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4. Monetary Accounting and Analysis1

International Monetary Fund
Published Date:
November 2005
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a. Some basic concepts

The monetary accounts are important because changes in liquidity can affect spending, output, and jobs, the average price level in the economy, and the balance of payments. In fact, change in the size of the money stock is one of the main policy instruments by which the authorities influence macroeconomic developments. The size of the money supply is strongly influenced by the central bank in a typical country. Money demand is determined by the behavior of economic agents, especially by households and firms. As a first approximation, it is the quantity demanded that adjusts to a change in supply. The factors that influence whether people would prefer to hold more or less money—especially real incomes, prices, and interest rates—will change in response to changes in liquidity until money demand moves into line with the level of supply set by the authorities.

Historically, commercial banks printed their own currency (“banknotes”). There was an expectation that banks would not create more notes than their holdings of precious metals would support. However, occasionally banks were mismanaged, and even well-managed banks could experience sudden large demands for withdrawals caused by rumors that the bank might be weak. Speculative panics against commercial banks in earlier centuries sometimes resulted in great losses to depositors. These disastrous experiences, sometimes not founded on any actual weakness, gave impetus to the “invention” of the central bank.

The central bank (called the “monetary authorities” in this chapter, for reasons given below) is part of government. Nevertheless, for macroeconomic analysis it is useful to separate the monetary role of government from the fiscal role, and the central bank and the finance ministry are treated as strictly separate throughout these chapters. In a typical arrangement, the central bank imposes certain regulations on commercial banks (also called “deposit money banks” in this chapter). Banks must hold reserves in the form of deposits with the central bank equal to a percentage of their deposit liabilities to the public. Besides that, banks must accept certain other prudential restrictions, including supervision of lending practices by the central bank. In exchange for this, the central bank is prepared to come to the defense of a commercial bank experiencing a “run” (a sudden large speculative withdrawal). The liquid resources of the central bank are sufficiently large that depositors are given confidence—if they stand in line long enough, they can all withdraw all of their deposits, down to the last kopek or centime; the bank need not “fail” because of speculation, whether the speculation is rational or irrational. Experience with central banking as a technique to prevent speculative runs on banks has been overwhelmingly positive, and in prudently managed systems the phenomenon of speculative withdrawals leading to bank failure had become rare by the middle of this century.2

One implication of the prudential rules established in the early days of central banking is that the central bank is assigned great influence over the size of commercial bank reserves. Typically, the central bank has the authority to change the minimum allowable level of reserves, and it can also engage in the sale or purchase of financial assets with the domestic public or foreigners—it can in principle sell or buy government securities, foreign exchange, and perhaps other kinds of assets, including its own IOU’s if it chooses to do so. These sales and purchases have a direct effect on banks’ reserves, as explained below in this chapter. But, by changing the level of reserves, and under conditions of fixed minimum required-reserve ratios, the central bank also determines the maximum amount of bank deposits that can be in existence at any moment. In a modern economy, these deposits form the largest part of what is conventionally defined to be the money supply.

While central banking has proved to be an effective tool in heading off domestic banking panics, it may not be successful in the case of a sudden speculative outflow of foreign exchange—a trade of domestic assets for foreign assets by domestic and foreign holders. The central bank can defuse domestic speculation against domestic banks partly because of its monopoly power to create domestic money, whereas foreign “capital” (financial) outflows involve foreign money. How to design a set of institutions and policies effective in offsetting disruptive outflows of foreign finance is an important issue at the present time.

b. Monetary accounting

(1) The structure of the financial system

Financial institutions specialize in channeling financial savings to firms planning to undertake real investment, although financial institutions can also provide funds for government and households. This process, called financial intermediation, is accompanied by a transformation of the maturity structure of financial assets. Typically the funds of savers are committed for a shorter period, while finance to borrowers is promised for a longer period. Both banks and nonbank financial institutions play a role in this process. Viable banks must attract a continuing inflow of deposits, at least enough to offset their withdrawals, in order to sustain a loan portfolio. In this way, banks add to the supply of longer-term funds available to borrowers in an economy. From funds deposited with the banking system, borrowers gain access to savings through a variety of credit instruments including commercial paper, mortgages, revolving consumer credit schemes, and mutual funds, as well as bank loans. These credits generally come from the shorter end of the maturity spectrum.3 Nonbank financial institutions provide credit in longer maturity categories, complimenting the role of banks in converting savings into funds for economic investment.

The financial system consists of deposit money banks and nonbank financial institutions such as insurance companies, mutual funds, pension funds, and money market funds. In many countries, there is a third sector, the unorganized financial sector, which can often be an important part of the financial system. The unofficial sector is comprised of small moneylenders and small-scale informal savings clubs.

The banking system, which consists of the monetary authorities (MA) and deposit money banks (DMBs), creates an economy’s means of payment, including currency and demand deposits. In International Financial Statistics (IFS), the IMF compilation of financial data reported to it by member countries, monetary and financial data are presented on three levels (see Figure 4.1). The first level contains the separate balance sheets for the monetary authorities and DMBs.4 The second level consolidates the data for the monetary authorities and the DMBs into the monetary survey, which provides a statistical measure of money and credit. Finally, the third level consolidates the monetary survey and the balance sheets of nonbank financial institutions (NBFIs) into the financial survey.

Figure 4.1.Scope of the Financial System

This chapter focuses on the banking system rather than the entire financial system, for three reasons. First, empirical evidence shows that the monetary liabilities of the banking sector strongly influence aggregate nominal spending in an economy and thereby affect the final objectives of economic policy—growth, inflation, and the balance of payments. Second, data for the banking system are usually readily available, even for developing and transition economies, making this source of information invaluable for timely economic analysis and monitoring of financial policies. And, third, in countries in which financial markets are not well developed, the banking system typically accounts for the bulk of an economy’s financial assets and liabilities (although, as noted above, the unorganized financial sector may also play an important role in financial intermediation in these economies).

