Banking Loans, Deposits, Reserves
So far we have studied the effects of domestic economic entities such as households, firms and governments on the money supply in the economy. We have also seen the effects of foreign investments on the supply of money, the effect of interest rates on the HPY of foreign assets, how economic events such as an increase in government deficits impact foreign flows and other such direct and indirect linkages.
These linkages present an opportunity for the government to influence the factors that cause demand and supply curves to shift thereby impacting interest rates and influencing growth and inflation. For example by increasing or decreasing tax rates or spending the government can impact the behaviour of households and firms thereby influencing money supply, interest rates and in turn growth, employment and inflation. Such policies are called fiscal policies and the responsibility for implementing fiscal policies in the US are shared by the White House and Congress. However these fiscal policies do not impact financial intermediaries such as banks directly.
We have mentioned that banks influence the money supply through loanable funds which in turn impacts the interest rates in the economy – a function far too important to be left to banks to monitor and influence. The government therefore forms a central bank, a banker for banks, that sets policies to regulate the influence of banks on the supply of money. The central bankâ€™s use tools such as reserves, open market operations, Fed funds rates etc that we need to understand so that when the Fed makes changes in their policies we can decipher its impact on the markets. In 1913, the Congress created the Federal Reserve System in the US for implementing the monetary policy. Policy changes also influences the pace of money creation, which in turn affects growth and inflation.
We need to understand what exactly the central bankâ€™s can and cannot control, the tools it uses, the economic data it monitors, how it implements monetary policy and much more. Now that we understand macroeconomic indicators, how indicators affect the behaviours of economic entities causing shifts in money supply or demanded, in turn causing shifts in interest rates and in turn affecting growth and inflation.
Factors that determine monetary policy such as economic indicators and tools that are used in implementing monetary policy are essential to know by traders and investors. The final objective is to decipher the signals the Federal Reserve Bank sends to the market about the desired levels of short term rates. Understanding how the monetary policy works is key to understanding the direction of short term interest rates. Any changes in policy can then be spotted to provide us early warning signals that interest rates are going to change, allowing us to position ourselves accordingly.
We still need to build on some more foundations before we can begin to understand the central bankâ€™s monetary policy determination and implementation. When introducing banking in our fictitious economy we had introduced the term reserves when discussing fractional reserve banking. With the invention of fractional reserve banking the one-to-one correspondence between bank deposits and cash in vaults no longer held true. Deposits were created when loans were sanctioned. Cash in vaults is a small percentage of deposits and now represent reserves required for servicing cash or cheque withdrawals.
In order for central bankâ€™s to influence the banking sector to impact interest rates, it needs to influence the quantity of loans created by the banking system. The question that therefore beckons is how can the central bankâ€™s influence loan creation by the banking system? What are the parameters of banks that can be influenced to alter their behaviour?
To understand this we need to understand a bit more about how a bank functions.