Chapter 10: Money and Banking
Chapter Outline
10.1 Introduction
10.2 Some Definitions
- Money supply
10.3 Financial Assets
10.4 What do Banks Do?
- The orthodox view: the money multiplier
- MMT representation of the credit creation process
- Summary
- A bank’s credit creation: A balance sheet analysis
Appendix: Advanced Material
- Theories of the yield curve and its dynamics
Learning Objectives
1. Gain an understanding of definitions of the money supply and financial assets.
2. Recognise the sharp distinction between the MMT and orthodox representations of the process
of credit creation by banks.
3. Be able to interpret a bank balance sheet and incorporate changes via flows of new
transactions.
10.1 Introduction
In this Chapter we have a number of objectives. First we will introduce students to commonly
used definitions of the money supply. Frequent reference has been made in earlier chapters to
the purchase or sale of financial assets by both the government through the central bank and
treasury, as well as by banks. Here we will provide students with a clear understanding of the
generic characteristics of financial assets. We then devote space to the development of an
understanding as to how banks behave in a modern monetary economy. In the process we will
expose some long-standing myths about the role that banks play in the operation of the financial
system. This analysis is complemented by the use of balance sheets in the following sub-section
of the Chapter, which adds further clarity.
10.2 Some Definitions
Money supply
Economists and commentators try to draw inferences about the economy from trends over time
in particular monetary aggregates. There are a number of measures of the so-called money
supply, which have been devised over the years, but there is some variation across countries. For
example, the Australian Bureau of Statistics (2012) defines the following:
The monetary base (HPM) comprises holdings of notes and coin by the private sector; deposits
of banks with the Reserve Bank (that is, reserves), and other Central Bank liabilities to the
private sector. In Australia and the UK, but not the USA, HPM is defined as ‘narrow money’ or
‘M0’ and is the most liquid measure of the money supply. On the other hand, the US definition
of M0 excludes bank reserves.
M1 is defined as currency (that is, notes and coins) plus current bank deposits held by the private
non-bank sector. This measure is used by economists trying to quantify the amount of money in
circulation. The M1 is a very liquid measure of the money supply, as it contains cash and assets
(bank deposits) that can quickly be converted to currency. Typically, central banks issue notes as
currency while treasuries issue coins as currency - however, it was common in the past for
treasuries to also issue notes.
M3 is defined as M1 plus all other Authorised Deposit-taking Institution (ADI) deposits from the
private non-bank sector plus certificates of deposit issued by banks less ADI deposits held with
each other. ADIs include banks, building societies and credit unions.
Broad money is the widest definition of money published by the Reserve Bank of Australia, the
central bank. Broad money is defined as M3 plus borrowings from the private sector by nonbank
financial intermediaries (including cash management trusts) less their holdings of currency
and bank deposits. This measure is generally used to estimate the entire supply of money within
an economy.
The US Federal Reserve defines M2 as M1 + most savings accounts, money market accounts,
retail money market mutual funds, and small denomination time deposits (certificates of deposit
of under $100,000). M2 has been typically used to forecast inflation.
10.3 Financial Assets
If a household engages in saving (a flow per period of time), over a number of months or years,
then it will accumulate a growing stock of wealth over time. The household needs to make a
decision about whether to continue to add its saving to its existing deposits at its bank or put
together a portfolio of financial assets, which have different degrees of risk - for example, stocks
(shares) or bonds (see below), which are also denominated in the money of account.
Treasuries in modern economies issue bonds (debt), which are financial assets bought and sold
by the central bank, banks and the private sector. In Australia these bonds are also known as
Commonwealth Government Securities (CGS).
These bonds acknowledge that the issuer is indebted (owes money) to the bondholder who buys
the new bonds in the primary market. The bond is negotiable because ownership of the
certificate can be transferred (sold) to another owner in the secondary market. Clearly secondary
market trading has no impact at all on the volume of financial assets in the system since it just
shuffles this wealth between wealth-holders.
The bond issuer must pay interest to the bondholder normally semi-annually and repay the
principal later, when the bond matures. Bonds represent wealth for bondholders.
Thus a bond is a formal contract to repay a loan (IOU) with interest at fixed intervals. The
bondholder is the lender (creditor). The borrower (debtor) issues the bond and the coupon is the
interest rate, which is paid on the face value of the bond, which is printed on the bond. This
means that semi-annual interest payments, say $R, are constant.
The issue price is what investors pay for the bond when it is first issued, and is about equal to
the face value on the bond. Later on, bonds may be traded: at a premium (above par, if good
quality, so that there is minimal default risk by the issuer), or at a discount (price below par).
A consol is a perpetuity, so there is no maturity date. Interest is paid on this asset forever.
Assume R is the annual interest payment, and r is the market rate of interest per annum, then the
sale price, P, in the absence of risk, can be shown to be P=R/r. This is the present value of the
stream of interest payments, R, forever.
A high sale price P means a low rate of return or yield r=R/P (with R fixed) and conversely.
So there is an inverse relationship between market (sale) price of a consol and its yield (rate
of interest).
This inverse relationship applies to bonds of shorter maturity, as well, but the algebra is a little
bit more complicated. This is a very important relationship.
A relatively safe bond, with a low risk of default by the borrower, will attract a high auction
price and a low yield (interest rate) since coupon R is fixed and the implied rate of interest,
r~=R/P.
A risky bond is less attractive to investors who would pay a lower price for it. They earn a higher
yield, which incorporates a risk premium.
Treasury bonds (debt) are sold by auction, where banks and other institutions bid for them.
Ten-year treasury bonds issued in countries, such as Australia, USA, UK and Japan are very
safe, and have attracted a relatively low yield (rate of interest) of under 5.5 per cent since 2008.
These countries issue their own currency. On the other hand, some of the Eurozone countries,
including Greece, Portugal and Ireland, experienced ten-year bond rates in excess of 10 per cent
over this period. These countries use a foreign currency, the Euro.
Bonds are also issued and sold in primary markets by state or provincial governments,
multinational and local companies, credit institutions and other public bodies. Companies raise
finance for new capital investment by: (i) issuing bonds; (ii) using retained profits, and (iii)
undertaking a new share issue.
Treasuries and other institutions issue bond with different times to maturity. For example the US
Department of the Treasury issues bonds of 1 month, 3 months, 6 months, 1 year, 2 year, 3 year,
5 year, 7 year, 10 year, 20 year and 30 year duration. We can use the term maturity and term
interchangeably. So a 10-year treasury bond matures in 10 years.
There are two ways we can use data on yields for bonds of different maturities but of similar risk
(see Mitchell, 2011b). First, we would see what is happening to the demand for bonds from
investors. Rising yields signal falling demand. This could be a reflection of a strengthening
economy with investors being prepared to acquire more risky assets and less very safe ones. This
is also usually when the central bank pushes up the target interbank rate and bond yields more or
less follow (see Chapter 15). Second, we will get an indication of what is happening to
inflationary expectations and risk-assessments. We could graph a time series of yields for
selected treasury bonds of different maturities say for the period of 1 January 2015 to 31
December 2015.
The second way of looking at the yields is to consider the yield curve. The yield curve is a
graphical depiction of the term-structure of risk-free interest rates and plots the maturity of
the government bond on the horizontal axis against the respective yields (rates of return) on the
vertical axis. There are broadly three shapes that the curve will take:
 Normal – Under normal circumstances, short-term bond rates are lower than long-term
rates. The central bank attempts to keep short rates down to keep levels of activity as high
as possible and bond investors desire premiums in longer-term maturities to protect them
against inflation. Thus, the yield curve is upward sloping.
 Inverted – Sometimes, short-term rates are higher than long-term rates and the yield
curve is said to be inverted. Usually the economy starts to overheat and expectations of
rising inflation lead to higher bond yields being demanded. The central bank responds to
building inflationary pressures by raising short-term interest rates sharply. Although bond
yields rise, the significant tightening of monetary policy causes short-term interest rates
to rise faster, resulting in an inversion of the yield curve. The higher interest rates may
then lead to slower economic growth.
