Economics of Banking and Finance Markets

Prof. Sukumar Vellakkal

Department of Economic Sciences
Indian Institute of Technology, Kanpur

Lecture - 39
Central Banking - II

(Refer Slide Time: 00:21)

Welcome to this session, in this session we are going to discuss the liability part of Fed’s
Balance Sheet, and subsequently we are going to see how changes in Fed’s balance sheet is,
when Central bank changes the components of their assets and liabilities, is going to affect
the money supply.

Coming to the liabilities part; two components of the liabilities of the Fed are, one is currency
in circulation and 2nd one is reserves. This is also called as monetary base and called as
high-powered money, and the definition that we have given earlier was the M0 money.

The monetary liabilities are equal to currency in circulation and reserves. So, let us discuss
this one-by-one. Currency in circulation means, the amount of currency in the hands of the
public; that is the amount of currency in the hands of the public that is called currency in
circulation. So, please note that currency held by depository institution is also a liability of
the Fed and it is counted as part of the reserve, but it is not part of the currency in
circulations.
That means, the currency held by the banking system is not included in currency in
circulation, but it’s a liability, we are going to include it in reserves. And, coming to the 2nd
component, that is reserves; a reserve means currency held by depository institutions at hand
and held in Fed’s account as reserves.

So, it’s a liability of the Fed, but it’s counted as part of our reserves. So, to summarize this
one, in the Fed’s balance sheet, what we can see here is that the liabilities, one is currency in
circulation; then 2nd one is reserves; that means, currency held by depository institutions at
hand (vault), as well as held in Fed’s accounts both are considered as a reserve.

(Refer Slide Time: 02:28)

We can divide the total reserves it into two categories; one is called as required reserve and
the 2nd one is called as excess reserve. So, coming to the required reserve; a required reserve
means a fraction of the total demand and time deposits must be kept with the Central banking
system, with the Central bank as required reserve. This is mandatory. For example, in India,
you know that is approximately 4 percentage, it changes often when Central bank announce
monetary policy.

So, that means, the here the required reserve means, a certain fraction of the total deposit kept
with the Central banking system, that is the required reserve. And in addition to that, banking
system also keep additional money in their reserve bank account; that means, any additional
reserve the bank chooses to hold, be it with the Fed account or be it with their own vault
(vault cash), this is called excess reserve.
So, totally we are going to make the total reserve is equal to required reserve and excess
reserve, both are considered as reserves in our definition.

(Refer Slide Time: 04:09)

So, look at this figure, what we can see here is that the bottom part you can see that at any
given period, this part, this much is the currency in circulation currency and the remaining,
this much is the reserves; that means, reserve means including required reserve and excess
reserve, and both are part of high-powered money.

So, the high-powered money means, the currency in circulation and reserve that the required
reserve and excess resource, we are going to call it as the monetary base and going to call it
as the high-powered money. This is the high-powered money.

So, this is the money supply; that means, currency in circulation, the amount is same, but the
deposit we can see that it consists of a larger component. So, based on this monetary base, we
are we are going to say that a Central bank can control the monetary base in fact. So, the
Fed’s control over the monetary base is the main route through which it determines the
money supply.

So, you can see that this is a smaller component, this is the based on this, the Fed is able to
increase the money supply to this much. So, this is the main route. So, what we are going to
focus here is that, mainly on the monetary base, when we discuss the function of Central bank
in affecting the money supply.
So, mainly through the monetary base, that is the main route through which it determines the
money supply.

(Refer Slide Time: 06:52)

So, let us now focus on this monitory base, this part. And, also before moving further, let me
also show you the money supply in India, what are the components included there. So, we
can say that a currency with the public, is the that 14.7 percentage, this one in March 2022.

So, you can see that this is the currency with the public, we can see that the C component
consist of approximately 15 percentage. So, the remaining 85 percentage; that means,
demand deposits with the bank consist of 8.1 percentage. Time deposit that also part of
money supply definition, it consists of approximately 75 percentage. And the 0.2 percent, this
is called other deposits by with the RBI, it is mainly done by Prime minister, ex-prime
minister, governors etcetera.

