Macroeconomics Macroeconomics - Rainer Maurer

Macroeconomics

© RAINER MAURER, Pforzheim

6. The Monetary Policy of the ECB

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Prof. Dr. Rainer Maure

Macroeconomics


6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB 6.2. The Policy Instruments of the ECB 6.3. Money Creation by Commercial Banks 6.4. Questions for Review

Literature: ◆ Chapter 18, Mankiw, Gregory; Macroeconomics, Worth Publishers. ◆ Kapitel 25, Blanchard / Illing, Makroökonomie, Pearson Studium. ◆ Kapitel 17, 18, Baßler, Heinrich; et al. Grundlagen u. Probleme der Volkswirtschaft, Schäfer und Poeschel.


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Macroeconomics


6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB

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6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB ➤ The policy target of the ECB is legally defined by the EU treaty (Art. 4.2; Art. 105) and in the ECB-Statute (Art. 2):

■ Primary target is “to guarantee price stability“. ➤ In the so called “Protocol on Convergence Criteria" article 1 statues that

■ “price stability" is defined by the “Consumer Price Index". ➤ In a press release of 13.10.1998 the ECB-Council declared: © RAINER MAURER, Pforzheim

■ “Price stability is defined as a yearly increase of the


“Harmonized Consumer Price Index” (HCPI) of the Euro Currency Area of less than 2%. Price stability shall hold over the medium term." -4-

6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB CHAPTER II: "OBJECTIVES AND TASKS OF THE ESCB" Article 2: Objectives


In accordance with Article 105(1) of this Treaty, the primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, it shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2 of this Treaty. The ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources, and in compliance with the principles set out in Article 3a of this Treaty. (Statute of the European System of Central Banks (ESCB) and of the ECB)

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6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB ➤ In the pursuit of this target the ECB is independent from the influence of governments or other political institutions. ➤ This is guaranteed by article 107 of the ECB-Statute: Article 107 “neither the ECB, nor a national central bank, nor any member of their decisionmaking bodies shall seek or take instructions from Community institutions or bodies, from any government of a Member State or from any other body.”


(Statute of the ESCB and of the ECB)

➤ Given this statute, the ECB is one of the most independent central banks of the world.


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➤ Empirical studies show, that political independence of central banks leads to lower average inflation rates:

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6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB ➤ Similarly as the ECB, other modern central banks have also a publicly declared inflation target: Bank of England: 2,5% RPIX1) ≈ 1,75% HVPI1) Riksbank of Sweden: 2 ± 1% VPI1) Norwegian Central Bank: 2½ ± 1% VPI Bank of Canada: 1% bis 3% VPI Bank of Australia: 1 bis 3% VPI Reserve Bank of New Zealand: 1% bis 3% VPI Swiss Nationalbank: Adoption of the ECB inflation target US-Federal Reserve System: : 1,5% - 2% PCE


■ ■ ■ ■ ■ ■ ■ ■

1)

RPIX = Retail Price Index; HVPI = Harmonisierter Verbraucherpreisindex; VPI = Verbraucherpreisindex; PCE= Personal consumption expenditures price index Prof. Dr. Rainer Maure

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6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB ➤ It is important to understand that a constant inflation target implies anticyclical monetary policy. ➤ In order to keep the inflation rate constant, a central bank must ■ in a demand-side caused recession increase money supply


to strengthen the demand for goods and prevent deflation and ■ in a demand-side caused boom decrease money supply to curb the demand for goods and prevent inflation

➤ This is implied for all kind of constant inflation targets – whether they are large or smaller than zero! ➤ Economists call this implication of a constant inflation target “divine coincidence”. -9-


6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB ➤ But why do basically all central banks have an inflation target above zero and not simply equal to zero? ➤ In the monetary policy debate, a couple of reasons for an inflation target larger than zero are discussed. The most important are:


1. Danger of a deflation spiral in the presence of a zero inflation target. 2. Potentially useful psychological effects in the presence of sticky nominal wages. 3. The possibility to generate negative real interest rates. ➤ All these arguments are heavily disputed – there exists no unanimity on these issues!


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6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB 1. Danger of a deflation spiral: ■ How would you react, if you wanted to buy new furniture for your apartment and you knew that the prices for furniture would decrease by 5% over the next year? ■ What would happen with the total demand for goods, if on average everybody would act this way? ■ How would this affect the business cycle? ■ In chapter 3 we simply assumed that households will not react in case of a deflation. However, this in not necessarily so:

◆


◆ ◆

In the presence of deflation, it is possible that households further postpone their consumption into the future, because they expect lower prices for goods in the future (naïve expectations). This however means that the consumption ratio will further decrease and the recession will therefore deepen. Some historians are convinced that it was a mechanism like this one that has caused the world economic crises of 1929-33. - 11 -



1%


0% 2% 3%


BOOM

2%

DOWNSWING

UPSWING

DOWNInflation SWING Target (=Long Run Average) = 2% RECESSION

UPSWING Actual Realization of Inflation

BOOM

3%

6.1. The Policy Target of the ECB

RECESSION

Inflation Rate

Time

In reality no central bank succeeds in keeping the inflation rate exactly equal to the inflation target: In booms the inflation rate is larger and in recessions the inflation rate is smaller than the target rate. => No deflation in recessions if the inflation target is “high enough”! - 12 -

6. The Monetary Policy of the ECB Inflation Rate

6.1. The Policy Target of the ECB UPSWING

DOWNSWING

UPSWING

DOWNSWING RECESSION

BOOM

1%

Actual Realization of Inflation

BOOM

2%

RECESSION

3%

Inflation Target (=Long Run Average) = 0%


0%

Time

2% 3%

=> Deflation in recessions if the inflation target is 0% ! => Danger of deflation spirals! - 13 -


6. The Monetary Policy of the ECB Inflation Rate

6.1. The Policy Target of the ECB UPSWING

DOWNSWING

UPSWING

DOWNSWING


0%

RECESSION

BOOM

1%

Actual Realization of Inflation

BOOM

2%

RECESSION

3%

Inflation Target (=Long Run Average) = 0%

Time

2% 3% Deflation spirals can boost recessions!


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6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB 2. Psychological effects in the presence of sticky nominal wages : ■ One assumption of the neoclassical model (Chapter 2.1.) was the


“absence of money illusion”. This means i.a. that an increase of goods prices P↑ causes workers to demand an immediate increase of nominal wages w↑, such that real wages stay constant w↑ / P↑. ■ However, laboratory experiments show that real-world people are not always that rational. If asked, what is more fair: (a) A decrease of nominal wages by 2% given 0% inflation or (b) an increase of nominal wages by 2% given 4% inflation? most people prefer option ( ). ■ Since there is always structural change in the economy, which urges a couple of industries to reduce their real wage in order to avoid dismissals (s. Chapter 5.1.3.5. “Mismatch Unemployment”.), an inflation rate above zero can increase the “social acceptance” of such real wage reductions. Critics argue however that this implies a deception of workers – an exploitation of mental shortcomings. - 15 -


6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB 3. The possibility to generate negative real interest rates ■ Imagine the inflation rate were equal to 5 % and the interest


rate you have to pay for a credit were equal to 2%. ■ What kind of deal would be profitable under such conditions? ■ What would happen with the total demand for goods, if everybody would act this way on average? ■ How would this affect the business cycle?


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6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB 3. The possibility to generate negative real interest rates ■ In order to create the above incentive, the nominal interest rate it must be lower than the inflation rate (Pt+1 - Pt) / Pt: it

New visit at the ATM… => Transaction costs…

Money spent per day

Time 6th day

1st day

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6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB 1. Inflation increases the costs of holding money.

50 € withdrawn at the ATM


Money


50% reduction of money holdings because of higher inflation

All money spent in 3 days => New visit at the ATM… => Transaction costs… Money spent per day 1st day

3rd day

Time - 22 -

6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB 1. Inflation increases the costs of holding money.

50 € withdrawn at the ATM


Money


50% reduction of money holdings because of higher inflation

=>2 visits at the ATM in 6 days! => Double as high transaction costs! Money spent per day

=> Inflation increasesTime the costs of holding money! 6th day

1 Day

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6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB 2. Inflation increases the real tax burden:

■ Numerical example: (a) The capital income tax rate is t=25%. The nominal interest is i=4%. The inflation rate is π = 2%. What is the real capital income tax rate?


(b) The capital income tax rate is t=25%. The nominal interest is i=4%. The inflation rate is π = 0%. What is the real capital income tax rate?