 Flat – A flat yield curve is seen most frequently in the transition from positive to
inverted, or vice versa. As the yield curve flattens the yield spreads drop considerably. A
yield spread is the difference between, say, the yield on a one year and a 10-year bond.
What does this signal about the future performance of the economy? A flat yield curve
can reflect a tightening monetary policy (short-term rates rise). Alternatively, it might
depict a monetary easing after a recession (easing short-term rates) so the inverted yield
curve will flatten out (Mitchell, 2011b).
Figure 10.1 US Treasury yield curve (February 3, 2016)
Data Source: Daily Treasury Yield Curve Rates, Resource Center, US Department of the Treasury.
In Figure 10.1 we show the US Treasury Yield Curve for 3 February 2016, which conforms to
the normal upward sloping form. This follows the Federal Open Market Committee’s decision to
raise the Federal Funds rate 25 basis points to a range of 25 to 50 basis points (0.25 percent to
0.50 percent) in December 2015. We will examine the impact of this decision on the yield curve
in Chapter 15 Monetary Policy in Sovereign Nations.
We explore some factors that influence the shape of the Yield Curve in Advanced Material in the
Appendix.
10.4 What do Banks Do?
The orthodox view: the money multiplier
In most textbooks, banks are presented as financial intermediaries that take in deposits, hold a
small fraction of these in the form of reserves, and then lend out the remainder. If each bank
follows these principles in making loans, aggregate lending expands through the ‘deposit or
money multiplier’. For the moment assume that all banks are required to hold reserves to deposit
ratio of 10 per cent. This is designed to enable them to readily respond to a loss of reserves
resulting from spending by customers on say goods and services, whose sellers bank elsewhere
and also those customers who seek to hold additional cash. We now outline the operation of the
money multiplier (see also Mitchell, 2011a):
i) Assume that a customer deposits say $100 in Bank A;
ii) Bank A retains $10 of reserves to conform to the required reserves to deposit ratio of 0.1.
To expand its loan portfolio and increase profits, the remaining $90 is loaned to a
customer whose deposits rise by $90;
iii) The customer spends these deposits and the recipient of the funds (seller) deposits $90 in
their bank, which for generality we will assume is Bank B;
0.0
0.5
1.0
1.5
2.0
2.5
3.0
1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 20 yr 30 yr
Percent
iv) Bank B then lends 0.9 times $90 = $81 (keeping 0.10 that is, $9 as additional reserves as
required) to a customer to finance their expenditure and so on.
In each stage the amount lent and then spent diminishes. It can be readily shown that $900 of
additional loans are created, which, with the initial new deposit, means that deposits have risen
by a total of $1000, which are ‘backed’ by $100 of reserves, thereby conforming to the required
10 per cent ratio.
This example is what the mainstream textbooks call a fractional-reserve banking system and it
purports to explain how banks create money, which increases the money supply, such as M1, due
to the increase in current deposits. The multiplier, in terms of the initial deposit of $100, is 10,
which is the inverse of the required reserves to deposit ratio of 0.1. A smaller money multiplier
results if the non-Government sector chooses to hold more cash when credit is created.
The standard example is typically assumed as a 10 per cent ratio, so that students could readily
calculate a money multiplier equal to 10! On 12 April 1992, the US Fed, for the first time, set the
required reserve ratio on demand deposits at the magical 10 per cent, making theory appear to
coincide with reality.
By way of summary, banks are considered to be financial intermediaries that maximise profits.
They take in deposits to build up reserves so that they can then on-lend the deposits at a higher
interest rate. However prudential regulations require that they maintain a minimum reserve to
deposit ratio. The fractional reserve requirements mean that the resulting credit creation process
is finite.
