Questions 1: Explain the traditional view of Bank as a financial intermediary versus the idea that Banks create money. Explain the concepts of endogenous and exogenous money, and how the multiplier is supposed to work and why it fails when money is endogenous.
Answer 1:
A: The traditional view adopted in the money supply debate is that banks create bank money by creating debt and granting loans. According to their view Banks are financial intermediaries because they gather money from depositors and lend it out to borrowers. In doing so, they act as intermediaries between these two groups. For example. If I lend you money personally, there is no intermediary. However, if you go to the bank and take out a loan, the bank is acting as an intermediary between you as the borrower and me (and all the other people who deposit money in the bank), whose money you are borrowing. That money is called the banks' required reserves. If the banks keep more money than required, the extra money is called their excess reserves. This explanation is then extended on the credit creation theory introduced by McLeod (1855); argued that individual banks create credit and money out of nothing whenever they do ‘lending’ or extend credit. However, this is an inadequate process of bank money creation.
On other hand in modern economy; Money is created when banks create credit either through making loans, buying existing assets or when customers draw down on their overdraft. In creating credit banks simultaneously creates deposits. New schools of thought , The Bank of England(2014), argues against the traditional view on money creation ,which holds that banks act simply as intermediaries, lending out the deposits savers place with them nor do they “multiply up” central bank money to creates new loans and deposits. Rather A bank first lends or invests and then “finds” the cash to cover whatever cash drains arise.
B: Explain the concepts of endogenous and exogenous money
1: Endogenous Money: The “money supply” is endogenous if we believe that; the level of money is determined by factors within the private sector. (The root endo- implies that it is an internal property; that is, the level of the money supply is determined within the model of the private sector.)
In short the Federal Bank has no ability to affect it, especially when nominal or money income is changed and reflected on money multiplier and money supply, and also when the monetary authority cannot restrict the monetary expansion as a result of different factors related to the economy structure or related to other non-economic factors.
2: Exogenous Money: The “money supply” is exogenous if we believe that; it is set directly by the Monitory Authority (Central bank) (Exo- is the Greek root that indicates that something is external; in this case, the money supply is set externally to the model of the private sector.)
C: How the multiplier is supposed to work and why it fails when money is endogenous.
In the traditional view the process of money creation goes through the operation of money multiplier. Money multiplier (also known as monetary multiplier) is the amount of money that banks generate with each dollar of reserves.
Key concept in calculating Money Multiplier
The Reserve Ratio: The reserve ratio is the % of deposits that banks keep in liquid reserves and is set by the board of governors of the Federal Reserve System and it varies based on the total amount of liabilities held by a particular depository institution. For example 10% or 20%
Money Multiplier = 1 / Reserve Ratio
The size of the multiplier depends on the percentage of deposits that banks are required to hold as reserves. In other words, it is the money used to create more money and is calculated by dividing total bank deposits by the reserve requirement. If, for example, the reserve requirement is 20% for every $100 a customer deposits into a bank, $20 must be kept in reserve. However, the remaining $80 can be loaned out to other bank customers. This $80 is then deposited by these customers into another bank, which in turn must also keep 20%, or $16, in reserve but can lend out the remaining $64.
- Based on the example above, here's what the schedule of deposits/reserves would look like:
This cycle continues as more people deposit money and more banks continue lending it until finally the $100 initially deposited creates a total of $500 ($100/0.2) in deposits.
- Theoretically this might work but Money Multiplier will fail if we take money supply as endogenous because the traditional, money multiplier assume that if the bank lends $100 – all of this will return. However, in the real world, there are many endogenous factors which can make the actual money multiplier significantly smaller than the theoretically possible money multiplier.
- The money multiplier model also suggests banks wait for deposit and then lend out. However, in the real world, banks may take it upon themselves to issue a loan, and then seek out reserves from other financial institutions/Central Bank or private individuals. Just like, in the credit bubble of 2000-2007, many banks were lending mortgages by borrowing on short-term money markets. They were lending money that wasn’t related to saving deposit accounts. These result are also strongly consistent with a Post Keynesian hypothesis that indicates the money supply is endogenous since loans make deposits, and the decision to borrow is made by credit –worthy borrowers, not the banks or the central.
So, whenever the money supply is subject to endogenous factors the Central bank and its monetary policy may have little effect and Money multiplier model will not hold.
Q 2. Explain what open market operations are, and how they are used to keep overnight discount rate at the policy level. Explain how this means that the Central Bank cannot control the money supply.
ANS 2: - Open Market Operation is a tool used by a Central Bank (or monetary authority) to inject or mop-up funds, based on the liquidity requirements, from the banking system via the purchase or sale of securities. The objective of Open Market Operation (OMO) is to regulate the money supply in the economy.
- When the Fed wants to increase the money supply in the economy, it purchases the government securities from the market and it sells government securities to suck out liquidity from the system. Fed also manages reserves to control discount rates. If there is excess, which drives rates below target, Fed must sell bonds (at near discount rates) to mop-up excess liquidity. If reserves are short, Fed buys bonds and injects reserves into the market, to maintain discount rates at target levels.
- Fed carries out the OMO through commercial banks and does not directly deal with the public.
- OMO is one of the tools that Central Bank uses to smoothen the liquidity conditions through the year and minimize its impact on the interest rate and inflation rate levels.
This means that the Central Bank cannot control the QUANTITY of the reserves; rather these are adjusted according to market conditions, to protect the discount rate. All of this was clearly articulated by Minsky a long time ago , now these ideas are widely accepted by all.
Q 3. Explain the concept of "maturity mismatch" and explain how this requires the existence of a Central Bank which would cover private banks when inflows of money are less than outflows on a daily basis. On this basis, some have said that there are no private banks - because these cannot exist without government support and protection (explain).
ANS 3: Maturity mismatch refers to the gap between inflows and outflows of liquidity arising from long-term illiquid assets and liquid liabilities, respectively. Such mismatches are inherent to banks given their fundamental role in the wider economy of transforming liquid liabilities (eg deposits) into illiquid assets (eg longer-term loans).
For example: A bank lends say Rs.10 Crores as long term loan for 10 years to infrastructure sector but has obtained the Rs.10 Crores from short term deposits which has to be repaid back in 3–5 years then there exists a risk of asset liability mismatch.
For this reason to cover the mismatches Central bank intervention are required to protect at least some financial institutions by temporarily providing finance through lender of the last resort facilitator. As central bank is the creator of the high powered money, only the government, central bank and the treasury can purchase or lend against these assets without any limit.
- Another good example is a thrift institution that purchases for example a thirty year mortgagees as assets but issues saving deposits that can be liquidated in not more than thirty days. These institutions require refinancing on favorable terms because the interest’s rate they earn is fixed and as these assets cannot be sold easily. Therefore Federal Home Loan Institution provides short term loans to these thrift institutions to cover mismatches and to meet the cash commitments.
B: On this basis, some have said that there are no private banks - because these cannot exist without government support and protection (explain)
By this Minsky meant that “at the time of financial disruption only Central bank interventions can help and facilitate the private banks by providing an infinitely elastic supply of high power money and this is applicable to all kind of economic unit further any economic unit can be analyze as if it were a “ bank” taking position by issuing debt”.
So it can be said that Private Banks cannot operate without the protection and support of the Government.
Ch 4 Why Minsky Matters? Minsky on Banking and Finance - Youtube Video Lecture 92m
Bank of England: How Money is Created in Modern Economy - Michael McLeay, Amar Radia and Ryland Thomas