How do banks change money supply?

Peyton Manning

Apart from the buying (creating money) and selling (removing money from circulation) of bonds, how do banks change the supply of money in an economy?


And also, if it was that simple, how come the central bank couldnt control the supply of money in the past?

ShoulderChip

print more notes

its done by european central bank - not Irish central bank.

google Monetary policy.

printing more notes leads to banks having more money available to lend out --> more spending ----> inflation

They also have money market opertations.

Where they will sell (buy) bonds to reduce (increase) money in circulation.

ShoulderChip

Deleted User wrote: »

They also have money market opertations.

Where they will sell (buy) bonds to reduce (increase) money in circulation.

that was in the OP

Jam-Fly

The Irish Central Bank can't do this, because we are part of the Euro. The European Central Bank controls printing notes etc.

The UK does have control of their currency however, and they have printed more meny thus reducing the value of the pound, therefore making British goods seem better value to other countries.

Économiste Monétaire

Archimedes wrote: »

Apart from the buying (creating money) and selling (removing money from circulation) of bonds, how do banks change the supply of money in an economy?


And also, if it was that simple, how come the central bank couldnt control the supply of money in the past?

There was a thread here a while ago, which you could look for, asking about specific money supply targeting by the central bank. I can explain money supply fluctuations, have you any understanding of macroeconomics?

ShoulderChip wrote: »

print more notes

its done by european central bank - not Irish central bank.

google Monetary policy.

printing more notes leads to banks having more money available to lend out --> more spending ----> inflation

No, the ECB does not print our notes. The ECB, through the governing council, directs a target value for the monetary aggregates that each of the national central banks attempt to follow. That's why we still have a currency centre in Sandyford. The Executive Board of the ECB decides how much to allocate on continuing basis to banks when we have variable MROs, but it's the NCBs who conduct these operations through their ESCB functions.

Économiste Monétaire

Archimedes wrote: »

Apart from the buying (creating money) and selling (removing money from circulation) of bonds, how do banks change the supply of money in an economy?


And also, if it was that simple, how come the central bank couldnt control the supply of money in the past?

The other threads here are currently engrossed in public sector rants, so I might as well try to answer your question properly; because they're incredibly dry to read and trite in the repetitious claims of laziness and what people are worth. First, I need to define “money.” In the Eurozone we define money as follows:

• Currency issued + Overnight deposits = M1
• M1 + Deposits with agreed maturity: up to 2 years + Deposits redeemable at notice: up to 3 months + Post Office Savings Bank deposits = M2
• M2 + Repurchase agreements + Debt securities: up to 2 years maturity + Money market fund shares/units = M3
• M3 being the broad money supply.

So, now, how do banks’ actions affect the money supply? Well, we live in a fractional reserve system, which means that banks do not keep 100 percent of the money you place on deposit with them. The story goes that in times gone past gold smiths acted as guardians of peoples’ money, as they owned large safe like objects in their workplace. They learned that people, who placed their gold in the smith’s care, only required some, not all, of the money they placed on deposit to meet frequent expenses. They then decided to lend some of that money to others with the hope of a return on their investment. Skip forward a few centuries to today. Now imagine a situation like this: The Central Bank makes a permanent open market operation to purchase €1,000 of government securities (permanent to keep it simple):

Note|Reserves €|Loans €|Deposits €
POMO €1,000|+1,000|0|+1,000
Bank 1 lends to Person 1|-|+900|+900
Person 1 purchases an air plane from Person 2|-900|-|-900
Person 2 deposits the money in Bank 2|+900|-|+900
Bank 2 lends to Person 3|-|+810|810
Person 3 purchases a computer from Person 4|-810|-|-810
Person 4 deposits the money in Bank 3|+810|-|+810
Bank 3 lends to Person 5|-|+729|+729
Person 5 purchases blow-up-doll from Person 6|-729|-|-729
Person 6 deposits money in bank 1/2/3|+729|-|+729
....|""|""|""
Totals|1,000|9,000|10,000

This is the type of table you'll see in any example/textbook. An initial injection of €1,000 has “created” €10,000 through the idea of multiple deposit creation. It’s an illustration of the money multiplier, which is to say that that the overall, broad money supply (M3) will increase by X, such that X = 1/minimum reserve requirement. Here, I’ve assumed a minimum reserve requirement of 10%. Now, this isn’t true for the real world as it makes several, possibly unrealistic, assumptions such as: banks do not keep any excess reserves, above the minimum reserve requirement, and people do not hoard cash to keep out of the banking system (thus ending the cycle at some premature point).