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2. Inflation increases the real tax burden:

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6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB 2. Inflation increases the real tax burden: (a) The nominal capital income tax rate is t=25%. The nominal interest is i=4%. The inflation rate is π=2%. What is the real capital income tax rate?


=>

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6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB 2. Inflation increases the real tax burden: (b) The nominal capital income tax rate is t=25%. The nominal interest is i=4%. The inflation rate is π=0%. What is the real capital income tax rate?


=>


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The effect of inflation on the real tax rate is the higher the lower the real interest rate.

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As this calculation shows, the real tax rate can reach levels above 200% for assets that pay only a low real interest rate. In this case the real tax payment is higher than the real return so that the investor suffers from a real loss!


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6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB 2. Inflation increases the real tax burden:


■ How to prevent this effect of inflation on the real tax burden? 1. Set the inflation target equal to zero! 2. Tax not the nominal income but the real income:

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6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB 2. Inflation increases the real tax burden ■ In the above example, the capital income tax rate is constant. ■ For other kind of incomes, the tax rate increases however with


the nominal level of income (tax progression). ■ As a consequence, if a household’s nominal income grows in order to compensate the household for inflation such that its real income stays constant, the household will have to pay more taxes – even if the household’s real incomes stays constant. ■ This is effect is called “bracket creep” (“Kalte Progression”).


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Marginal income tax determined by tax law => Changing tax rate for every single Euro of income

Resulting average tax rates


Example: For a yearly income of 20000 Euro the average tax rate is 14,56%

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Marginal income tax determined by tax law => Changing tax rate for every single Euro of income

Resulting average tax rates


Example: For a yearly income of 20400 Euro the average tax rate is 14,83%


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6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB 2. Inflation increases the real tax burden ■ The following numerical example reveals this effect:


◆

■ The following diagram applies the formula for the growth rate of the real income tax for an inflation rate of 2% and 4% to the average income tax rate according to the German income tax tariff: - 35 -



A worker with an income of 20 000 € receives as a compensation for an inflation rate of 2% an increase of his nominal wage of 2%. According to the German income tax tariff, his income tax rate at the income of 20 000 € was equal to 14,56 %. After the increase of his income, the tax rate is equal to 14,83 %. (a) Calculate the real increase in the household’s income before tax. (b) Calculate the real percentage increase in the tax burden.


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6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB 2. Inflation increases the real tax burden ■ It is of course possible to argue that it is not monetary policy


that is to be blamed for this effect but the tax system. ■ Countries like Switzerland allow their citizens to deflate their nominal incomes by the inflation factor (=divide by factor [1+inflation rate] ), before their tax rate is determined. ■ This way, the part of income growth that compensates only for inflation, is not taxed. ■ As a result, if incomes grow only by the inflation rate, the real tax burden stays constant.

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6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB 2. Inflation increases the real tax burden ■ It is of course possible to argue that it is not monetary policy


that is to be blamed for this effect but the tax system. ■ Countries like Switzerland allow their citizens to deflate their nominal incomes by the inflation factor (=divide by factor [1+inflation rate] ), before their tax rate is determined. ■ This way, the part of income growth that compensates only for inflation, is not taxed. ■ As a result, if incomes grow only by the inflation rate, the real tax burden stays constant.


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6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB 3. Wrong decisions caused by money illusion ■ Theoretically most people understand the consequences of inflation. However, in cases where they have to decide fast and base their decision on a gut level they very often make big mistakes. ■ These mistakes would not appear if the inflation rate where zero. The following experiment illustrates the problem: ■ Alex, Berta und Charly inherit 200 000 €. All invest their money in a house. After 10 years they resell their houses:

◆

Alex lives in a country, where prices on average have fallen by 25%, and receives a selling price, which is 23% lower than his purchase price. Berta lives in a country with zero inflation and receives a selling price that is lower than 1% of her purchase price. Charly lives in a country, where prices on average have grown by 25% and receives a selling price, which is 23% higher than its purchase price.


◆ ◆

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6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB 3. Wrong decisions caused by money illusion ■ Rank the profitability of the investments according to their real return:

Rank

Alex

Berta

Charly

Alex 37 % 10 % 53 %

Berta 15 % 74 % 11 %

Charly 48 % 16 % 36 %

1. 2. 3.


Rank 1. 2. 3.

■ The consequences of such wrong decisions would not happen in case of a zero inflation rate.

■ If one could be sure today that in 10 or 20 years the price


level would be the same as today, many financial decisions would be become easier to make. - 40 -

6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB ➤ To sum up: ■ In order to decide, whether the inflation target of a central

bank should be larger than zero the pros and cons of such an inflation rate must be evaluated. ■ This is a complex task and can lead to different conclusions depending on the subjective weights one applies to the various arguments.

■ The evaluation that the advantages of a “not too high but


constant inflation rate above zero" outweigh the disadvantages is internationally widespread a often called the “consensus point of view”.

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6.2. The Policy Instruments of the ECB

Prof. Dr. Rainer Maure Prof. Dr. Rainer Maurer

“And please let Mario Draghi accept the things he cannot change, give him the courage to change the things he can and the wisdom to know the difference.”

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Macroeconomics


6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB 6.2. The Policy Instruments of the ECB

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6. The Monetary Policy of the ECB 6.2. The Policy Instruments of the ECB

6 Members of the ECB Board


Nineteen

…plus Slovenia, Malta, Cyprus, Slovakia,Estonia, Lettland, Lithunia

➤ The ECB Council decides about the application of the monetary policy instruments of the ECB. ➤ The council regularly meets every 2nd Thursday. In normal times, monetary policy decisions are made every 6 weeks. ➤ The members of the council decide by majority vote. In case of a standoff the president decides.


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Eurozone (18) EU states obliged to join the Eurozone (7) EU state with an optout on Eurozone participation (1) EU state with a public referendum to opt-out the Eurozone (1)


L Areas outside the EU using the euro with an agreement (Monaco, San Marino, Vatican)


Areas outside the EU using the euro without an agreement (Andorra, Kosovo, Montenegro,) - 45 -

Exkurs: Die Euroland-Mitgliedsländer


Nach der 2004 erfolgten Erweiterung der EU um 10 neue Mitglieder bestand für die neuen Mitglieder die Möglichkeit, einen Antrag zur Teilnahme zum „Wechselkursmechanismus II“ des Eurosystems zu stellen. Wenn sie dann über zwei Jahre die Kriterien dieses Wechselkursmechanismus erfüllen, können sie Mitglied im Euroraum werden. Bislang haben Slowenien (2007) sowie Malta und Zypern (2008) die Slowakei (2009) und Estland (2011) davon Gebrauch gemacht. Drei weitere Länder (Dänemark, Lettland, Litauen) nehmen Wechselkursmechanismus II teil und können prinzipiell ebenfalls den Euro einführen. Dänemark und Großbritannien hatten sich im Vertrag von Maastricht eine Ausnahmeklausel vorbehalten und von dieser auch Gebrauch gemacht. Schweden verletzte die Konvergenzkriterien bewusst, damit es den Euro nicht einführen musste. Monaco, San Marino und Vatikan sind keine EU-Mitglieder sind und deshalb nicht Teil des Eurosystems. Aufgrund bilateraler Abkommen mit der EU haben sie aber das Recht, den Euro als einzige Währung zu nutzen sowie eigene Euromünzen im begrenzten Umfang prägen zu lassen. Insgesamt nutzen rund 40 Staaten und Teilstaaten den Euro oder eine vom Euro abhängige Währung (z.B. ehemalige Kolonien in Afrika). Manchmal wird auch diese ganze Staatengruppe als „Eurozone“ oder „Euroland“ bezeichnet. Die mit der Vergrößerung des Eurosystems einhergehende Vergrößerung des ECBRates führt zu Problemen: Wenn die drei weiteren Anwärterländer (Estland, Lettland, Litauen) beigetreten sind, würde er 19 Notenbankpräsidenten umfassen, was den Abstimmungsprozess erschweren würde. Es ist deshalb eine Reform des ECB-Rates vorgesehen. Danach sollen nie mehr als 15 Länder stimmberechtigt sein. Das Stimmrecht soll rotieren, wobei große Länder häufiger stimmberechtigt sein sollen als kleine Länder. Prof. Dr. Rainer Maurer

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6. The Monetary Policy of the ECB 6.2. The Policy Instruments of the ECB In the year 2015 Lithunia has joined the European Currency Union ECB-Board (6 permanent voting rights) such that 19 countries send now members to the ECB Council. To keep the coordination process practicable, a 1. Group of 5 monthly “rotation Largest Total of 21 Voting Rights Countries with 4 mechanism” will Rotating Voting be implemented that allows to Rights restrict the = Germany, number of voting France, Italy, countries to 15. Spain, All countries keep Netherlands always their voice in the council. - 47 -


New Rotation Mechanism of the ECB-Council

2. Group of 14 Smaller Countries with 11 Rotating Voting Rights


6. The Monetary Policy of the ECB 6.2. The Policy Instruments of the ECB ➤ What kind of instruments does the ECB use to achieve the decisions of the ECB Council? ➤ The ECB uses the supply of money to commercial banks as its instrument. ➤ There are two kind of operations that are normally used to supply money to commercial banks:

1. Refinancing Operations


◆ ◆


Main Refinancing Operations Longer Term Refinancing Operations

2. Standing Facilities:

◆ ◆

Marginal Lending Facility Deposit Facility - 48 -

6. The Monetary Policy of the ECB 6.2. The Policy Instruments of the ECB 1.

Refinancing Operations 1.1. Main Refinancing Operations

◆ ◆

Every workday Monday, an online-auction takes place where about 800 commercial banks bid for money credits with a maturity of one week. Banks must provide fixed rate securities (of high creditworthiness) as collateral.

1.2. Longer Term Refinancing Operations

◆


■

…basically identical to Main Refinancing Operations with exception of the maturity: 3 - 6 months.

The standard auction (deviations are possible!) is based on an action mechanism called „American Interest Tender“.

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American Interest Tender i

Maximum Bid

Planed Allotment Volume Marginal Rate Minimum Bid Rate


imin


Credit Volume in €

Bids with Allotment

Bids without Allotment- 50 -

6. The Monetary Policy of the ECB 6.2. The Policy Instruments of the ECB ➤

American Interest Tender: ■ The ECB determines the Minimum Bid Rate. ■ Only Banks that bid an interest rate, which is at least as high as the ■ ■ ■ ■


■ ■ ■

Minimum Bid Rate have a chance of receiving a credit. Banks name the interest rate they are willing to pay and the credit volume they demand at this interest rate. The ECB ranks the offers according to the interest rates banks are willing to pay. The ECB then determines the total allotment volume and allocates this volume to the banks following this ranking This means, the bank with the highest interest offer receives its credit first, the bank with the second highest offer receives its credit in second place and so on. If the allotment volume is exhausted, before all banks have received an allocation, the remaining banks will receive no credit. Hence banks that bid an interest rate equal to the minimum bid rate only, run the risk of receiving no credit. The interest rate of the bank that receives the last allocation is called the “Marginal Rate” (see next table).

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Quelle: ECB Monatsbericht, Tabelle 1.3. Geldpolitische Geschäfte des Eurosystems


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Quelle: ECB Monatsbericht, Tabelle 1.3. Geldpolitische Geschäfte des Eurosystems


6. The Monetary Policy of the ECB 6.2. The Policy Instruments of the ECB From monetary policy instruments to currency in circulation:

+

+

./.

≈

./.

≈


+

Monetary policy instruments of the Absorption of liquidity by deposit ECB = Money supply of the economy accounts of the government and required by the ECB. reserve holding of commercial banks. Quelle: ECB Monatsbericht, Tabelle 1.4. Mindestreserve und Liquiditätsstatistik


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6. The Monetary Policy of the ECB 6.2. The Policy Instruments of the ECB 2.

Standing Facilities are intended to smooth the development of the interest rate on the interbank market. Therefore, they can be steadily used by commercial banks: 2.1. Marginal Lending Facility

◆

„Overnight Credit“: Commercial banks can get a short-run credit in case of an unexpected liquidity shortage. They have to pay a special interest rate called “marginal lending rate”

2.2. Deposit Facility © RAINER MAURER, Pforzheim

◆


„Overnight Saving“: Commercial banks can deposit money at the ECB in the short run in case of an unexpected liquidity glut. They receive a special interest rate called “deposit rate”.

