposits.

  29. Bank A Assets Liabilities Reserves + $100 Checkable Deposits +$100 First National Bank Assets Liabilities Deposits + $100 Securities – $100 Reserves + $100 Loans + $100 Actually, the bank will credit the borrower’s checking account with $100. So very briefly First National’s B/S will look like this. Note that this is not a deposit that came from outside. • Suppose the borrower of First National buys a camera that costs $100 and the camera shop owner deposits the check in his checking account at Bank A.

  30. Bank B Assets Liabilities Reserves +$90 Checkable Deposits +$90 ΔR Bank A Assets Liabilities rΔR Reserves + $10 Loans + $90 Checkable Deposits +$100 • Bank A keeps $10 (10% of the new deposit) on reserve and loans out $90, the entire excess reserves. • Suppose Bank A’s borrower buys a CD player that costs $90 from someone who is a customer of Bank B.

  31. (1-r)2ΔR (1-r)ΔR r(1-r)2ΔR r(1-r)ΔR Bank B Bank C Assets Assets Liabilities Liabilities Reserves +$ 9 Loans +$81 Reserves +$ 8.1 Loans +$72.9 Checkable Deposits +$90 Checkable Deposits +$81 • Bank B keeps $9 (10% of the new deposit) on reserve and loans out $81, the entire amount of the excess reserves. • Suppose borrower from Bank B buys a wrist watch that costs $81 from someone who is a customer of Bank C. Now, Bank C keeps $8.10 (10% of the new deposit) on reserve and loans out $72.9, the entire amount of the excess reserves.

  32. Bank A Assets Liabilities Reserves + $10 Securities + $90 Checkable Deposits +$100 The process keeps going until the loan amount reaches zero. This will result in a total increase of deposits of $1,000. Notice that the increase is tenfold, the reciprocal of the 10% required reserve ratio. ☼What if Bank A buys securities (instead of making loans) with $90 check Seller of securities, we assume, deposits $90 at Bank B and the process is the same. Whether bank makes loans or buys securities, we get the same deposit expansion.

  33. Multiple Deposit Creation

  34. Expansion of $100 at Varying Required Reserve Ratios $ Bank Deposits

  35. Derivation of Simple Deposit Multiplier Confirm from the previous table ΔD = $100 + $90 + $81 + $72.9 + ‥‥ = $100 + (1-0.1) $100 + (1-0.1)2 $100 + (1-0.1)3 $100 +‥‥ = $1,000 In general, ΔD = ΔR +(1-r)ΔR + (1-r)2ΔR + (1-r)3ΔR + ‥‥ = the sum of an infinite geometric series Simple deposit multiplier

  36. Simple Deposit Multiplier It is equal to the reciprocal of the required reserve ratio. As required reserves ratio increases, the deposit multiplier falls, and it slows down the deposit creation. If r = 0.1, then for every dollar increase in reserves, there will be a ten-fold increase in deposits. How about change in required reserves for all the banks? ΔRR = $10 + $9 + $8.1 + $7.29 + ‥‥ = 0.1∙$100 + 0.1(1-0.1)∙$100 + 0.1(1-0.1)2 ∙$100 +‥‥ = $100

  37. In general, ΔRR = rΔR + r(1-r)ΔR + r(1-r)2ΔR + r(1-r)3ΔR + ‥‥ Increase in loans? ΔLoans = $100 + $90 + $81 + $72.9 + ‥‥ = $100 + (1-0.1) $100 + (1-0.1)2 $100 + (1-0.1)3 $100 +‥‥ = $1,000 (same as ΔD) It is equal to the reciprocal of the required reserve ratio. As required reserves ratio increases, the deposit multiplier falls, and it slows down the deposit creation.

  38. Deposit Creation by a System of Banks Alternatively, we can also derive the formula by looking at the entire banking system. • Let D = the total amount of checkable deposits at all banks • By assumption, banks do not hold excess reserves and therefore, total bank reserves(R) is the same as total required bank reserves(RR). R = r X D → D Tanking the change in both sides, we get

  39. Critique of the Simple Model Back to those 3 simplifying assumptions…… 1. Banks keep zero excess reserves 2. No proceeds are withdrawn as cash 3. Required reserve ratio(r) = 10% on checkable deposits 1 → Banks may not use all of their excess reserves to make loans or to buy securities 2 → Depositors may withdraw a portion of loans or receipts as cash. 3 → Required reserve ratios may be different depending on types of deposits.

  40. Money Multiplier Model Assumptions As economy grows D will also grow and as D grows C and ER are also likely to grow. So we assume: Desired holdings of currency C and excess reserves ER grow proportionately with checkable deposits D such that Let r = required reserve ratio. Note that RR = r·D

  41. • Then C = c·D and ER = e·D….. (1) • Let’s define money supply as currency plus checkable deposits: M = C + D • The total amount of reserves (R) is the sum of required reserves (RR) and excess reserves (ER): R = RR + ER ….. (2) • Substituting RR = r·D & ER = e·D in equation (2), we get R = r·D + e·D ….. (3) • The Monetary Base(MB), which equals currency(C) plus reserves (R), can be written as below after plugging in (3) for R: MB = C + R = C + r·D + e·D …… (4) Equation (4) reveals the amount of the monetary base needed to support the existing amounts of checkable deposits, currency and excess reserves.

  42. • Substituting C = c·D in equation (4), we get: MB = C + R = c·D + r·D + e·D = (c + r +e )D …… (5) • Dividing both sides by the term in the parenthesis • M = C + D = c·D + D = (1+c)·D money multiplier

  43. • The money multiplier is then Let r = 0.1, c = 0.3, e = 0.001 Then simple deposit multiplier = 1/0.1 = 10 money multiplier If c ↑ to 0.5, then r ↑ e ↑ c ↑ money multiplier ↓ money supply ↓

  44. Central Bank’s Ability to Control MB • The central bank cannot determine the amount of borrowing by banks from the central bank. • Split the monetary base into two components, non-borrowed monetary base(MBn) and borrowed reserves(BR): MB = MBn + BR • The money supply equation M = m · MB is then: • For the Central Bank, it is easier to control the monetary base but not easy to control the money supply.

  45. BOK’s Required Reserve Ratio • Current reserve requirement ratios vary from 0% to 7%, depending on the type of deposits, and the average ratio stands at around 3.6%. • Demand deposit: 7% Time deposit, fixed-installment savings deposit, & CDs: 2% Long-term savings deposit: 0% • On December 23, 2006, the reserve requirement was raised from 5% to 7% against demand deposits.

  46. BOK’s Average Required Reserve Ratio and Money Supply

  47. Average Required Reserve Ratio in Recent Years

  48. Korean Money Multipliers (Jan/1986 – Feb/2011)

  49. US Money Multipliers (Jan/1980 – Mar/2011)

  50. Application: The Great Depression Bank Panics, 1930-1933 • Bank failures (with no deposit insurance at the time) were largely due to: - Increase in deposit outflows and holding of currency (depositors) - An increase in the amount of excess reserves (banks) • For a relatively constant MB, the money supply decreased due to the fall of the money multiplier. Decrease in money supply was responsible for the worsening of the economy at the time.

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