(2) Accounting principles underlying monetary statistics

Stocks versus flows. Monetary statistics are based on balance sheets and therefore are compiled in the form of stock data—that is, in terms of aggregate values of assets and liabilities at a particular point in time rather than as flow data, which record transactions carried out over a period of time. Nevertheless, the statistics are analyzed in terms of changes in stocks from one period to the next, or in terms of flows. Since changes in stocks need to be assessed in relation to the value of assets or liabilities outstanding at the beginning of the period, both stocks and flows are important.

Cash versus accrual. IFS records transactions on a cash basis (when an obligation is settled rather than when it is incurred). In many countries, banking sector data tend to be recorded on an accrual basis (when a liability is incurred), because the balance sheets of the banking system from which the statistics are derived are constructed in accordance with the rules of business accounting. However, since most transactions of banks are typically carried out immediately in cash, this distinction is of little importance for banking data.

Currency denomination. Monetary accounts are expressed in domestic currency. All items denominated in foreign currency are converted into domestic currency at the exchange rate prevailing on the date the balance sheet is compiled (for yearly data this will be the end-year exchange rate, and so forth) because balance-sheet aggregates are stocks. This is in sharp contrast to the conversion of flow aggregates (such as imports or exports), which implicitly are converted at the period-average exchange rate.

Consolidation. Unlike aggregation, consolidation involves netting out the transactions between the entities being consolidated. For example, in consolidating the accounts of different deposit money banks, interbank entries (items due from and to other banks) are netted out. Two levels of consolidation are carried out for the monetary survey. First, the balance sheets of all DMBs are consolidated. Second, the balance sheet of the monetary authorities is consolidated with the consolidated balance sheet of all DMBs to obtain the monetary survey.

(3) The monetary authorities

The definition and role of monetary authorities

The term “monetary authorities” is a functional rather than an institutional concept. In most countries, the monetary authorities are represented by the central bank, but the concept can include agencies or parts of agencies of the government, such as the treasury, that perform some of the functions of a central bank. The monetary authorities issue currency, hold the country’s foreign exchange reserves, borrow for balance of payments purposes, act as banker to the government, supervise the banking system, and serve as lender of last resort to it. In some countries, the treasury issues coins and/or currency, and in a few cases, the treasury, or a treasury-controlled exchange stabilization fund, holds the official reserves. Under the reporting procedures used in IFS, all of the monetary functions of government are grouped with the accounts of the central bank so that they are presented under one accounting unit, the “monetary authorities.”

As noted above, an important function of the monetary authorities is to act as a lender of last resort to the banking system. When financial panic threatens the banking system, the monetary authorities need to take swift action to restore depositors’ confidence and avoid a sudden, speculative attempt by deposit-holders to withdraw their funds all at the same time. The rationale for using the central bank as a lender of last resort is based on the essentially illiquid nature of the credit system. While borrowers can, given time, repay their loans, they cannot do so on demand. If one deposit money bank has payment difficulties, the entire system can become illiquid, and because of the many layers of credit and intermediation in the system, the source of the actual default may not be clear. The result of this uncertainty is a systemwide crisis of confidence that leads to a credit “freeze.” To prevent financial collapse, the central bank can isolate the problem bank and guarantee payment to its depositors, preventing spillover effects in the credit market. As lender of last resort, the central bank comes into its own when it steps in to prevent illiquidity, either on the part of an individual bank or throughout the banking system.5

Because of its unique nature, the balance sheet of the monetary authorities has a central place in monetary analysis. The creation of high-powered money (also known as reserve money or the monetary base) is a prerogative of the monetary authorities. The control they exercise over the amount of high-powered money in the economy is the main route through which the monetary authorities control the money supply.6 Since the central bank creates reserve money whenever it acquires assets and pays for them by creating liabilities, an analysis of its balance sheet is the natural starting point to understanding the process of money creation. The monetary authorities’ operations, such as open market purchases or sales of government securities, lending to government as well as to the deposit money banks, and purchases and sales of foreign exchange—known as foreign exchange market intervention—all affect the amount of reserve money. By virtue of being the monopoly supplier of reserve money, the monetary authorities are the undisputed arbiter of monetary policy and monetary conditions in the economy.

The balance sheet of the monetary authorities

The main items in a typical balance sheet of a central bank are shown in Box 4.1, and an analytical summary table is presented in Box 4.2. While most of the items in the balance sheet are self-explanatory, it is important to highlight the key features of some of them, and to explain how they are combined in the analytical summary table.

Box 4.1.Typical Balance Sheet of the Monetary Authorities

GoldDeposits of foreign central banks
Foreign exchangeSwap facilities
Reserve position in the FundUse of IMF credit
Holdings of SDRsOther foreign liabilities
Deposits in foreign banks
Non-liquid foreign assetsCENTRAL GOVERNMENT DEPOSITS
Treasury billsCurrency issued
Other Government securitiesDeposit money banks’ deposits
Loans and advancesPublic sector demand deposits other than
Other claimscentral government
Nonmonetary financial institutions’ deposits
CLAIMS ON LOCAL GOVERNMENTSOther private sector demand deposits
Time deposits other than central government
CLAIMS ON NONFINANCIAL PUBLIC ENTERPRISESForeign currency deposits other than central government
Loans and advances
Bills and securitiesBONDS
Other claims
Rediscounts and secured advancesCapital
Loans and overdraftsReserves
Other claims
Rediscounts and secured advances
Loans and overdrafts
Other claims

Net foreign assets include the domestic currency value of (i) gross net official international reserves (including gold, foreign exchange, the country’s reserve position in the IMF, and holdings of SDRs); (ii) liquid foreign liabilities (including short-term liabilities to foreign monetary authorities—that is, deposits of foreign central banks—and swap facilities, overdrafts, and a country’s use of IMF credit); and (iii) any other foreign assets and liabilities of the monetary authorities such as inconvertible and medium- and long-term items.7 (For the treatment of IMF transactions, see Box 4.4).