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6. The Monetary Policy of the ECB 6.2. The Policy Instruments of the ECB ➤ The impact of the ECB interest rates on the interbank credit market:

■ ■

(currently + 0,25%)

Deposit Rate = Main Refinancing Rate ./. 1%

(currently - 0,4%)

As the following diagram shows, the EONIA rate (= the interest rate on which banks lend overnight money among each other) lies always between the Marginal Lending Rate and the Deposit Rate.


■

Marginal Lending Rate = Main Refinancing Rate + 1%

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Source: ECB - 58 -


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1) 2)

Private Haushalte; Laufzeit 1-5 Jahre; Zinsfixierung; Neugeschäft Unternehmen außerhalb des Finanzsektors; Laufzeit 1-5 Jahre; Zinsfixierung; Neugeschäft


Quelle: ECB - 60 -


Quelle: ECB - 61 -


6. The Monetary Policy of the ECB 6.2. The Policy Instruments of the ECB


➤ The Impact of the ECB on the real economy:


■

This shows that the ECB is able to affect the longer term segments of the credit market (= markets for consumer, corporate and mortgage credits) with its policy instruments.

■

Even though the impact is certainly not as strong as the impact of the central bank on the economy in the neoclassical or the Keynesian textbook model, there is nevertheless a strong and significant impact.

■

The diagram also shows that the impact is transmitted over the demand for consumer and investment goods.

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Macroeconomics


6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB 6.2. The Policy Instruments of the ECB 6.3. Money Creation by Commercial Banks

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6. The Monetary Policy of the ECB 6.3. Money Creation by Commercial Banks ➤ Up to this point, we implicitly assumed that “money” is always equal to “cash”.

■ ■

In reality however, cash plays a less and less important role. More and more payments are not carried out with cash but with EC- or credit cards, i.e. with so called “cashless” money.


➤ Where does this “cashless” money come from?


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6. The Monetary Policy of the ECB 6.3. Money Creation by Commercial Banks Money creation in a two-tier banking system*):

Central Bank

Cash

Commercial Banks


Non-Banks = Households, Firms, Government

Cash & Deposit Money

*) Not all banking systems work as “two-tier banking systems”. An important example for a (nearly) pure open market system is the Fed-System. The creation of “deposit money” is similar in such a system. - 65 -


6. The Monetary Policy of the ECB 6.3. Money Creation by Commercial Banks


➤ As the diagram shows, commercial banks lend more money to non-banks than they receive from the central bank. ➤ This additional money is called “money creation” of business banks. ➤ Why is this possible?


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Why is „deposit money creation“ possible?

Commercial Bank

10 € credit transferred to the deposit account of the firm

10 € credit retransferred to the deposit account of the bank

This shows: The commercial bank needs only 2 € cash to grant a credit of 10 € !

Firm


10 € wage payment transferred to the deposit account of the household

Prof. Dr. Rainer Maurer Maure

8 € payments for goods transferred via credit card to the deposit account of the firm Household

2 € withdrawn from the deposit account and used to pay goods in cash.

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Digression: Why is money creation by commercial banks possible? As the diagram shows: If a commercial bank loans 10 € to firms, only a fraction of this money will be typically withdrawn in cash: The commercial bank pays these 10 € not out in cash, but credits 10 € to the deposit account (=giro account) of firms. When the firms use this money to pay their workers for their labor services, they will normally not withdraw the 10 € in cash, but transfer them cashless on the deposit accounts of workers. Workers will normally use this money to buy consumption goods and services from firms or to transfer savings to firms. If workers want to transfer savings to firms, they buy stock of firms or corporate bonds or transfer savings to a bank, which transfers these savings as a bank credit to firms. All of these transactions are normally conducted in a cashless way, i.e. as a transfer of deposit money. If workers want to buy goods and services from firms, they mostly pay with deposit money (=credit cards, EC-cards, cashless check transfers etc.), e.g.: rents, insurance contracts, electricity bills, supermarkets with cashless paydesks. Cash is needed today only for a small amount of all purchases of goods and services, e.g.: small stores with no cashless pay-desks or payments of small amounts of money. Consequently, only a small fraction (typically 20%) of the deposit money granted as a credit to firms will be withdrawn in cash. Most of this deposit money is not withdrawn but used as a means for cashless payment. As a result, a commercial bank needs to cover only 20% of its credits with cash from the central bank. The remainder is “deposit money creation” by commercial banks! In the above example, the commercial bank need to borrow only 2 € from the central bank in cash, in order to loan a credit of 10 €. - 68 -

Prof. Dr. Rainer Maurer Maure

6. The Monetary Policy of the ECB 6.3. Money Creation by Commercial Banks ➤It is simple to describe this relationship mathematically: ■ Assume that “c” is equal to the percentage fraction of all transactions which are conducted in cash. “c” is then called the “cash ratio”.