In addition, many economists still believe that High Powered Money (HPM), which consists of
bank reserves and cash held by the non-government sector, is under the control of the central
bank. Thus by controlling the size of the stock of HPM and setting the required reserve ratio, the
central bank controls the size of the money supply or quantity of money.
Money is said to be ‘exogenous’ in the control sense, determined by the central bank. This has
been called the ‘verticalist’ approach, because in most textbooks the money supply is presented
as ‘vertical’ (perfectly inelastic with respect to interest rates), where the supply of money
(horizontal axis) is plotted against the interest rate (vertical axis). As we will see in Chapter 11,
the quantity of money is alleged to determine the rate of inflation, under the Quantity Theory of
Money.
The implication of the operation of the money multiplier is that a bank would forego profitable
loan opportunities, if it did not have sufficient reserves to enable additional credit creation. Some
allowance is made for discretion: the deposit multiplier is claimed to be a function of interest
rates and interest rate differentials, bank preferences regarding their holdings of excess reserves,
and also public preferences regarding their holdings of cash, as noted, and time deposit and
demand deposit ratios. However, as Brunner (1968) ‘demonstrated’, these factors are of only
minor importance.
MMT representation of the credit creation process
We shall now argue that this characterisation of the credit creation process, which is driven by
fractional reserve requirements, is not an accurate depiction of the way banks operate in a
modern monetary economy characterised by a fiat currency and a flexible exchange rate.
In reality, the business of banking is complicated but is, in some respects, similar to that of other
profit-seeking firms. Like non-bank firms, banks are seeking to earn profits and thereby generate
returns for shareholders. Making loans secures profits as long as the banks are paying a lower
rate of interest on funds that they borrow than they receive from their customers who take out
loans.
First, a necessary condition for credit creation is that there are non-bank firms and/or households
who are seeking loans to finance their planned spending on goods, services or assets. Second,
some of these entities must be considered creditworthy by the banks, so that there is a high
probability that the loan will be repaid in full. What constitutes credit-worthiness varies over the
business cycle and lending standards tend to become more lax at boom times as banks chase
market share. Third, the banks must assume that there is profit to be made by making these loans,
as described above.
Banks make loans independently of their reserve positions (that is, their holdings of reserves,
relative to their liabilities) and then borrow additional reserves if required. Bank managers
generally neither know nor care, about the aggregate level of reserves in the banking system.
Certainly, no loan officer ever checks the individual bank’s reserve position before approving a
loan. Bank lending decisions are affected by the price of reserves and expected returns, not by
reserve positions. If the spread between the rate of return on an asset (loan) and the interbank rate
is wide enough, even a bank that is already deficient in reserves will purchase the asset and cover
the reserves needed by purchasing (borrowing) reserves in the interbank market.
The important point is that when a bank originates a loan to a firm or a household it is not
lending reserves. Bank lending is not easier if there are more reserves, just as it is not harder if
there are less. Bank reserves do not fund money creation in the way that is claimed in the money
multiplier and fractional-reserve deposit story (Mitchell, 2011a).
The main difference between banks and other types of firms involves the nature of the liabilities.
Banks ‘make loans’ by purchasing IOUs of ‘borrowers’. This results in a bank liability, usually a
demand deposit, at least initially, that shows up as an asset (‘money’) of the borrower. Thus a
customer of a bank who secures a loan is simultaneously a ‘creditor’ of the bank, due to holding
a demand deposit, but is also a ‘debtor’ to the bank. These creditors will almost immediately
exercise their right to use the newly created demand deposits as a medium of exchange for
purchases of goods and services. Bank liabilities (bank deposits) are the money used by
households and non-bank firms for transactions in the form of cheques or transfers or are first
redeemed at par ($ for $) against fiat money (which is guaranteed by the government) to enable
cash to be used. The government will also accept some bank liabilities in payment of taxes.