Depository institutions in the Eurozone are required to keep 2 percent of short-term deposits, i.e. overnight deposits and up to 2 years; a reserve requirement does not apply to deposits with maturity of 2 years or more. That means for every €100 a bank has in deposit accounts, it must keep €2 in cash and reserves at the national central bank (the CBFSAI is the central bank for Irish depository institutions in the ESCB).

Banks don’t just keep 2 percent of reserves, that’s a minimum imposed to ensure that banks can meet short-term liquidity requirements of depositors (on an average, to not so average, day). Each bank will come to a sufficient level through their experience of the demand for money. Today banks don’t use your average Joe as a main basis upon which they can lend, really. Money markets are used more frequently to allocate required credit to banks on a short-term basis which banks may use to accumulate long-term assets (money market participants aren't just banks, I'm just simplifying). This can be as short as overnight, or up to a year (+). The most frequent transactions are around 2-3 months, which is why people focus on 3-month LIBOR and EURIBOR. So, banks’ demand for liquidity can change and the money supply can be altered based upon bank’s preference for risk, and the price of that money. If they have an excess of reserves at the end of the day, they can dump that on the money market and it may have a multiplier effect, based on other bank's desire for reserves.

The Central Banks hold power over the monetary base, which is high-powered money (physical currency) and reserves held at the central bank by depository institutions. There’s a more complicated way to look at the money multiplier, which you can use to give an approximate value for the multiplier through the value of deposits, currency, and reserves held for the purpose of minimum reserve requirement. I can type out the method, but it’s long and boring—it also depends which deposits you factor into calculations (both deposits in MFIs and NCBs). My own loose estimate is for an average money multiplier, for the start of November 2008, being around 12.5. So, for every €1 increase in high-powered money we should get €12.5 increase in the money supply. This is called a base-multiplier approach, which alters the money supply through the multiple deposit creation factor due to an increase in the monetary base.

Now, as you asked in your question, why can’t the central bank just control the overall money supply by altering the high-powered money supply? Well, we tried that. Here’s what you may be presented with as a money supply function (I typed it out and used it as an image because I have no idea how to write this here):

Or, the money supply is a function of: the monetary base; money’s own rate of interest; technological conditions; return on alternative liquid assets, which here is the bond rate; rediscount rate charged for the lender of last resort facilities; the return on excess reserves relative to the bond rate; reserve requirement, and; the variability of flows of money banks are subject to. A change in any of these, given that some have a greater effect than others, can alter your money supply. (Bain-Howells 2003)

Essentially, the attempts to rigidly control the money supply failed. Central banks have two separate visions: An end objective being, say, price stability, and a choice of intermediate goals, such as: monetary targeting and short-term interest rates. The problems of a base-multiplier approach to monetary targeting are numerous. An inability to judge the money supply ex-ante, as opposed to ex-post, led to numerous readjustments of forecasts because it’s difficult to project the effects of an increase/reduction in the monetary base; interest rates in the money market change violently when demand changes (which proponents of monetary targeting asserted was constant); a fixed amount of money makes commitments to lend difficult to keep with unknown funding costs for a bank (money market rates changing); and so on.

This is also further complicated by: international money and capital flows moving with greater freedom (less barriers); other arguments, such as Goodhart’s conjecture vis-a-vis expectations of top-level institutions defining what is “money” and people ignoring this, and; the demand side for money (which is a whole different level of boring) changing. I think you might be looking for an answer to today's problem of a falling money supply (why can't we just increase it at will?). In simple terms, banks are using their excess reserves, from the fact that money is quite cheap now, to purchase government, short- and long-term, debt. That's quite effectively illustrated in the U.S. with this:



(I've robbed this from Mankiw's blog because I'm too lazy to go to FRED and make my own.) Here we see the ineffectual attempts to unfreeze credit markets for your average Joe and local shop, by a B-M approach. You also have the problem of lending being curtailed in areas where commercial banks did not operate (the operations of investment banks, and such), and commercial banks being told to pick up the slack.

So, to be short, it comes down to fluctuations in the money supply and a weird demand side for money... :pac: