au 6 the monetary policy of the ecb.ppt [kompatibilitätsmodus] · © rainer maurer, pforzheim...

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- 1 -Prof. Dr. Rainer Maure

Macroeconomics

6. The Monetary Policy of the ECB

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Macroeconomics

6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB6.2. The Policy Instruments of the ECB6.3. Money Creation by Commercial Banks6.4. 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 ECB6.1. The Policy Target of the ECB

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➤ 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:

■ “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."

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CHAPTER II: "OBJECTIVES AND TASKS OF THE ESCB"

Article 2: Objectives

In accordance with Article 105(1) of this Treaty, theprimary objective of theESCB shall be to maintain price stability. Without prejudice to the objectiveof price stability, it shall support the general economic policies in theCommunity with a view to contributing to the achievement of the objectives ofthe Community as laid down in Article 2 of this Treaty.The ESCB shall act inaccordance with the principle of an open market economy with freecompetition, favouring an efficient allocation of resources, and in compliancewith 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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➤ In the pursuit of this target the ECB is independent fromthe influence of governments or other political institutions.

➤ This is guaranteed by article 107 of the ECB-Statute:

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

Article 107

“neither the ECB, nor a national central bank, nor any member of theirdecisionmaking bodiesshall seek or take instructions from Communityinstitutions or bodies, from any government of a Member State or from anyother body.”

(Statute of the ESCB and of the ECB)

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

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➤ 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

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➤ 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 deflationand■ 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”.

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➤ 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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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 furtherdecrease 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.

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6. The Monetary Policy of the ECB6.1. The Policy Target of the ECBInflation

Rate

TimeB O

O M

UPSWING DOWN-SWING

R E

C E

S S

I O

N

B O

O M

UPSWING

2%

3%

1%

0%

2%

3%

DOWN-SWING

R E

C E

S S

I O

N

Inflation Target (=Long Run

Average) = 2%

Actual Realization of Inflation

=> No deflation in recessions if the inflation target is “high enough”!

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.

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Rate

TimeB O

O M

UPSWING DOWN-SWING

R E

C E

S S

I O

N

B O

O M

UPSWING

2%

3%

1%

0%

2%

3%

DOWN-SWING

R E

C E

S S

I O

N


Average) = 0%


=> Danger of deflation spirals!

=> Deflation in recessions if the inflation target is 0% !

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Rate

TimeB O

O M

UPSWING DOWN-SWING

R E

C E

S S

I O

N

B O

O M

UPSWING

2%

3%

1%

0%

2%

3%

DOWN-SWING

R E

C E

S S

I O

N


Average) = 0%


Deflation spirals can boost recessions!

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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.

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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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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 < (Pt+1 - Pt) / Pt

■ The lowest level of the nominal interest rate a central bank can reach with normal monetary policy is it = 0 (In this case the central bank must offer money credits at an interest rate of zero).

■ Consequently at an inflation rate of zero, (Pt+1 - Pt) / Pt = 0, it is not possible to create

it < (Pt+1 - Pt) / Pt = 0

■ Therefore in order to have the possibility to push the nominal interest rate below the inflation rate, the inflation rate must be largerthan zero!

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3. The possibility to generate negative real interest rates■ If the nominal interest rate (e.g. 2%) is lower than the inflation

rate (e.g. 5%), the “real interest rate” is negative (e.g. -1%), because the real interest rate is defined as:

real interest rate = nominal interest rate ./. inflation rate

rt = it ./. (Pt+1 - Pt) / Pt

=> -3% = 2% ./. 5%

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➤ However, also a couple of reasons for an inflation target equal to zero are in the debate. The most important are:

1. Inflation increases the costs of holding money.2. Inflation increases the real tax burden3. Wrong decisions caused by money illusion

➤ These arguments too are heavily disputed – there exists no unanimity on these issues!

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1. Inflation increases the costs of holding money.■ How much money do you hold in your moneybag?■ How much money would you hold, if the inflation rate would

be 10%?

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1. Inflation increases the costs of holding money.