While in many countries the net foreign assets of the monetary authorities are equated with net official international reserves, the definition of net foreign assets is broader than the definition of reserves. For example, in some transition economies, net foreign assets include the monetary authorities’ holdings of foreign assets that are not regarded as available if a balance of payments problem develops. Such holdings include foreign currency that cannot be freely exchanged for currencies commonly used in international transactions and claims arising from bilateral payments agreements. By definition, the latter category of assets can be used only for official settlements with specific countries.

Claims on government, net are direct loans to government plus government securities held by the monetary authorities. These liabilities are shown net of central government deposits. The reason for substracting deposits from credits is analytical, not due to accounting logic. For economic agents in general (such as enterprises and households), economic theory and empirical evidence strongly suggest that liquidity influences spending. A household with a large bank-deposit balance is more likely to spend than one with a low balance, other things (such as income) being equal. The central government, on the other hand, has special access to credit from the central bank and possibly from the securities markets, and its spending program is determined ultimately by the political process. The cash balance of the central government is unlikely to have a significant effect on its spending.

By excluding central government deposits from total banking system deposits in defining money (see below), one produces a superior measure of liquidity from the point of view of explaining changes in spending. On the other side of the ledger, by subtracting central government deposits from loans to central government, one also obtains a better measure of the effect of credit to government on economic resources and money growth; loans that are unspent do not lead to monetary expansion and upward pressure on the price level.8

Claims on deposit money banks include direct credits to DMBs and bills of exchange accepted for discount by the central bank. The central bank interest rate on either kind of loan to banks is called the discount rate. Both the amount of central bank lending to deposit money banks and the discount rate can be important instruments of discretionary monetary policy. These claims are gross claims; DMBs’ deposits in the central bank are not netted out.

Claims on the private sector are likely to be insignificant; typically it is the business of deposit money banks, not the central bank, to make loans to households and enterprises. Note, however, that this category may include the monetary authorities’ claims on nonbank financial institutions and on public enterprises.

Other items, net is a residual item equal to the difference between miscellaneous assets and miscellaneous liabilities. It may appear either as net assets or net liabilities. In Box 4.2, it is shown on the asset side. “Other items, net” includes: (i) the physical assets of banks (on the asset side); (ii) capital and reserves (as a liability); (iii) profits or losses of the central bank not transferred to government by the end of the accounting period; (iv) the offset to valuation adjustments to the net foreign asset position and to foreign-currency-denominated assets and liabilities resulting from changes in the exchange rate; and (v) any other items that have not been classified elsewhere.

Reserve money is the main liability of the monetary authorities, and it plays a central role in monetary analysis and policy. Reserve money is made up of bank reserves plus other liabilities of the central bank that could potentially become bank reserves. Although practice varies from country to country, typically reserve money includes currency that has been issued, whether held by banks (cash in vault) or by the nonbank public (currency in circulation), plus bank deposits with the monetary authorities. It excludes the deposits of the central government and of nonresidents; these are netted against claims on government and foreign assets, respectively. Deposits of other domestic sectors (including local governments and state enterprises, and also conceivably private individuals and firms) with the monetary authorities, if any, may be included as well as foreign currency deposits of residents.9

The analytical significance of reserve money is based on the fact that the central bank has the power to create potential bank reserves simply by writing a check against itself. When it makes a payment to a domestic resident (for instance, for a government bond it purchases from the resident) by writing a check, the resident will deposit the check in a deposit money bank, which in turn will deposit it at the central bank. The resulting increase in commercial bank deposits with the central bank adds to reserve money. No other entity in the economy has this authority.10

Box 4.2.Analytical Balance Sheet of the Monetary Authorities

Net foreign assets (NFA)Reserve money (RM)
Currency issued (CY)
Net Domestic Assets (NDA)Deposits of deposit money banks
Domestic credit (net) (NDG)Other nonbank, non-government
Claims on government, net (NCG)deposits.
Gross claims on the DMBs (CDMB)
Gross claims on other domestic economic sectors (CPS)
economic sectors (CPS)
Other items, net (OIN)

Given the balance sheet constraint that assets are identically equal to liabilities, it can be seen from Box 4.2 that changes in reserve money (RM) must be matched by changes on the asset side of the balance sheet of the monetary authorities (Box 4.3). An overall surplus (deficit) in the balance of payments adds to (subtracts from) the net international reserves of the monetary authorities. This increase (decrease) in net foreign assets will be associated with an increase (decrease) in reserve money. Similarly, if the monetary authorities bring about a net increase (decrease) in their domestic assets by buying (selling) government securities or making (calling in) loans to (from) deposit money banks, the increase (decrease) in these assets results in an increase (decrease) in reserve money.

The balance sheet constraint of the monetary authorities in Box 4.2 may be summarized by the identity

Define Δ to mean the change in a stock from the end of the preceding period to the end of the present period. Then, in terms of flows (changes in stocks), this identity can be rewritten as

Box 4.3.Chart of the Reserve Money Identity

Dividing both sides of equation (4.2) by the lagged value of reserve money,RMt-1, yields the growth rate of reserve money, ΔRMtRMt1,, on the left-hand side;

this can be expressed in terms of the “contributions” of the various asset items on the right-hand side:


In other words,

growth rate of reserve money = sum of weighted growth rates of asset items,

where the weights are the lagged relative shares in reserve money of the main asset items on the balance sheet.

The monetary authorities’ control over reserve money tends to be incomplete. Changes in net foreign assets, which are a reflection of the balance of payments outcome, cannot generally be considered to be a fully policy-controlled variable. Also, variations in claims on government are, in many countries, adjusted passively to the government’s budgetary position, especially in countries in which the central bank has limited independence from government. To some extent, perhaps small, the central bank can offset the effects on reserve money of the balance of payments and credit to government by its own purchases or sales of domestic assets to residents and nonresidents.

Interpretation of balance sheet changes

The monetary authorities influence monetary conditions through their control of reserve money. There are five main direct instruments available to them to do this: foreign exchange intervention, open market operations, financing of the budget deficit, rediscount policy, and changes in reserve requirements.11

  • Foreign exchange intervention: Monetary authorities intervene in the foreign exchange market, among other reasons, in order to defend the exchange rate and to achieve a desired amount of international reserves. Their interventions directly affect reserve money and hence have a direct impact on overall liquidity in the economy and the stance of monetary policy. For example, suppose an exporter deposits foreign exchange in an account at a commercial bank. The commercial bank has no prospective need for the foreign funds, and sells the exchange to the central bank. The central bank will pay for the foreign exchange by writing up the deposit balance of the commercial bank at the central bank. With its reserves now greater than the required minimum, the commercial bank may expand loans and deposits. In this way, the central bank purchase of foreign exchange increases reserve money. Its balance sheet of the central bank shows an increase in foreign assets and a corresponding rise in banks’ deposits. Conversely, when the central bank sells foreign exchange, foreign assets are reduced, and there is a corresponding reduction in reserve money.12
  • Open market operations: This consists of buying and selling government securities in the secondary market. For example, when the central bank purchases government securities from the public, the central bank’s holding of government securities increases (an increase in its assets), with an equal increase in liabilities (reserve money) in the form of larger commercial banks’ deposits in the central bank. Conversely, a sale of government securities to the public will reduce the central bank’s holding of government securities and thus will reduce reserve money.
  • Financing of the government deficit: When the government finances its deficit by borrowing from the central bank (or equivalently, by selling a government security to the central bank), the central bank’s holdings of securities increase. Initially, government deposits with the central bank also rise; there is no change in net claims on government. But when the government uses the borrowed funds to make a payment to the private sector, the government’s check will likely be deposited, first, in a commercial bank, and subsequently in the commercial bank’s account at the central bank. The reserve account of the deposit money bank will increase (reserve money will increase on the books of the central bank), and the deposit balance of the government will be reduced (net credit to government increases). A fiscal deficit financed by borrowing from the central bank thus results in a one-for-one increase in reserve money. For this reason, financing a deficit by central bank borrowing is equivalent in its effects on the money supply to financing a deficit by printing currency (frequently referred to as monetization of the deficit).

Box 4.4.Transactions with the IMF

Transactions between a member country and the IMF are recorded in the balance sheet of the monetary authorities. SDR holdings are classified as foreign assets of the central bank; the counter-entry of an SDR allocation is a liability included in the capital account in the analytical balance sheet of the monetary authorities. A country’s reserve position with the IMF is included in foreign assets while the use of IMF credit is included in foreign liabilities. Examples of transactions with the IMF include paying a quota subscription and purchasing a credit tranche, transactions that leave the net foreign asset position unchanged. In the first case, the increase in the country’s reserve position with the IMF is offset by a decline in the country’s foreign exchange position. In the second case, there is an increase in foreign exchange from the proceeds of the purchase that is equal to the increase in foreign liabilities in the form of use of IMF credit. In contrast, a new allocation of SDRs increases the net foreign assets of the country because the increase in assets is not matched by an increase in foreign liabilities.

  • Discount window: The discount mechanism is an instrument of monetary control encompassing a variety of arrangements designed to influence the level of centra! bank credit to the banking system. The most important aspect of the arrangements is the rate of interest charged.13 The central bank’s credit to deposit money banks is in practice the source of reserve money most directly under its control.14 An increase in the interest rate the central bank charges (the discount rate) signals its intention to tighten monetary conditions. By making such borrowing more costly, it tends to reduce bank borrowing from the central bank. Conversely, a reduction in the discount rate signals easier conditions as well as inducing an increase in banks’ borrowing from the central bank and in reserve money.
  • Reserve requirements: The central bank can influence reserve money simply by changing the amount of reserves that banks are required to hold with it in a fractional reserve system. For example, an increase in the reserve requirement will force the banking system to hold a larger level of reserves for the same level of deposits, which will lead to reduced credit and a smaller stock of bank deposits in the economy.

(4) Deposit money banks

DMBs include commercial banks and similar financial institutions with appreciable liabilities in the form of deposits that can be withdrawn without prior notice (“payable on demand”) and that can be transferred by check or otherwise used to make payments. DMBs have four primary economic roles. First, and most importantly, DMBs provide financial intermediation between savers and investors. Second, DMBs are the primary creators of deposit money in the economy, a role they fulfill by extending credit and creating corresponding deposit balances, which are spent. Third, DMBs evaluate the creditworthiness of potential borrowers and charge them an interest rate that reflects the assessed degree of risk (or, they refuse to lend when customary rates do not cover assessed risk). As a result, credit tends to be provided to borrowers whose undertakings are more likely to generate revenue sufficient to repay loans. This aspect of banking benefits the economy as a whole since the most profitable ventures are most likely to receive credit. Finally, acting within the constraints set by the monetary authorities, DMBs help to transmit monetary policy from the monetary authorities to the public. DMBs are able to fulfill this role because, unlike other financial institutions, their deposit liabilities serve as a means of payment—that is, deposits are used to settle deposit holders’ obligations.

Box 4.5.Typical Balance Sheet of Deposit Money Banks

Cash in vaultCURRENCY
Deposits with the monetary authorities
Claims on nonresident banksDEPOSITS15
Claims on nonresident nonbanks
Treasury billsCertificates of deposit
Other Government securitiesPromissory notes
Loans and advancesOther instruments
Other claims
ENTERPRISESImport prepayments
Deposits on letters of credit
CLAIMS ON FINANCIALOther restricted deposits
Deposits in correspondent domestic DMBsFOREIGN LIABILITIES
Loans to nonbank financial institutionsNonresident banks
Nonresident nonbanks

The definition of DMB indicates that the line dividing those financial institutions that are regarded as deposit money banks from those that are not is somewhat arbitrary; the distinction is based on the size and composition of deposits rather than on the nature of the institutions themselves.

A typical balance sheet of a deposit money bank is shown in Box 4.5 and a summary analytical presentation is presented in Box 4.6. Most of the items in the box need no additional explanation. A few points, however, are worth noting.

  • The abbreviated, analytical balance sheet shown in Box 4.6 no longer contains banks’ deposits with domestic correspondent banks. In Box 4.5, such accounts are shown both as assets (a bank’s deposit in another bank) and liabilities (a bank holds deposit balances due other banks) But the analytical balance sheet in Box 4.6 is “consolidated”—it represents the result of adding together the balance sheets of all the banks in the system in such a way that when the same item appears on both sides of the total balance sheet, the two entries cancel out. The consolidated statement shows claims by banks on nonbanks, and by nonbanks on banks, but not claims by banks on banks.

Box 4.6.Analytical Consolidated Balance Sheet of Deposit Money Banks

Net foreign assetsDeposits of government
ReservesDeposits of nongovernment
Required reservesDemand (DD)
Excess reservesTime and savings
Foreign currency (FC)
Domestic credit
Claims on government, netCentral bank credit, discounts1
Claims on other domestic sectors
Other, less liquid, liabilities
Other items, net

This item is the counter-entry to the claims of the monetary authorities on DMBs.

This item is the counter-entry to the claims of the monetary authorities on DMBs.

  • DMBs typically hold foreign assets because of their activities in financing foreign trade. Whether these foreign assets are included as part of the net official reserve position of the country is a matter of judgment and depends primarily on the extent to which the monetary authorities control their use.16
  • Unlike their assets, DMBs’ liabilities are classified primarily by maturity rather than by sector. This classification system is analytically useful to the extent that liquidity varies with maturity. Some items will be included in the narrow concept of the money supply, based on high liquidity, and less liquid items will be included only in broader concepts of money.
  • In many countries, DMB’s hold a fraction of their total assets in the form of deposits with the monetary authorities, a legal or regulatory requirement. This arrangement is known as fractional reserve banking. Originally a prudential arrangement, the requirement that banks hold reserves gives the central bank strong influence over the size of the money stock because it controls the quantity of reserve money in the banking system, of which bank reserves is the main component.17
  • DMB deposits at the central bank constitute the major or sole component of bank reserves. In some countries, banks’ holdings of vault cash may also be used to satisfy their reserve requirements. In countries that are or were sparsely populated (Mongolia, the United States), banks are allowed to count vault cash as required reserves perhaps because the cost of carrying it to the central bank, or a branch of the central bank, and depositing it, is prohibitively high. (France, Greece, and Ireland also allow vault cash to be counted.) A possible disadvantage of this practice is that the central bank may not find it easy to monitor the accuracy of banks’ reported holdings of cash in vault. In the majority of industrialized countries, vault cash is not eligible to be included as part of banks’ required reserves whereas in developing and transition countries it included in about half of cases (not in Turkey).18

Banks may hold a small cushion of reserves over and above their minimum required levels. They may do so because it is an essential function of commercial banks to convert deposit liabilities into cash “on demand”. Demand deposits may be cashed immediately, whereas time deposits and other less liquid items may be liquidated only at a certain date or after a specified period. In normal circumstances, bank withdrawals are likely to be offset by deposits (unless, say, the economy of the region in which the bank is located is declining). Reserves are held to cover random instances when withdrawals exceed deposits. It seems natural to think of a probability distribution for such events; any given level of reserves provides confidence to a particular level, and other assets and central bank credit may be relied upon in instances of an unanticipated, large demand for cash. When confidence in a particular bank falls, however, and the bank experiences sudden, heavy withdrawals, then only the central bank has sufficient resources to cover the immediate demand for withdrawals.

The reserves that banks must hold to satisfy the legal or regulatory requirement of the central bank can also be used to finance temporary, large withdrawals. Banks are not necessarily required to satisfy the reserve requirement at each moment in time, but only periodically (for example, once per week at a regular, given time) or on average. A bank’s required reserves can therefore be used rather flexibly to meet net withdrawals as long as the average level is in line with the central bank’s required minimum. In addition, banks routinely borrow funds from each other to make sure their reserves are adequate at the times when the requirement must be met. (These loans take place on the “interbank” market, also called the overnight market or the call money market; the loans are usually for one or a few days.) Even if banks fail to meet their reserve requirement, the penalty may not be severe if shortfalls are small, temporary, and infrequent. Banks can also borrow reserves by discounting paper with the central bank. Thus, in practice there are numerous ways for a bank to keep itself liquid enough to meet even an irregular pattern of withdrawals as long as it is well managed and the economy is fairly healthy.

(5) The monetary survey

The “monetary survey” is a table showing the combined assets and liabilities of the banking system with respect to nonbank residents and nonresidents. It is a particular rearrangement of balance sheet items devised by the IMF in the early years of its operations to create a format that aids analysis of monetary developments In terms of the preceding portion of this chapter, the monetary survey is a consolidation of Boxes 4.2 and 4.6. Foreign assets and liabilities of the central bank and DMBs are aggregated and presented as a single net-asset value. Central government bank deposits are aggregated and subtracted from the sum of bank and central-bank credit to government. Credit to other sectors is aggregated into a single total (but perhaps displayed showing some detail of the distribution among public-sector enterprises, nonbank financial intermediaries, and private nonfinancial enterprises and households). The components of the analytical definition of money are left on the liability side. Other items net is calculated as residual assets minus residual liabilities and shown as a net-asset item.

Some items disappear in the consolidation. Central bank credit to DMBs is canceled by DMB borrowing from the central bank. The same happens to commercial banks’ reserve deposits in the central bank. In practice there may be slight discrepancies between the two records because of items in the process of collection. (In banking, this discrepancy is called the “float.”)

Box 4.7 shows an abbreviated version of a typical monetary survey. On the liability side, the monetary survey contains the overall liquidity generated by the banking system, or the stock of money.19 Narrowly defined, the money stock consists of currency in circulation outside banks (CY) plus demand deposits held by residents, excluding central government, in the banking system. This narrow money stock is referred to as M1.20

A broader definition of money includes, in addition, quasi-money (QM), which consists of time and savings deposits in the banking system. Money-market instruments, such as certificates of deposit, are also part of quasi-money. The sum of money plus quasi-money is referred to as broad money or (M2);


Box 4.7.Analytical Balance Sheet of the Banking System:

Monetary Survey
Net foreign assets (NFA)Broad money (M2)
Net Domestic Assets (NDA)Narrow money (M1)
Currency in circulation (CY)
Net domestic credit (NDC)Demand deposits (DD)
Net claims on Government (NCG)
Gross claims on the Private SectorQuasi-Money (QM)
(CPS)Time and savings deposits (TD)
Foreign currency deposits (FGD)
Other items, net (OIN)Money market instruments

The identity between assets and liabilities of the banking system implies that the stock of broad money is identically equal to the sum of net foreign assets (NFA) valued in domestic currency, and net domestic assets (NDA). In other words, for the banking system as a whole,

Since NDA consists of Net domestic credit (NDC) and Other items net (OIN), equation (4.6) can be rewritten as

or, in terms of changes,


Algebraic manipulations similar to those involving the accounts of the monetary authorities—equations (4.1) to (4.4)—can be performed to derive the “contributions” of various asset items to the growth of M2.22

The above two definitions of money (M1 and M2) are among the most widely used. However, with financial liberalization, even broader definitions (M3, M4, L) of the money stock have been found useful in many countries. Although the precise definition differs from country to country, M2X is often defined to equal M2 plus foreign-currency-denominated deposits of residents M3 adds term repurchase agreements and term Eurodollars. “Liquidity” (L) includes, in addition to M3, liquid government securities, negotiable bonds, and liabilities of other financial intermediaries.

Box 4.8.Valuation Adjustments

Changes in stocks of foreign or foreign-currency-denominated assets and liabilities reflect not only transactions flows but also valuation changes. The valuation effects result from changes in the prices of financial assets and liabilities in domestic currency due to fluctuations in market prices or in exchange rates. (Other possible sources of change in the value of a country’s official net foreign assets include the allocation or cancellation of SDRs and the forgiveness of debts by creditors.)

Equating changes in stocks to transaction flows is particularly misleading when exchange rate changes are significant over the period of analysis. Assume that, in a particular case, it is important to estimate how much of an observed change in value of a particular stock A is due to valuation change and how much to transactions. Formally, let

ATLt : value of A at end of period t denominated in local currency;

Ast : value of A at end of t in foreign currency;

Et : exchange rate (local currency units per dollar), end-of-period;

E*t : exchange rate (period average);


In terms of the foregoing definitions one may write,

total change in stocks = (ATLt- ATLt-1);

transaction flows1 = E*t (A$t- A$t-1);

total change in stocks = transaction flows + valuation change.


valuation change = (ATLt - ATLt-1) - E*t(A$t - A$t-1).

The valuation change ΔVA may also be expressed (by rearranging the above expression) as

VA = A$t-1(Et - Et-1)+Δ A$t(Et- E*t),

which underlies the calculations in Tables 5.5 and 5.7 of the following chapter. Valuation changes are offset in the accounting sense in “other items, net” to preserve the equality between assets and liabilities.


Transaction flows expressed in terras of local currency. The average- period exchange rate is used to convert dollar denominated transactions into local currency. This reflects the assumption that these transactions took place throughout the period and not just at the end of the period.

Financial innovations, which have tended to blur the distinction between money and near-money assets, have led to a continuing debate about where to draw the line between financial assets that form part of money and those that do not. In the spectrum of financial assets, currency (which carries no interest) is at one end, and assets with higher yields but less liquidity are at the other. The choice of one or more of these measures of money for purposes of formulating monetary policy and monitoring monetary developments is influenced by the stability and predictability of the relationship between the monetary aggregate and nominal aggregate demand in the economy,23 and by the degree to which the monetary authorities control the monetary aggregate. This trade-off implies, however, that no one set of assets will always be included in the money supply and that present definitions of money may change in the future. (See also Section c(3), below.)

c. Monetary analysis

(1) Application of the monetary survey identity

The monetary survey brings together several important relations: the link between a country’s external position and the net foreign assets of the banking system, the link between the fiscal accounts and financing provided to government by the banking system, and the link between private sector developments and credit aggregates. The monetary survey, which is derived from accounting identities, indicates that these relationships must fit within the scope of monetary developments; changes in domestic credit and foreign assets must equal the change in the money stock. Whether the cause of a change can be traced to external developments, credit to government, credit to the private sector, or to the size of the money supply itself, the accounting identity underlying the monetary survey must hold at all times. This provides a framework for analyzing combinations of events that can or cannot occur together.

(2) Money market equilibrium

Functions of money

In a market economy, money serves several functions. It can be any one or a combination of the following:

  • A medium of exchange. This function corresponds to the transactions motive for holding money.
  • A store of value. Money is an asset that can be used to transfer purchasing power from the present to the future. This function corresponds to the portfolio (speculative) motive for holding money; demand for money in this role is therefore determined by the rate of return to money compared with yields on alternative assets (Box 4.9).
  • A unit of account. Prices of goods, services, and assets are typically expressed in terms of money (for instance, dollars, rubles, or pesos).