■ Assume that the amount of all credits commercial banks lend to nonbanks in form of deposit money is equal to „M“.

■ Consequently, the amount of cash needed by commercial banks „B“


is given by the following equation: B = c * M ■ We can rewrite the equation in the following way: B * (1 / c) = M ■ Consequently, if the central bank offers an amount of money equal to 800 billion € to commercial bank and the cash ratio is c = 20%, commercial banks can create a total amount of money (=cash + deposit money) equal to 800 bn € * (1 / 0,2) = 4000 bn € ■ Consequently, money creation by commercial banks equals 3200 Billion €. - 69 -


What explains the downward trend of the average cash ratio in the high-income countries? © RAINER MAURER, Pforzheim

Source: IMF International Financial Statistics


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6. The Monetary Policy of the ECB 6.3. Money Creation by Commercial Banks ■ ■ ■ ■ ■


■

■

As the diagram shows, the cash ratio “c” is not perfectly stable, but shows some fluctuations. On the individual bank level, these fluctuations are even stronger than for the averaged values in the diagram. Therefore, commercial banks typically hold a voluntary safety margin „rv“ of additional cash for the case that “c” will become temporarily larger. Additionally, in most countries laws prescribe commercial banks to hold a “required reserve” of „rr“. Taking these reserves into account, the above formula must be rewritten in the following way: B = (c + rv + rr) * M Consequently, if the central bank offers an amount of cash equal to B, the maximum amount is somewhat reduced by the necessity to hold these reserves: M = B * (1 / (c + rv + rr) ) This formula is called the “money multiplier”. - 71 -


6. The Monetary Policy of the ECB 6.3. Money Creation by Commercial Banks ■ ■


■

For the European Currency Union the empirical value for the cash ratio is c = 18 %, the voluntarily hold reserve ratio is rv ≈ 0,0 and the required reserve ratio is rr = 0,02. Consequently, if the European Central Banks offers an amount of cash equal to 1000 billion €, commercial banks in the European Currency Union are able to offer a total amount of money equal to: M = 1000 bn € * (1 / (0,18+ 0,00 + 0.02) ) M = 5000 bn € Consequently, the amount of deposit money that can be created by commercial banks is equal to: D = M – B = 5000 bn € - 1000 bn € = 4000 bn €


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6. The Monetary Policy of the ECB 6.3. Money Creation by Commercial Banks

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■


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■

As the money multiplier formula shows the central bank is always able to steer the process of money creation by steering the amount of cash: M ↑ = (1 / (c+ rv + rr) ) * B ↑ M ↓ = (1 / (c+ rv + rr) ) * B ↓ Consequently, even though commercial banks are able to increase the amount of money significantly by their creation of deposit money, the central bank can steer the growth rate of M by steering the growth rate of B. If the trend towards a “cashless economy” holds on (s. the above diagram) and the cash ratio grows smaller and smaller „c↓“ so that commercial banks are able to create more and more deposit money out of 1 €, the central bank can react with a reduction of B or with an increase of the required reserve ratio rv ! Hence central bank will always be able the to control the seize of M. Ex 17 - 73 -


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Components of Monetary Aggregates, End of February 2009, Bil. €

Decreasing Liquidity -->

Quelle: ECB Monatsbericht, Tabelle 2.3. Monetäre Statistik

6.2. The Policy Instruments of the ECB


Liabilities of Central Bank & Commercial Banks to Non-banks

M1

Currency in circulation

721

721

721

3417

3417

3417

Deposits redeemable up to 3 month

1621

1621

Deposits redeemable up to 2 years

2331

2331

Overnight deposits

M2

M3

Repos of com. banks with non-banks

330

Money market funds,maturity up to 2 years

782

Debt securities,maturity up to 2 years

223

Sum

4138

8090

9427 - 80 -

Digression: The two Main Businesses of Commercial Banks As this stylized balance sheet of a typical commercial bank shows, commercial banks are not only engaged in supplying means of payments to non-banks but also in “financial intermediation”. This means, commercial bank borrow money from households and hand this money over (=“intermediate”) to firms and other households: Balance Sheet of a Commercial Bank Assets R = Reserves