Money

Time

1st day

Money spent per day

All money spent in 6 days

=> New visit at the ATM…=> Transaction costs…

100

€w

ithdr

awn

at th

e A

TM

6th day

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Money

Time

1st day

Money spent per day

All money spent in 3 days

=> New visit at the ATM…=> Transaction costs…50

€w

ithdr

awn

at th

e A

TM 50% reduction of money holdings because of higher inflation

3rd day

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Money

Time

1 Day

Money spent per day50 €

with

draw

n at

the

AT

M 50% reduction of money holdings because of higher inflation

6th day

=>2 visits at the ATM in 6 days!

=> Double as high transaction costs!

=> Inflation increases the costs of holding money!

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

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

Resulting average tax rates

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2. Inflation increases the real tax burden■ The following numerical example reveals this effect:

◆ 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.

■ 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:

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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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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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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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3. Wrong decisions caused by money illusion■ Rank the profitability of the investments according to their

real return:

■ 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.

Rank Alex Berta Charly

1.2.3.

Rank Alex Berta Charly1. 37 % 15 % 48 %2. 10 % 74 % 16 %3. 53 % 11 % 36 %

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➤ 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 conclusionsdepending 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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- 42 -Prof. Dr. Rainer MaureProf. Dr. Rainer Maurer -42-

“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.”

6. The Monetary Policy of the ECB6.2. The Policy Instruments of the ECB

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Macroeconomics

6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB6.2. The Policy Instruments of the ECB

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➤ 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.

…plus Slovenia, Malta, Cyprus,

Slovakia,Estonia, Lettland, Lithunia

Nineteen

6 Members of the ECB Board

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Eurozone (18)

EU states obliged to join the Eurozone (7)

EU state with an opt-out on Eurozone participation (1)

EU state with a public referendum to opt-out

the Eurozone (1)

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,)

L

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- 46 -Prof. Dr. Rainer Maurer - 46 -Prof. Dr. Rainer Maurer

Exkurs: Die Euroland-MitgliedsländerNach der 2004 erfolgten Erweiterung der EU um 10 neue Mitglieder bestand fürdie neuen Mitglieder die Möglichkeit, einen Antrag zur Teilnahme zum„Wechselkursmechanismus II“ des Eurosystems zu stellen. Wenn sie dannüber 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) davonGebrauch gemacht. Drei weitere Länder (Dänemark, Lettland, Litauen) nehmenWechselkursmechanismus II teil und können prinzipiell ebenfalls den Euroeinführen. Dänemark und Großbritannien hatten sich im Vertrag von Maastrichteine Ausnahmeklausel vorbehalten und von dieser auch Gebrauch gemacht.Schweden verletzte die Konvergenzkriterien bewusst, damit es den Euro nichteinführen musste. Monaco, San Marino und Vatikan sind keine EU-Mitgliedersind und deshalb nicht Teil des Eurosystems. Aufgrund bilateraler Abkommenmit der EU haben sie aber das Recht, den Euro als einzige Währung zu nutzensowie eigene Euromünzen im begrenzten Umfang prägen zu lassen. Insgesamtnutzen rund 40 Staaten und Teilstaaten den Euro oder eine vom Euroabhängige Währung (z.B. ehemalige Kolonien in Afrika). Manchmal wird auchdiese ganze Staatengruppe als „Eurozone“ oder „Euroland“ bezeichnet. Die mitder Vergrößerung des Eurosystems einhergehende Vergrößerung des ECB-Rates führt zu Problemen: Wenn die drei weiteren Anwärterländer (Estland,Lettland, Litauen) beigetreten sind, würde er 19 Notenbankpräsidentenumfassen, was den Abstimmungsprozess erschweren würde. Es ist deshalbeine Reform des ECB-Rates vorgesehen. Danach sollen nie mehr als 15Länder stimmberechtigt sein. Das Stimmrecht soll rotieren, wobei große Länderhäufiger stimmberechtigt sein sollen als kleine Länder.

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In the year 2015 Lithunia has joined the European Currency Union such that 19 countries send now members to the ECB Council.To keep the coor-dination process practicable, a monthly “rotation mechanism” will be implemented that allows to restrict the number of votingcountries to 15. All countries keep always their voicein the council.