In turn, bank reserves are the ‘money’ used as means of payment (or interbank settlement)
among banks and for payments made to the central bank. Thus, when bank ‘creditors’ draw
down their demand deposits, by either spending or choosing to hold more cash, this causes a
corresponding loss of reserves for the individual bank. The bank may then either sell an asset, or
increase its liabilities by borrowing additional reserves, in order to cover the loss of reserves. In
the aggregate, however, such activities only shift reserves from bank to bank.
The interbank market (say the federal funds market in the US) functions to shuffle the reserve
balances that the member (private) banks keep with the central bank to ensure that each of these
banks can meet their reserve targets, which might be simply zero balances at the end of a period
of time, which, for simplicity, we could assume is a day.
The bank expands its balance sheet by lending. Loans create deposits, which are then backed by
reserves after the fact. The process of extending loans (credit), which creates new bank liabilities
is unrelated to the reserve position of the bank. The major insight is that any balance sheet
expansion, which leaves a bank short of the required reserves may affect the return it can expect
on the loan as a consequence of the ‘penalty’ rate the central bank might exact through the
discount window. But it will never impede the bank’s capacity to effect the loan in the first
place. So it is quite wrong to assume that the central bank can influence the capacity of banks to
expand credit by adding more reserves into the system. We will address this proposition in more
detail in Chapter 15.
Aggregate excesses or shortages of reserves across the banking system have to be rectified by the
central bank. Ultimately then, the size of the stock of reserves is not discretionary in the short
run. The central bank can determine the price of reserves, admittedly within some constraints,
but then must provide reserves more or less on demand to hit its ‘price’ target, that is the target
interbank rate (for example, the Fed funds rate in the USA and the Bank Rate in the UK), which
we will describe in detail in Chapter 13.
The approach outlined in this section has been called the ‘endogenous money’ approach, in the
sense that the supply of bank money is determined ‘endogenously’ by the demand for bank
loans, plus the willingness of banks to lend, (which gives rise to the creation of deposits) rather
than ‘exogenously’ (Moore, 1988). According to those who adopt this approach, any impact of
monetary policy on the quantity of money is very indirect and operates primarily through interest
rate effects.
The demand for loans, in turn, is determined by spending decisions of private economic agents
(including decisions regarding asset purchases). These can be affected, but only very indirectly,
by the loan rate of interest. The supply of loans is then never independent of the demand; banks
supply loans only because someone is willing to ‘borrow’ bank money by issuing an IOU to
banks. This means that the interest rate cannot be determined by the ‘supply and demand’ of
loans since supply and demand are not independent. Rather, banks are price-setters in short-term
retail loan markets. They then meet the demand for loans with some quantity rationing, at that
price. Thus some requests for loans are refused, even though these aspiring borrowers claim to
be willing (and able) to pay the going interest rate.
There can be several reasons for such quantity rationing of large segments of the population.
Banks might worry about the default risk of borrowers, but might not be able to raise interest
rates sufficiently to cover default risk, so that quantity rationing is superior to price rationing.
Often, banks probably have better information than do borrowers about such risks. For example,
the borrower who wishes to open a new restaurant might not have good access to information
about bankruptcy rates in the industry or might simply be overly optimistic. On the other hand,
banks can never know the future, so must operate on the basis of rules of thumb (for example,
informal rules that restrict loan size). Some quantity rationing can even be irrational, perhaps
discriminatory, because banks have traditionally forgone certain kinds of loans or are reluctant to
lend to certain groups in the community. The key point is that the supply of loans does not
simply adjust to the demand for loans at some interest rate.
The short-term retail interest rates can be taken as a mark-up over short-term wholesale interest
rates. Exactly what determines the mark-up (and whether it is variable) is controversial, but not
important to our analysis here (see Moore, 1988). Wholesale interest rates, finally, are under the
influence of central bank policy. Individual banks use wholesale markets to rectify a mismatch
between retail loans and deposits. Most banks will not be able to match exactly their retail loans
and deposits. Some banks will be able to make more retail loans than they can retain in deposits
and thus suffer a loss of reserves, while others will find fewer loan customers than depositors, so
they will have a surplus of reserves. Banks then use wholesale markets to either ‘purchase’
reserves by issuing wholesale liabilities (for example, negotiable, large denomination certificate
of deposits (CDs) or by borrowing central bank funds), while surplus banks will sell their excess
reserves.