And the government also deposit money with the Central bank, this is called ‘other deposit
with the RBI’. So, you can see from here itself, currency constitute only 15 percentage of the
total money supply, all the remaining parts, the deposits, that is demand deposit, time deposits
and other deposits with the RBI constitute larger share in money supply.
(Refer Slide Time: 08:19)

So, from the balance sheet, what we can see that in the Fed assets; that means, government
securities and discount loans, you can see that both earn interest income, right. From the
government securities which is being held by the Central bank, you know that periodically
they will be getting interest income. When they lend to the commercial banking system, there
also the central bank earns interest income.

Fed’s liabilities are mainly currency in circulation, and the reserves. So, you can see that
practically, it cost nothing; though, there are currencies minting cost; it involves some
currency distribution cost, all these are very nominal cost. And maintaining reserve also
involves some nominal cost.

But in overall, as compared to the income that they are earning from these assets, it cost
nothing, mini-meager amount. So, in that way, Central bank can earn huge profit from their
operations.
(Refer Slide Time: 09:44)

You are now familiar with what are the key components of a Central bank’s asset side and the
liability side. Let us now see when Central bank using open market operations, that is buying
and selling government securities, how does it affect the balance sheet of the commercial
banks?

And then, what are the impact of open market operations on the monetary base and the
money supply? So, in this session, we will mainly focus on the monetary base, to see how
does open market operation affect the monetary base.

(Refer Slide Time: 10:29)

So, let us start for example, suppose that Fed purchases 100 dollars of bonds, that is
government securities from a bank and pays for them with 100 dollars check. So, result, what
are the resulting changes in the T account.

So, we can see that, in the banking system, we can see that the amount of their securities has
declined by 100 dollars, then you know that when this one is transferred to the Fed, the Fed
will be crediting in the accounts of the banking system with 100 dollars.

Immediately, there is an increase in the reserve of the banking system by 100 dollars. How
about the federal reserve system? And you can see that federal reserve system’s assets have
increased by 100 dollars; but when they are getting this asset, they must credit 100 dollars in
the account of the bank who had sold this security to the Fed; that means, the liability of the
federal reserve system is increased by 100 dollars.

So, let us see the net result here is that the reserves have increased by 100 dollars; that means,
through an open market operation, that is through an open market purchase from a bank, the
net result that in the banking systems reserves have increased by 100 dollars. And, about the
currency in circulation? We can see that, there is no change in currency in circulation
immediately after that.

So, what is monetary base? Monetary base, we already seen the monetary base means C plus
reserve with the banking system. So, in the monetary base, we see that there is no change in
currency in circulation, but the reserve has increased.

So, you can see that, because of this open market purchase, the monetary base has increased
by 100 dollars, that is the first impact of Open market purchase in the banking system. The
reserve of the banking system has risen by 100 dollars.
(Refer Slide Time: 12:56)

Let us discuss two cases of open market purchase, 1 is open market purchase from nonbank
public that is the public. Assume that a person or a corporation sells 100 dollars of bonds to
the Fed and deposit the check in a local bank.

So, how does it affect the nonbank public balance sheet? Suppose the corporation, you can
see that their securities have declined by 100 dollars, and checkable deposits increased by
100 dollar; that means, when the Fed issue a check and this check has been deposited in a
bank, then you know that a bank will be crediting this amount of 100 dollar immediately in
the account of the depositor; that means, in the form of a checkable deposit.

That means, nonbank public checkable deposit has increased by 100 dollars. Then, about the
banking system and you can see that immediately when the public or the corporation deposit
this money in the banking system, this check will be presented to the Federal resource
system.

So, Central bank will be crediting these 100 dollars in the account of this banking system,
then you can see that, immediately, this crediting means nothing but an increase in the
reserve, the reserve of the banking system increased by 100 dollars. At the same time,
liabilities you know that this amount, this bank already credited in the account of as
checkable deposit in the account of the depositor. So, that is, checkable deposit also increases.
So, in the banking system, assets increased by 100 dollars and liability increased by 100
dollars. What about the federal reserve system? So, you can see that federal reserve system’s
security increases, that assets increased by 100 dollar and the liability also increased by 100
dollars.

So, what is the net outcome you can see that the net result here is that reserves have increased
by 100 dollars. But no changes in currency here and again, what we have seen in the previous
discussion, like that, the monetary base has increased by 100 dollars. Later, we are going to
discuss the monetary base is going to play a crucial role in determining the money supply.