Monetary theory focuses on the quantity of liquid financial assets that serve as transaction balances—usually currency in circulation plus demand deposits (M1). However, as the liquidity characteristics of financial assets other than money begin to resemble those of money, broader monetary aggregates become relevant to formulation of monetary policy.

The quantity theory and the demand for money

The earliest monetary theory—and one of the most influential—is based on the link between the stock of money (M) and the market value of output that it finances (P • Y). The so-called quantity equation of exchange equates the stock of money with output using a proportionality factor,

V is defined to be the (income) velocity of money,24 which is the ratio of nominal income, or GDP, to the money stock. Put differently, velocity is the number of times the stock of money is spent, on average, in a given period in financing the flow of nominal spending.

Rewriting (4.9) in terns of changes in variables, one obtains25

Box 4.9.Interest Rates and Rates of Return

1. Financial Assets and Rates of Return

The assets commonly found in the financial portfolios of households and firms can be grouped into four categories: money; other interest-bearing financial assets (credit market instruments or bonds); equities or stocks; and real (or tangible) assets. The theory of asset demand, or portfolio choice, suggests that demand for an asset is governed by three characteristics: (I) the expected rate of return or yield (compared with other assets); (ii) the riskiness of the expected return; and (iii) the liquidity of the asset. The rate of return on a financial asset has two components: the interest or dividend paid on the asset on a regular basis, plus capital gain or loss (the increase or decline per period of time in the market price of the asset). As a holding, currency pays no interest. Demand or checking deposits usually pay a zero or low rate of interest compared with less liquid forms of wealth. By holding money, people sacrifice the higher rate of return they could earn from illiquid assets such as bonds or time deposits. In an inflationary environment, if alternative financial assets carrying attractive positive real rates of return are not available (see Box 4.11), people tend to shift their wealth from money to real assets such as property, gold, commodities, or foreign currencies; the values of all of these assets tend to be more stable in real terms.

2. Nominal and Real Interest Rates

In an environment of low and stable rates of inflation, the behavior of nominal financial variables (such as the monetary and credit aggregates or the spectrum of interest rates) can serve as useful indicators of monetary developments and the stance of monetary policy. However in general, and particularly in the presence of high inflation, the focus should be on the movements of real (adjusted for the expected rate of inflation) rather than nominal rates in order to properly assess monetary developments and policies. If prices are rising, borrowers pay back loans in terms of a currency that has lost value. If prices are rising by 10 percent, and one can borrow at 6 percent, the nominal cost of borrowing is 6 percent, while the real cost of borrowing is negative. This real interest rate (r)can be expressed as 100[(1+i/100)/(1 + ∏/100)-1]


i : nominal interest rate, in percent, r: real rate of interest, in percent, and ∏ : expected inflation rate.

When the inflation rate is low, (i - r) gives a good approximation of the actual real interest rate.

In some economies, although nominal interest rates appear high, real rates of interest may be negative. Since saving and investment respond to movements in real rates of return, a negative real return on financial assets suggests a disincentive to save and an incentive to spend, aggravating inflationary pressures and hurting long-term prospects for economic growth.

If V can be predicted with confidence, then the policymaker can aim at a level of the money supply that is consistent with the attainment of the desired real growth and inflation rate. For example, if one assumes a constant velocity, ΔV/V = 0, equation (4.10) becomes a simple restatement of the quantity theory. It states that the rate of growth in money demand is equal to the sum of the growth in prices (inflation) and in real GDP. In this case, the rate of change in money supply necessary to keep prices constant would equal the rate of growth of real GDP (a proxy for real income). Another way of looking at the implications of equation (4.10) is to note that, for constant velocity, growth in money supply beyond the growth in real income will lead to inflation. The higher the growth in money supply, the higher the inflation rate.

In the above discussion, velocity has been assumed constant, but clearly velocity is not generally constant. In many countries it has been shown to increase somewhat with increases in inflation and interest rates, and also to be slightly sensitive to changes in income.26

Demand for money

The nominal demand for money is the demand for a given number of specific currency units, such as rubles or pesos. The real demand for money, or the demand for real money balances, is the demand for money expressed in terms of the number of units of goods that the money balance can buy. Therefore, the demand for real money balances is the quantity of nominal money (M) expressed in real terms (M/P)—that is, deflated by the index for the general level of prices. The demand for money is fundamentally a demand for real money balances because people hold money for what it can buy.

There is considerable support in the economic literature for the view that the demand for real money balances, like the demand for any other asset, is a function of its price, of the price of related assets, and of income, wealth, taste, and expectations. In a simplified form, the demand for real cash balances is positively related to real income and negatively related to the opportunity cost of holding money.

  • Real income: As real income grows, the demand for real cash balances also increases, reflecting the increased level of transactions. As noted earlier, the impact of growth on velocity will depend on the income elasticity of demand for real cash balances.
  • Opportunity cost of holding money: In earlier decades banks typically paid no interest on demand deposits. Since neither currency nor checking account balances paid any interest, the opportunity cost of keeping one’s assets in this highly liquid form could be equated with the nominal rate of interest on less liquid assets—yields on government or corporate bonds, for example. An increase in an average of yields or interest rates on nonliquid assets (hereafter referred to as “the” interest rate) would, according to economic theory, cause money holders to economize on their liquid balances because of the inducement to hold more wealth in interest-earning form, and a decrease in the rate would lead to larger money holdings.