As discussed above, the central bank sets the overnight interbank rate. This rate then determines
other short-term wholesale rates (mainly as a mark-up, but also as a mark-down) through
arbitrage. In conclusion, the supply of money is determined endogenously while the price of
money short-term interest rate is determined exogenously as a result of central bank policy.
Summary
The orthodox position is that banks leverage (create credit) when provided with new deposits,
but are constrained by fractional reserve requirements. Since the central bank is claimed to be
able to control the stock of HPM or monetary base, the central bank is able to control the supply
of money according to this deterministic theory of credit creation.
MMT would first deny that the central bank can control the stock of HPM, because monetary
policy is conducted by the central bank setting a target interbank rate and providing the right
level of reserves to the banking system so that banks lend to and borrow from each other at this
target rate (for more details, see Chapters 13 and 15). Second, a bank is not constrained by its
reserve position in deciding whether to make a loan to a particular customer. As long as the
customer appears creditworthy and the loan is profitable to the bank, it will make the loan and
then acquire sufficient reserves by borrowing from other banks or the central bank. Thus in
contrast to the orthodox position of deposits driving loans, MMT argues that loans drive
deposits. Further the experience of the 1980s cast considerable doubt on the relation between
total reserves (HPM) and monetary aggregates, because the ‘money multiplier’ became unstable.
A bank’s credit creation: A balance sheet analysis
The balance sheet of a typical bank looks like this:
Figure 10.2 A typical bank balance sheet
Assets Liabilities
Advances (Loans)
Securities
Reserves
Other Assets
Checking accounts
Savings accounts
Other liabilities
Net Worth
The money entries are the cheque and savings accounts on the balance sheet. Note that they are
the IOUs of banks, and hence appear as liabilities on the balance sheet. The bank promises to
convert deposits in a cheque account (and deposits in most savings accounts) into cash on
demand. Banks hold financial assets in the form of loans to customers and securities, that is
Treasury debt and other assets.
Firms in general and banks in particular, should have positive Net Worth that is the difference
between Assets and Liabilities. Total assets in the left hand column will balance with the items in
the Liability column, because the latter includes Net Worth.
The following simplified series of balance sheets will clarify the process of credit creation by
Bank A. Let us assume that Bank A starts with the following very simple balance sheet.
Figure 10.3 Bank A balance sheet
Assets Liabilities
Building = $200 Net Worth = $200
Its owners have raised capital and bought the building. The owner’s equity or net worth is equal
to the value of the building they have purchased. Bank A has not engaged in any banking activity
yet. Now a customer comes into the bank and says that they would like to borrow $200 to
finance the purchase of a car. The bank checks their creditworthiness (asks for income tax
returns, proof of assets, credit history, etc.). If the customer is approved then the following
occurs on the bank’s balance sheet.
Figure 10.4 Bank A balance sheet
Assets Liabilities
Loan to Customer = $200
Building = $200
Cheque Account of Customer = $200
Net Worth = $200
The bank just created $200 of money entries (deposits in the cheque account of the customer in
return for the customer’s IOU, or promise to pay $200). The bank’s total assets, which equal
liabilities plus Net Worth, are now $400.
Before we move on to the customer’s spending of their deposit, let us examine this balance sheet
carefully.
Where did the bank get the money entry it created?
 A cheque account was created ex-nihilo, that is, from nothing, by entering a number
(200) in a computer. In the past banks could also issue their own banknotes - but
generally only central banks can do that now.
 The bank did not need any prior deposits, or any cash in its vault. In fact the bank did not
have any cash in its vault, nor any deposits in its account at the central bank in this
simplified example.
 The bank is not lending anything it has, it just creates money entries, (bank deposits), at
will.
 Those money deposits or entries are its liabilities/IOUs.