Monetary base is the main tool or route through which a Central bank can influence money
supply in an economy.

(Refer Slide Time: 15:58)

Let us see another case, case 2, again, open market purchase from non-general public. But
here the person selling the bonds or the corporation selling the bonds, cashes the Fed check
either at a local bank or at the Fed for currency, immediately. They are not keeping these
proceeds from the selling of this bond in the form of deposit, instead they just cash it out and
you can just see that nonbank public, the securities have declined by 100 dollar and currency
has increased by 100 dollars.

And, what about the federal reserve system? We can see that securities how increase; that
means, asset has increased, at the same time liabilities also increased. Assets and liabilities
both have increased by 100 dollars here. We can see that there is no change in the reserve;
because it is not going through the banking system, they are not keeping it with there at all.

So, we can see that there are no reserves. Reserves are unchanged because the seller of this
bond immediately cashed it out. They are not keeping it as a checkable deposit with the
banking system. So, currency in circulation has increased by 100 dollar and the monetary
base, C plus R, the R remaining constant, but currency in circulation has increased, thereby
the monetary base also increased by 100 dollars.

(Refer Slide Time: 17:38)

The summary here is that in both processes, be it whether person selling the bond and deposit
the check in a bank or person selling the bond to the Fed cashes the Fed check either at a
local bank or Fed for a currency, in both cases what we are going to see that MB that is C
plus R, in one process 1st process we can see a R has increased. In 2nd case we can see
currency has increased.

In both processes, either it does not matter, but because the monetary base increase in the
same amount. Does not matter whether they are depositing in a bank or cashes the proceeds.
So, net outcome is that monetary base increases.
(Refer Slide Time: 18:50)

So, this is the summary, we can do that the open market purchase, the effects of open market
purchase on reserves depends on whether the seller of the bonds keep the proceeds from the
sale of sale in currency or in deposits. If the proceeds from the sale are kept in currency, open
market operation purchase has no effect on reserve, that is one point. And, if the proceeds are
kept as deposits, then the resource increased by the amount of the open market purchase.

So, the effect of open market operation purchase on the MB; however, it’s always the same;
that means, MB increases by the amount of the purchase, whether the seller of the bonds keep
the proceeds in deposits or in currency.
(Refer Slide Time: 19:48)

So, now let us see, shifts from deposits into currency. Suppose that a person decides to close
her account, her, or his account by withdrawing his or her 100 balances in cash and wow
never to deposit it in a bank again. In this case, you can see that banking system loses 100
dollar of deposits and hence 100 dollars of reserves as well. So, the main point here is that,
even if there is a shift from deposits into currency, the monetary base is unaffected by
persons’ disgust at the banking system.

(Refer Slide Time: 20:44)

So, shift from deposit into currency, let us see how it affects monetary base. Nonbank
public’s checkable deposits decline: that means, currency in circulation increases, we can see
that deposit component declines and C component that the currency component increases.

In the banking system, what you can see that, there is a decline in the reserve, as well as a
decline in the checkable deposits.

So, in this case also, again our MB definition is C plus R. So, we can see that, though
reserves have declined, but C has increased. So, the monetary base remaining unaffected. So,
the reserve declined by 100 dollars, but currency in circulation increased by 100 dollars here.
So, in summary, we can say that monetary base is unaffected.

(Refer Slide Time: 22:00)

The second one is discounting of loans by the Central bank. So, what is mean by discounting
of loans? It’s a borrowing window, the discounting window, that is direct loan to commercial
banks without collaterals by central bank.

In practice, it is considered as long-term loans to commercial banks by the RBI at a discount

rate. So, this is mainly done as a lender of last resort role. And, coming to nonbanking
financial institution, they are not allowed to use this discount window, but can participate in
the open market operation with government securities.
(Refer Slide Time: 22:57)

So, let us now discuss how making a discount loan to a bank, affect the monetary base. So,
here we are going to discuss how making a discount loan may affect the T account of banking
system and federal reserve system and its subsequent impact on the monetary base. So, when
the Fed makes a 100-dollar discount loan, to one commercial bank, let us call it as First
National Bank, a name to a commercial bank.