New Rotation Mechanism of the ECB-Council

ECB-Board (6 permanent voting rights)

2. Group of 14 Smaller

Countries with11 Rotating

Voting Rights

1. Group of 5 Largest

Countries with 4 Rotating Voting

Rights

Total of 21 Voting Rights

= Germany, France, Italy,

Spain, Netherlands

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➤ 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 banksas 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

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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 credit-worthiness) 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

Credit Volume in €

Maximum Bid Planed Allotment Volume

Minimum Bid Rate

Bids with Allotment Bids without Allotment

imin

Marginal Rate

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➤ 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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- 52 -Prof. Dr. Rainer MaureQuelle: ECBQuelle: ECB Monatsbericht, Tabelle 1.3. Geldpolitische Geschäfte des Eurosystems

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- 53 -Prof. Dr. Rainer MaureQuelle: ECBQuelle: ECB Monatsbericht, Tabelle 1.3. Geldpolitische Geschäfte des Eurosystems

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- 54 -Prof. Dr. Rainer MaureQuelle: ECB Monatsbericht, Tabelle 1.4. Mindestreserve und Liquiditätsstatistik

+ + + ./. ≈ ./. ≈


From monetary policy instruments to currency in circulation:

Monetary policy instruments of the ECB = Money supply of the economy

by the ECB.

Absorption of liquidity by deposit accounts of the government and required

reserve holding of commercial banks.

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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◆ „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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➤ The impact of the ECB interest rates on the interbank credit market:

■ Marginal Lending Rate= Main Refinancing Rate + 1% (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.

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Source: ECB

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Quelle: ECB1) Private Haushalte; Laufzeit 1-5 Jahre; Zinsfixierung; Neugeschäft2) Unternehmen außerhalb des Finanzsektors; Laufzeit 1-5 Jahre; Zinsfixierung; Neugeschäft

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Quelle: ECB

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➤ The Impact of the ECB on the real economy:

■ This shows that the ECB is able to affect the longer termsegments 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 theneoclassical or the Keynesian textbook model, there isnevertheless a strong and significant impact.

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

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Macroeconomics

6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB6.2. The Policy Instruments of the ECB6.3. Money Creation by Commercial Banks

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6. The Monetary Policy of the ECB6.3. 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 importantrole.

■ 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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Money creation in a two-tier banking system*):

Central Bank

Commercial Banks

Non-Banks= Households, Firms,

Government

Cash

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.

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➤ 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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- 67 -Prof. Dr. Rainer Maure - 67 -Prof. Dr. Rainer Maurer

Why is „deposit money creation“ possible?

Commercial Bank

Firm

Household

10 € credit trans-ferred to the

deposit accountof the firm

10 € wage payment transferred to the deposit account of

the household

2 € withdrawn fromthe deposit account

and used to pay goods in cash.

8 € payments for goods transferred via credit card to

the deposit account of the firm

10 € credit re-transferred to the deposit account

of the bank

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

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- 68 -Prof. Dr. Rainer Maure - 68 -Prof. Dr. Rainer Maurer

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

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➤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 non-

banks 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 €.

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What explains the downward trend of the average cash ratio in the high-income countries?

Source: IMF International Financial Statistics

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■ 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 strongerthan 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”.

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■ 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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■ 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

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

Liabilities of Central Bank & Commercial Banks to Non-banks

M1 M2 M3

Decreasing Liquidity -->

Currency in circulation 721 721 721

Overnight deposits 3417 3417 3417

Deposits redeemable up to 3 month 1621 1621

Deposits redeemable up to 2 years 2331 2331

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

Que

lle: E

CB

Mon

atsb

eric

ht, T

abel

le 2

.3. M

onet

äre

Sta

tistik

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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

LiabilitiesAssets

B = Cash from the Central

BankM = Money

Based Credits D = Giro Accounts

R = Reserves

Payment Transactions

Financial IntermediationSaving

Deposits, Time Deposits etc…

Intermediated Credits

M = B-R +D

B-R = Cash in Circulation

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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.

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


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6.4. Questions for Review

➤ You should be able to answer the following questionsat the end of this chapter. All of the questions can beanswered with the help of the lecture notes. If you havedifficulties in answering a question, discuss thisquestion with me at the end of the lecture, attend mycolloquium or send me an E-Mail.

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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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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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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

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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 1990has 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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