 By creating those bank IOUs, the bank promises to:
- Convert deposits into cash on demand;
- Accept any of those IOUs in payment of debts owed to the bank.
The cheque account is just a legal promise to convert to cash on demand, and to accept payment
in the form of the bank’s own IOUs. The bank does not have to have any cash now.
The success of the banking operation (lending by accepting an IOU, and the creation of a
demand deposit) depends on:
 The capacity of the customer to repay that is creditworthiness. If they have problems in
making timely payments on their debts, this affects the value of the bank’s assets and its
own income inflows and ultimately affects the net worth of the bank, the bank’s capital
ratio, and the shareholders’ return on equity.
 The bank’s capacity to acquire reserves at low cost if:
- The customer wants to withdraw cash;
- The bank needs to pay debts to other banks through an interbank settlement
following the customer’s spending (see below);
- The bank needs to settle tax payments made by the customer to the government.
If these conditions are not satisfied the bank gets in trouble; it can become insolvent or illiquid.
The first means its net worth falls to or below zero; the second means it cannot meet cash
withdrawals or clearing. Thus, even though banks can create unlimited amounts of money
deposits, they have no incentive to do so because they may be unprofitable.
So what happens if now the customer pays $200 to a car dealer who happens to have a bank
account at another bank called Bank B? The balance sheet of Bank A looks like this:
Figure 10.5 Bank A balance sheet
Change in Assets Change in Liabilities
Cheque Account of the customer = -$200
Reserves due to Bank B = +$200
Figure 10.6 Bank B balance sheet
Change in Assets Change in Liabilities
Claim on Bank A Reserves: +$200 Cheque Account of Car Dealer +$200
Bank A’s liabilities in the form of the customer’s cheque account have dropped by $200 through
the purchase of a car, but the transaction is not confined to the reduced balances in the
customer’s account at Bank A and the increased balances of the Car Dealer at Bank B. Bank A
now owes Bank B $200 and needs reserves to settle this debt, but does not have reserves. Where
does it get the reserves?
The banks are required to keep reserve accounts at the central bank. These reserves are liabilities
of the central bank and assets of the banks. These reserves function to ensure the payments (or
settlements) system functions smoothly. That system relates to the millions of transactions that
occur daily between banks as cheques are tendered by citizens and firms and more. Without a
coherent system of reserves, Bank A could easily find itself unable to fund Bank B’s demands
based on the cheque drawn on the customer’s account and presented at Bank B by the Car
Dealer.
Bank A will get the reserves from the source that is the least costly. It may sell assets, but, in our
example, Bank A only has a building so it would be very costly to get reserves that way. Bank A
could sell bonds, if it had any, or it may borrow reserves from other banks (domestic or foreign)
or the central bank. A common way to get the reserves is to borrow from the central bank, which
is the monopoly supplier of reserves. Figure 10.7 documents the latest change to Bank A’s
balance sheet, associated with obtaining these reserves:
Figure 10.7 Bank A balance sheet
Change in Assets Change in Liabilities
Reserve: +$200 Debt to Central Bank: +$200
Figure 10.8 Central bank balance sheet
Change in Assets Change in Liabilities
Reserve Loan to Bank A: +$200 Reserve: +$200
Now that Bank A has the reserves it can settle its debt with Bank B.
Figure 10.9 Bank A balance sheet
Change in Assets Change in Liabilities
Reserves: -$200 Reserves due to Bank B = -$200
Figure 10.10 Bank B balance sheet
Change in Assets Change in Assets Liabilities
Claim on Bank A: -$200
Reserves: +$200
The debt between the two banks has been settled. The final balance sheets of Bank A, Bank B
and the central bank look like this:
Figure 10.11 Bank A balance sheet
Assets Liabilities
Funds Advance to Customer= $200
Building = 200
Debt to Central Bank = $200
Net Worth = 200
Bank A makes money as long as the interest it receives on the loan to the customer is higher than
the interest it pays to the central bank on the reserves. The balance sheet of Bank B is shown
below, where we assume Bank B had reserves prior to the checking account of the Car Dealer
being increased by the sale of the car to the customer.