How does it affect the balance sheet? So, you know that the bank is credited with 100 dollars
of reserves from the proceeds of the loan. So; that means, putting in another words, when the
federal reserve system or the Central bank makes a loan to the commercial bank, the proceeds
will be immediately credited with the commercial bank in the form of reserve; that means, in
the banking system you can see that, the reserve will be increased by 100 dollars, that is, the
asset of the banking system increased by 100 dollars.

But the liability also increases; that means, a discount of loan, because its borrowing from
Fed also increases. You can see that the monetary liabilities of the federal reserve system now
increased by 100 dollars in the form of reserves. And the asset also increased because it has
given a loan of 100 dollars to the banking system.

So, here, we can see that the monetary base, when a Central bank give discount loan to
commercial bank, the immediate impact is that the monetary base increases; that means,
increased by 100 dollars.
(Refer Slide Time: 25:01)

So, this is the one effect. As like open market operation when a Central bank is giving a loan
through the discount window, then we can see that the monetary base is increasing.

So, this is the 2nd tool, that is discount loan through which a Central bank can affect the
monetary base. What if the commercial bank repays a discount loan from the Fed? If the
bank pays back of the loan from the Fed, thereby reducing is borrowing from the Fed by 100,
the net effect is that there is a reduction in the monetary base. There is a reduction in the
reserves, thus, the asset also declines.

To summarize, these are the two tools that we have discussed. The one is open market
operations and another one is discount loans.
(Refer Slide Time: 26:39)

Then the 3rd part is ‘other factors affecting the monetary base’. There are mainly two
important items that affect monetary base, but they are not controlled by the Fed. So,
importantly recall that, Central bank or the federal reserve can control open market operations
and discount window, but the other items are not in the control of the Fed.

One is called float; float means when the Fed clears checks for banks. It often credits the
amount of the check to a bank that has deposited it. It increases the banks reserves, but only
later debits it; that means, decreases the reserve of the bank on which the check is drawn.
Suppose, for example, you have an account with the State Bank of India, and you write a
check to another person who is having an account with another bank.

For example, you are having an account in the SBI, and you write a check, and you hand it
over to a person or a company who is having account in another bank called HDFC, then the
proceed, how this transaction will be settled, the person who is getting this check will
immediately depositing this one with the HDFC and HDFC will be submitting it into the
RBI.

So, when the person who gets this check and deposit with the HDFC bank, immediately this
much money will be credited into the account of this person who is depositing this cheque;
that means, for example, this one is 100 dollars, this one will be immediately credited to the
account holder of HDFC. And immediately you can see that it would not be debited in the
SBI account; that means, SBI the same amount of money will be there.
So, it will take some time, maybe a couple of minutes when they deposited with the RBI. And
RBI will be deducting from SBI. It may take some couple of minutes or may be hours, that
means, until then, this money it is credited into the account of who deposited this check with
the HDFC and it also you can see that this is yet to be deducted, that 100 dollar is yet to be
deducted from the account of SBI.

So, this amount is called float, resulting temporary net increase in the total amount of
reserves in the banking system.

So, this is occurring from the Fed’s check clearing process, this is called floating. So, it
causes a temporary rise in the reserves in the banking system and thus the monetary base also
rises.

(Refer Slide Time: 29:38)

And 2nd one is treasury deposits at the Federal reserve. When the treasury moves its account
from commercial banks to the Fed, it also causes a deposit outflow at these banks. So, when
there is a deposit outflow, because when the government deposit their money at the federal
reserve, when they move their deposit from the commercial bank to the federal reserve
system, it causes a fall in the resource in the banking system and thus the monetary base also
falls. So, importantly we saw two things, one is float and another one is treasury deposit
movement. So, both you can say that there is an impact in monetary base, but this change in
monetary base is not at the hands of the Federal reserve system, not with the Central bank.
So, what we have covered here is mainly how the Fed can Fed through the open market
operation and discount window influence the monetary base. But there are other factors
which also affects monetary base, but not in the control of the federal resource system. Thank
you for watching this video and see you in the next session

Thank you.

Keywords: central bank, balance sheet, currency, reserves, open market operation, discount
loans, cheques, cash, monetary base, money supply, float, treasury deposit at central bank