M = Money Based Credits

Intermediated Credits

M = B-R +D

Liabilities

B-R = Cash in Circulation

B = Cash from the Central Bank

Payment Transactions

D = Giro Accounts Saving Deposits, Time Deposits etc…

Financial Intermediation

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2% * (

+

) = 128,9

The required reserve ratio „rr“ for the commercial bank in the European Currency Area is 2% of their deposit credits (=overnight deposits) plus time deposits with a maturity up to 2 years.


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Since the commercial banks of the European Currency Area have always the possibility to receive additional short run cash credits via the „marginal lending facility“, their amount of voluntary reserves (=excess reserves) is typically very small. - 83 -




6.3. Money Creation by Commercial Banks


Sure, we need more research in alchemy, witchcraft and sorcery to know where is the money going to come from! - 84 -

6.4. Questions for Review


➤ You should be able to answer the following questions at the end of this chapter. All of the questions can be answered with the help of the lecture notes. If you have difficulties in answering a question, discuss this question with me at the end of the lecture, attend my colloquium or send me an E-Mail.

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6.4. Questions for Review 1.

What is the policy target of the ECB?

2.

What are the three principal arguments in favor of an inflation target above zero?

3.

What are the four principal arguments against an inflation target above zero?

4.

Calculate the real tax rate, if the nominal tax rate is equal to 25%, the nominal interest rate is 5% and the inflation rate is 4% and your investment is equal to 1€.

5.

A worker with an income of 20 000 € receives as a compensation for an inflation rate of 2% an increase of his nominal wage of 2%. According to the German income tax tariff, his income tax rate at the income of 20 000 € was equal to 14,5 %. After the increase of his income, the tax rate is equal to 15,1%. Calculate the real increase in the tax burden. Calculate the real increase in the household’s after tax income.

6.

Describe the function, composition and decision regularities of the Council of the European Central Bank.


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6.4. Questions for Review 7. Explain the policy instruments of the ECB. 8. Explain the standard procedure of an “interest tender” of the ECB. 9. Why does the overnight rate of the European interbank market (=EONIA) always lies in between the margin of the deposit facility and the marginal lending facility? 10. Describe the influence of the ECB on the capital market. 11. On what segments of the capital market has the ECB a strong impact, on what segments the impact is weaker? What explains the difference? 12. Explain the channel, which the ECB uses to influence the real economy.


13. Explain the process of money creation by commercial banks. 14. Why can deposit money be used as a means of payment?

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6.4. Questions for Review


16. How large is the maximum amount of deposit money commercial banks can create, if the sum of all cash credits from the central bank is equal to 2000 bn €, the cash ratio of non-banks is 5%, the voluntary reserve ratio is 0%, the required reserve ratio 0% ? How does the maximum amount of deposit money change, if the central bank introduces a minimum reserve requirement of 5%? 17. Assume that the long-term downward trend in the cash ratio causes a decrease from 18% in the year 2009 to 16% in the year 2010. Assume furthermore that the voluntary reserve ratio rv is zero and the required reserve ratio is equal to 2% and the amount of cash supplied by the central bank in the year 2009 is equal to 1000 €. (a) By how much must the central bank change its supply of cash, if it wants to keep the monetary aggregate M (=deposit money + cash) on the level of the year 2009? (b) How could the same effect be reached by a change of the required reserve ratio rr?


Ex 17 - 88 -

6.4. Questions for Review 18. In country A a stock investment of 1 million € in the year 1990 has led to a total return of 2 million € in the 2000. The yearly rate of inflation was 4%. In country B a stock investment of 1 million € in the year 1990 has led to a total return of 1,6 million € in the 2000. The yearly rate of inflation was 1%. In which country was the real return on investment higher? 19. Explain the danger of a “deflationary spiral” in the presence of a inflation target equal to zero. 20. Why can a negative real interest rate be a strong incentive to buy goods?


21. Give a verbal explanation, why an inflation rate above zero leads to a steady increase of the real income tax burden in the presence of a progressive tax scale.


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