Figure 10.12 Bank B balance sheet
Assets Liabilities
Reserves + $200 Checking Account of Car Dealer + $200
Finally the balance sheet of the central bank is shown in Figure 10.13.
Figure 10.13 Central bank balance sheet
Assets Liabilities
Reserve Loan to Bank A= $200 Reserves: +$200
Note that none of these operations involved any transfer of physical cash. It was all bookkeeping
entries through keystrokes to computers. Also note we only show the assets and liabilities
directly related to our examples. Of course, private banks and the central bank have many other
assets and liabilities, as well as net worth on their balance sheets.
In practice, the central bank will usually not advance reserves to the bank directly in the form of
an unsecured advance; instead it will ask for collateral (usually a treasury security) in exchange
and will provide funds for less than the value of the collateral. So, if Bank A has a $300 bond, it
surrenders it to the central bank in exchange for reserves. The Fed will give only say $285 if the
discount rate is 5 per cent.
Appendix: Advanced Material
Theories of the yield curve and its dynamics
Mitchell (2011b) notes that there are various theories about the yield curve and its dynamics. All
share some common notions – in particular that the higher is expected inflation the steeper the
yield curve will be other things equal.
The basic principle linking the shape of the yield curve to the economy’s prospects is explained
as follows. The short end of the yield curve reflects the interest rate set by the central bank. The
steepness of the yield curve then depends on the yield of the longer-term bonds, which are set by
the market. But the short end of the curve is the primary determinant of its slope. In other words,
the curve steepens mainly because the central bank is lowering the official cash rate, and it
flattens mainly because the central bank is raising the official cash rate.
Bond traders link the dynamics of the yield curve to their expectations of the future economic
prospects. When the yield curve flattens it is usually accompanied by deflation or steady and low
inflation and vice versa.
One of the risks in holding a fixed coupon bond with a fixed redemption value is purchasing
power risk. Economists believe that most people would prefer to consume now rather than later
if there was to be a trade-off. To encourage foregone consumption now, a yield on savings must
be provided by markets. The yield is intended to allow a person to consume more in the future
than has been sacrificed now. But if the prices of real goods and services increase in the
meantime, then inflation could completely wipe out any gain in real consumption, so that the real
interest rate is zero.
Consider a person who invests in a one-year $1,000 coupon treasury bond with a single coupon
payment expected of $100. The individual will expect to get $1,100 on the redemption date.
Assume that over the holding period, prices rise by 10 per cent. At the end of the year, a basket
of goods that previously cost $1,000 would now cost $1,100. In other words, the investor is no
better off at the end of the year as a result of the investment. The nominal yield has been offset
by the price inflation.
Purchasing power risk is more threatening the longer is the maturity. This is one reason why
longer maturity rates will be higher. The market yield is equal to the real rate of return required
plus compensation for the expected rate of inflation. If the inflation rate is expected to rise, then
market rates will rise to compensate. In this case, we would expect the yield curve to steepen,
given that this effect will impact more significantly on longer maturity bonds than at the short
end of the yield curve.
References
ABS (2012) Year Book Australia, 1301.0, available at:
http://www.abs.gov.au/ausstats/abs@.nsf/mf/1301.0
Brunner, K. (1968) “The Role of Money and Monetary Policy”, Federal Reserve Bank of St
Louis Review, 50, pp.8-24.
Mitchell, W.F. (2011a) “The role of bank deposits in Modern Monetary Theory”, blog posted on
Thursday, May 26, 2011, available at: http://bilbo.economicoutlook.net/blog/?p=14620.
Mitchell, W.F. (2011b) “When might that be?” blog posted on Thursday, July 21, 2011, available
at: http://bilbo.economicoutlook.net/blog/?p=15348.
Moore, B. (1988) Horizontalists and Verticalists: The Macroeconomics of Credit Money,
Cambridge University Press, Cambridge.