Chapter 8: The means of monetary and foreign trade policy





01st The mode of operations of the bank rate policy

02nd Difficulties in the banking system

03rd Measures to overcome these difficulties

04th Difficulties caused by foreign trade

05th Measures to overcome these difficulties

06th Difficulties due to insufficient interest rate elasticity

07th Difficulties due to insufficient price flexibilities

08th The instrument of monetary policy of the European Central Bank



01st The mode of operations of the bank rate policy


Before the establishment of the European Monetary Union, a distinction was traditionally made between the following instruments of the central bank:


· the bank rate,

· the Lombard rate and

· the key interest rate for repurchase operations.


Initially, we examine the mode of operations of a bank rate variation. The bank rate is the interest rate that the central bank charges to private banks that take a loan from the central bank. A bank rate increase will result in:


· a decline in the demand for credit by the banks,

· a lower money supply by the banks,

· higher debit interest rates for the bank customers and finally in

· a lower demand for investment credit.


As a result, an increase in the bank rate will dampen the economy. As it is the case with any good, if private banks demand credit from the central bank, then an increase in interest rates will have a dampening effect on demand. But if private banks take out fewer credits from the central bank, they also have less liquidity and can therefore grant only fewer credits to private customers (enterprises and households).


The reduction in the credit offer by private banks is linked to an increase in the debit interest that bank customers must pay to private banks. Enterprises and households are finally responding to the interest rate increase with a decline in demand for credits. A bank rate increase by the central bank is thus in principle a suitable means of slowing down the economy in times of an overheated economic situation.


Analogous effects can be seen with a bank rate reduction. This leads to:


· an increase in the demand for credit by banks,

· an increased money supply by the banks,

· lower debit interest rates and finally to

· an increased investment credit demand.



02nd Difficulties in the banking system


However, we cannot always expect private banks to react to a change in the bank rate in the manner described above and thus guarantee the success of the policy of the central bank. This is the case because the banks do not react if they have a high level of liquidity and are therefore not dependent at all on the credits of the central banks. But if private banks do not incur any higher costs due to an increase in the bank rate, there is neither a reason why the interest rate variations initiated by the central bank should be passed on to the customers of the private banks. If the private banks compete, they will only raise their debit interest rates if they themselves have higher costs. An unnecessary increase in debit interests would entail the risk that customers would migrate to competitors.


Now, the savings deposits of customers at the private banks are certainly limited. But if private banks often have a nevertheless high level of liquidity, even without borrowing from the central bank, then this is because the private banks have the possibility of creating deposit money, based on which the banks can grant a multiple of the deposits as credits.


This possibility for the creation of means of payment applies primarily to the entire banking system. To a limited extent, an individual bank also has the possibility of creating a limited amount of bank money on its own. These possibilities of an individual bank result from the fact that, on the one hand, a part of the borrowed money is transferred to customers of the same bank and, on the other hand, that the requested credit amount is usually not used 100%.


As a rule, investment projects are associated with a certain risk, and often it is not obvious at all before the execution of an investment which total cost will be entailed for the investor. It must also be reckoned always that not everything works out as it should, and that therefore in connection with an investment further costs will arise in the future which could not have been foreseen at the beginning of this investment.


All these reasons usually cause investors to apply for a slightly higher credit amount than the investment project requires if everything works out well. But this also means that, on average, not the entire approved credit amount is drawn down. Based on the previous experience, the private bank can as-sume that on average a certain percentage of the credit amount is not withdrawn and can therefore be lent again to another customer as a credit.


The following table shows how great the money creation opportunities of an individual bank are. The money creation multiplier calculated in this way indicates how many times the deposit total can be lent as a credit.


Take the case, that a bank has a surplus reserve of 100 (e.g. one hundred thousand €). This bank can therefore grant a credit in the amount of this deposit, i.e. a total of 100, in the first period. We like to suppose now that experience showed that on average 80% of the credit amount is withdrawn, i.e. neither returned as a transfer to the bank granting the credit nor spent.


The bank thus retains 20 monetary units for a further credit in the next period. This surplus continues in the following periods, in the second period 20% of 80 = 4% and so on can be lent additionally.


In this way, a principally infinite number of further credit granting is created. The sum of all these credits based on the initial surplus reserve of 100 can be calculated according to the formula for infinite sums, which results, as is well known, in a certainly finite total value. In our example, the total amount of credits granted adds up to the threshold value of 125. Even though this is principally an infinite series, our example shows that the threshold value was almost reached very soon (in our example already after the third period). (B1)




Greater opportunities arise when the entire banking system is considered. The precondition, however, is the lockstep of the banks. The amount of the money creation depends on the cash management of the economic entities. The credit multiplier under consideration here is much larger than the corresponding multiplier of a single bank, since the largest part of the credit amount returns in form of transfers to one of the banks.


If a customer receives a loan of 100, only a small part of this credit amount will be transferred to the accounts of the credit granting bank. However, it can be expected that the largest part of the credit amount drawn down will be transferred to the accounts of any bank, so that the largest part of the credit amount will remain in the banking system. Only a small part is paid out in cash by the recipients of these sums of money and thus no longer returns to the banking system by transfer.


We want to assume now that on average 20% of a credit sum is held in cash by households and enterprises. If we assume again an excess reserve of 100, then 80 monetary units will remain in the banking system and can therefore be lent again in the next period. In this way, an infinite series of credit amounts is created. But now that a much smaller amount leaves the banking system, the sum of these credits is also much higher than the credit multiplier of a single bank. In the second period 80 monetary units can still be lent, in the third further 64 monetary units. The total amount reaches its limit at 500 monetary units. Thus here, the bank credit multiplier would be 5. (B2)



However, banks will only be able to increase their bank money amount if the banks proceed in lock-step, i.e. if not just one bank, but all or still most banks try to increase their bank money amount by the same percentage rate.


Let us take the case of a single bank attempting to increase its credits without having previously raised bank deposits. In this case, the bank cannot assume that the accounts of customers who have not applied for additional credit will also increase. Only the funds which the borrower himself transfers to accounts of the same bank return to the lending bank.


If, however, the other banks are also willing to expand their lending volume and if they do so exactly to the extent of the first bank, it can be expected that approximately the same percentage of the granted credit amount will be returned to accounts of the same bank as in the past. Although these funds do not return because they were ultimately spent by the bank itself, money returns because the other banks have also expanded their credit volume to the same extent.


This means, however, that the power of private banks to create bank money and therewith foil the aim of the central bank depends on whether the banks are willing to increase their credit amount to the same extent, thus proceeding in lockstep.


A lockstep in this sense is not only present if the banks would enter into a cartel-like agreement concerning this intention. Such an approach would in any case be prevented by most state supervisory authorities. It is quite sufficient if banks expand their credit offer to the same extent spontaneously, i.e. without any particular agreement. With the increase in the accounts of their customers who have not received any credit from this bank, a bank can very well register whether and to what approximate extent the other banks have expanded their credit offers.



03rd Measures to overcome these difficulties


Two instruments were given to the central bank to overcome these difficulties in the postwar period: the collection of a minimum reserve and the possibility of open market policy.


The minimum reserve comprises the requirement for private banks to deposit a certain percentage of their liabilities with the central bank as minimum reserve. The central bank now has the right to vary the minimum reserve rates and to set different rates depending on the modality. Originally, the minimum reserve did not bear interest.


Within the framework of open market policy, the central bank can act as buyer or seller on the money markets and capital markets and thus influence the money in circulation and the level of interest rates.


The difference between the money market and capital market is that short-term credits are traded on the money markets and long-term investments are traded on the capital markets. In principle, the central bank can set the interest rate at which it buys or sells money or securities and leave it to the market to determine the size of these revenues. Or the central bank can also determine the amount of money or the amount of securities. Here, the market decides which interest rate is finally set based on these market movements.


Let us start with the analysis of minimum reserve policy:


A certain percentage of the liabilities of the bank must be deposited with the central bank. This percentage varies according to the investment. These deposits were interest-free in the national monetary system of the Federal Republic of Germany. As will be shown later, the monetary system of the European Community provides for an interest rate of these deposits, although the minimum reserve policy is no longer the centre of the monetary policy efforts of the European payment bank.


The obligation to hold minimum reserves changes the credit multiplier of the private banks. The part of the excess reserve that can no more be loaned further refers to both the average cash position (k = 0.2) and the legal minimum reserve (r = 0.2*V). Accordingly, the summation formula also results in a much lower value for the overall bank money creation. In our example, the multiplier is slightly more than 2.7 times. (B3)


The obligation to hold minimum reserves was already introduced in connection with the global economic crisis at the end of the 1920s. However, initially it only fulfilled a safety function. This should ensure that banks are able to satisfy increased withdrawals of money in times of recession. Thus, the minimum reserve was back then a kind of reserve on which private banks could fall back if customers had their savings deposits paid out in times of a commencing financial crisis and the private banks therefore would become insolvent without this reserve.


In the period after the Second World War, the minimum reserve was introduced as a control instrument. In this way, the central bank should be given the possibility to control the creation of bank money by private banks.


A differentiation was made according to the maturity of the deposits and the size of the banking institution. There happened to be further differences in whether credits were granted to residents or nonresidents, whether main and secondary places were present and whether the minimum reserve was raised on the stock or the growth of deposits. While initially a minimum reserve had to be established only for deposit business, an extension of the minimum reserve requirement also to lending business was introduced later.


Let us now look on greater detail on the instrument of open market policy:


The central bank has the right to buy or sell securities. At this, a distinction is made between price policies and quantity (tender) policies. In price policy, the central bank sets the interest rate at which it buys or sells securities. The exchange partners of the central bank now decide how many securities they want to buy or sell at this interest rate set by the central bank.


In its quantity policy, the central bank determines the volume of securities which it buys or sells and leaves it to the market to find the interest rate where supply and demand correspond.


Both instruments (minimum reserve plus open market policy) have been used in combination in practice: on the one hand, free funds were tied up by the minimum reserve obligation; on the other hand, banks were induced by the open market policy to invest their free cash reserves in securities.


Now, what are the limitations of an open market policy? The central bank does not always have enough securities in its portfolio. However, these difficulties were overcome in the past by the federal government creating socalled mobilisation papers to overcome this difficulty.


A second limitation of an open market policy is given when the liquidity preference of the privates is high and therefore their willingness to buy securities is low. We have already seen above that Keynes has shown in its liquidity theory that it can be quite rational for economic entities to hold their savings in cash temporarily and therefore go without the interest they would have received if they bought securities.


Such behaviour may be rational when the interest rate is extremely low, and it can be assumed that the interest rate will rise soon. Increased interest rates mean that the investment in fixed income securities now yields a lower interest rate than other investments and that therefore fixed income securities are sold. This however leads to a price reduction. And this price reduction can turn out so highly that the loss caused thereby is larger than the anyway small interest yield. Thus, it can very well be rational to keep money in cash temporarily in times of low interest rates.


If both the bank rate policy and the open market policy fail to reach their aims, the central banks can usually resort to dirigiste measures as ultima ratio. These include:


· the rediscount allocation,

· the allocation of the securities lending, and

· the ceilings for credits.



Here, the instrument of rediscount allocation refers to the possibility for the central bank to provide the individual banks with only a limited contingent of credits; the central banks could also provide maximum contingents for securities lending. Finally, the granting of credit by private banks could also be limited.



04th Difficulties caused by foreign trade


Due to the convertibility of currencies, money supply control can be undermined in certain cases. Private banks and enterprises usually have the possibility to raise money abroad. Here, the control by the central bank fails, as it has no possibility to prevent this borrowing due to fundamentally free international capital movements.


Furthermore, it must be reckoned with the possibility that an import of inflation and unemployment will take place in a system of fixed exchange rates. Although Classics and Keynesians reach at the same results, they base this result on different mechanisms of action.


From a Keynesian point of view the following applies: if the inflation rate abroad is higher than domestically, export opportunities improve and at the same time the demand for imported goods from abroad decreases. This results in a current account surplus, which in turn increases domestic demand and therefore also domestic inflation.    (B4)


In the Classical approach, however, the following applies: If the inflation rate abroad is higher than domestically, there results a current account surplus. So much for the similarity of both schools. Due to the intervention of the central bank in the foreign exchange markets, however, the domestic money supply is being expanded and this expansion of the money supply leads to domestic inflation. The difference between these two approaches thus lies in the fact that in a quantity theoretical approach the domestic price level rises due to an increase in the money supply, whereas in a demand theoretical approach the increase in the price level is explained directly with demand surpluses. (B5)


The impediment of the domestic monetary policy can furthermore be triggered by capital movements. If it cannot be assumed that the same monetary policy measures will be taken abroad, there will be an arbitrage margin between home and abroad, with the result that interest rate-induced international capital movements will occur: for example, if the domestic interest rate decreases and the foreign country does not follow this policy, a capital export takes place, since now a capital investment receives a higher interest rate abroad than domestically. This capital migration can lead to a rise in interest rates now within the framework of a system of fixed exchange rates, thus impeding expansionary monetary policy. Let us illustrate this connection with a concrete example.


A resident wants to invest his savings in a foreign security. To purchase this foreign security, he needs foreign exchange. This additional demand for foreign exchange would lead to an increase in the exchange rate on a free exchange market. In order to prevent this increase, the central bank must offer foreign exchange in a system of fixed exchange rates and this sale of foreign exchange effects that domestic money is taken out of the circulation.


A reduction in the amount of domestic money in circulation, however, will in turn lead to an increase in the interest rate. But this means that the expansionary monetary policy (the interest rate cut) is undermined. In this context, it is spoken of crowding out which is triggered by international capital movements. Thus, the following chain of effects applies: (B6)


· KEX: capital export

· i: interest rate

· NEDEV: demand for foreign exchange

· MI: domestic money supply


Finally, an import of inflation can also occur in a system of free exchange rates, like if e.g. the oil price rises (p$): more foreign exchange is in demand (NEDevisen+), the exchange rate rises (w$+) accompanied by the cost of living (pC$) as well as the prices of imported raw materials (pInl$). Both pro-cesses increase domestic inflation (PInl$). (B7)



05th Measures to overcome these difficulties


Firstly, free convertibility could be abandoned. But this measure clearly contradicts the general principles within the EC and is therefore not under consideration.


Secondly, taxation can reduce the profitability of foreign capital that is invested domestically, but the Foreign Tax Act provides that these possibilities are limited to certain types of capital import.


Thirdly, the exchange rates could be adjusted by floating the exchange rates or by broadening the fluctuation bands.



06th Difficulties due to insufficient interest rate elasticity


Monetary policy measures can only be successful if the investments depend on the level of the interest rate. Now Keynes doubted that interest rate variations were capable of significantly influencing the volume of investment, thus that the interest rate elasticity of investment demand was low.


Possible reasons for a low interest rate elasticity of capital investments are:


The interest costs can be passed on to the price of the goods. This means, for example, that a reduction in interest rates does not at all improve the profit situation of the enterprises as intended, as the entrepreneurs must pass this interest gain on to the consumers due to strong competition in times of economic downturn.


In addition, the share of interest costs in total costs can be so small that changes in interest rates do not influence the investment behaviour of entrepreneurs (significance of the so-called payoff method).


Construction investments play a special role, since in this case very long investment periods are present and therefore high investment elasticity must be expected.


For the question of interest rate elasticity, it also matters whether rationalisation investments or expansion investments are present: rationalisation investments react very well to interest rates! This applies also or particularly in times of economic downturn. In an economic downturn, entrepreneurs can improve their sales situation by means of cost-cutting or quality-enhancing investments. Only expansion investments decline in times of economic downturn, since production capacity is too large anyway.


Let us ask ourselves now which influence the interest rate policy has on private savings: According to neoclassical understanding, an increase in interest rates should trigger an increase in savings and thus cause a decline in consumption.


According to Keynesian ideas, this effect does not occur, since the savings only represented a residual and the corresponding consumption rate was only dependent on income. If savings are made for a commercial motive, the desired interest rate effects occur, though. But if savings are made for a certain purpose, an increase in interest rates even causes a decrease in savings. Thus, it must be expected that the different reactions to interest rate changes cancel each other out at least partly, so that on balance interest rate changes do not lead to any significant changes in the savings volume.


07th Difficulties due to insufficient price flexibilities


Monetary policy can also fail due to insufficient price flexibility. Let us initially consider the case of a restrictive economic policy. The intention is to stop the price increase with a contractive monetary policy. Instead of prices, however, the quantities of goods may possibly decrease if excess supplies are not responded with price reductions.


With stagflation, there is a price increase even despite a decline in demand. A possible explanation for this is that the costs increase due to the high share of fixed costs when the production volume is reduced. Thus, the entrepreneurs produce in the still descending branch of the unit cost function, here. With this development of prices and quantities, however, it is no longer possible to influence prices. If the central bank tries to prevent the price increase by a contractive monetary policy, then indeed the demand decreases, the excess demand is being reduced. Nevertheless, prices are rising.


For example, we assume production x. Since the unit cost curve first shows a decreasing trend and then a rising trend only after a critical limit, and since current production was still in the range of decreasing unit costs, the decline in demand shows a price-increasing effect.  (B8)



We now consider the case of an expansive economic policy: there is a risk of structural unemployment. If bottlenecks are present, though, economic policy will reach its limits. The interest rate cut should lead to an increase in demand for goods and via demand to an increase in employment.


It is thus produced here in the ascending branch of the cost function. But, since the capacity limit (x1) has already been reached, production cannot be expanded at all here, at least not in the short term; the increases in demand almost completely vanish into price increases. (B9)



08th The instrument of monetary policy of the European Central Bank


The monetary policy instruments differ from the monetary policy instruments currently in force in the FRG. Insofar as the instruments of bank rate and Lombard rate policy were abolished. As before, a refinancing of the banks is taking place, though. The key interest rates are decisive here.


A distinction is made between short-term repurchase operations and outright purchases or sales of securities. Whereas securities sold at repurchase operations must be redeemed again by banks in a future period, within the framework of open market policy securities are bought or sold outright. National monetary authorities have access possibilities to foreign exchange credits (facilities).


The importance of the minimum reserve policy has decreased. A limited use of bank deposits is still possible, but on these deposits, there occurs in principle an interest payment now. However, the current interest rate may drop to zero at times.