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) Foreign exchange interventions The concept of sterilization

A nation’s monetary base Domestic credit (DC) Foreign exchange reserves (FXR) Monetary base (MB) Assets Liabilities Currency (CURR) Bank reserves (BRES) Monetary base (MB)

A nation’s monetary base MB = DC + FXR = CURR + BRES

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 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 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 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 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 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 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 Assume the Fed buys £1 m from a foreign exchange dealer in New York Also assume that: m US = 2.6 m UK = 2.1 s = $1.6/ £

Foreign exchange transactions: Effect on US money supply 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 supply Domestic credit (DC) Foreign exchange reserves (FXR) + $1.6 m Monetary base (MB) + $1.6 m Assets Liabilities Currency (CURR) Bank reserves (BRES) + $1.6 m Monetary base (MB) + $1.6 m

Foreign exchange transactions: Effect on UK money supply 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 supply Domestic credit (DC) Foreign exchange reserves (FXR) - £1 m Monetary base (MB) - £1 m Assets Liabilities Currency (CURR) Bank reserves (BRES) - £1 m Monetary base (MB) - £1 m

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 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

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

Summary 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