At present it is common for commercial banks to pay interest on demand deposits. A slightly higher rate will likely be received by depositors on time and savings deposits, and still higher rates on less liquid items. In this case, what happens to the demand for money when the “opportunity cost” increases? If the structure of interest rates rises, there will be two effects. First, money holders will prefer to hold less currency (which earns no interest) and more quasi-money relative to demand deposits. At the same time, they will prefer to hold smaller stocks of liquid assets (money) and larger stocks of illiquid assets, other things being equal. Since for some components of the money stock these effects work in opposite directions, it is not easy to specify whether the algebraic sign of the effects of interest rate changes on money demand should be positive or negative. It would be logical to include, as an explanatory variable, an interest rate differential—the average interest rate on less-liquid, non-money items, minus the average rate on the components of the money stock. Since there may be some difficulty in obtaining data for the average nominal yield on money holdings, one might try a simpler version, the yield on government bonds less the yield on time deposits.

An interest-differential variable omits a component of the opportunity cost of holding money, namely the inflation rate. Subtracting one interest rate from the other means that the inflation component of nominal rates is partly or wholly cancelled out. A measure of inflation may be added to the specification to capture this aspect of money demand.

The concept of the money multiplier

As emphasized in the discussion of the balance sheet of the monetary authorities, an increase in reserve money serves as the basis for monetary expansion by the banking system. Under the fractional reserve system, banks use their deposits to make loans, keeping reserves of liquid assets equal to only a fraction of their deposits.27

A simple model of the money supply process starts with the supply of reserve money (RM) generated by the monetary authorities.28 Starting with definitions of reserve money (RM = CY + R) and narrow money (M = CY + DD), the multiplier mm is simply the ratio of the money stock to reserve money,

where CY = currency outside banks (currency in circulation), DD = demand deposits, and R = banks’ reserves.

Dividing the numerator and denominator on the right side by DD in (4.11), and defining c as the currency-deposit ratio and r as the reserve-deposit ratio, one obtains

This identity shows how the size of the money supply depends on two parameters, c and r, and the exogenously given RM. The factor of

proportionality (C+1)(C+r) is the money multiplier and shows how much money (c+r)

is potentially created by one unit of reserve money. Thus, the money supply function can be rewritten as

In terms of changes,

The above equation shows that the money supply can increase either because of an increase in the multiplier or an increase in reserve money. In particular, an increase in the money multiplier with the same reserve-money stock would loosen monetary conditions. It can be seen from equation (4.12) that the money multiplier (mm) is larger (i) the smaller the reserve-deposit ratio and (ii) the smaller the currency ratio.

In interpreting the foregoing equations, one must distinguish whether bank reserves are equal to required reserves or larger than required reserves. In the latter case banks are said to hold excess reserves; they can increase loans and deposits relative to current levels. However, banks have an incentive to stay “loaned up”—to minimize excess reserves. In this case, the interpretation of the preceding equations is that M is approximately equal to its maximum value given the level of RM determined by the monetary authorities. Moreover, it is in this circumstance that the money multiplier is a stable parameter, so that equations (4.12) to (4.14) have explanatory power.

A more general formulation of the money multiplier is developed below. In this second version the reserve-money stock is decomposed to allow explicit representation of the required reserve ratio applied to demand deposits (rd), the required reserve ratio for time and savings deposits (rd), and excess reserves as a proportion of demand deposits (re). This expression can be obtained by re-expressing M and RM as follows:

where variables and parameters are defined as follows:

TD: time and savings deposits,

rd: required reserve ratio against demand deposits,

rt: required reserve ratio against time and savings deposits, and

re: excess reserves as a proportion of demand deposits.

The general multiplier can be written as

Again dividing the numerator and denominator by DD, and defining c and b as ratios to demand deposits of currency outside banks and time and savings deposits, respectively, the value of the multiplier can be expressed as


Equations (4.15) and (4.16) indicate that the value of the multiplier may not be constant over time because the level of excess reserves held by banks may vary (for example, with the outlook for the strength of economic activity). Depending on the variability of re (and discretionary changes in reserve ratios), there will be some reduction in the predictability of the relationship between reserve money and the money supply. Moreover, the equations highlight the underlying reality that changes in the multiplier reflect the behavior of three different types of economic agent: (i) the monetary authorities that set the reserve requirements and influence the stock of reserve money; (ii) the commercial banks that decide which loans to approve and how much to hold in excess reserves; and (iii) the nonbank public, which determines the composition of the money stock (the amount of currency held relative to deposits and the relative share of demand deposits in total deposits) in light of the structure of interest rates, inflation, and other factors. Figure 4.2 summarizes the factors that affect the money supply process. In other words, the monetary authorities do not fully control the money stock. The public’s preference for cash or deposits and DMBs’ desire to hold excess reserves also contribute to the determination of the money stock. However, if the multiplier is constant, at least in a probabilistic sense, then a possible strategy for the central bank to achieve a targeted level of money would be to obtain an estimate of the multiplier and then set reserve money so that the targeted money supply is attained using equation (4.17).

Foreign currency deposits

It is possible to reinterpret equations (4.15) and (4.16) to cover the case in which foreign-currency deposits (FCDs) of residents make up a substantial fraction of domestic liquidity, as in Turkey. Let us assume that domestic households and enterprises hold part of their liquid assets in the form of deposits denominated in foreign currency in commercial banks, and that commercial banks are obliged to hold a stipulated minimum fraction of these foreign currency deposits with the central bank in the form of deposits denominated in foreign currency. Residents may prefer to hold deposits denominated in foreign currency so that if the domestic currency depreciates, the deposit holder is protected against capital loss. In principle, withdrawals from such accounts may be made in the form of domestic currency instead of Deutsche marks or dollars.

Figure 4.2.Factors Affecting the Basic Money Supply Process

In general, domestic money holders will prefer to hold foreign currency accounts if they anticipate a need to make foreign payments or if the expected return on such accounts measured in domestic currency (interest earnings plus exchange rate effects) is higher than the expected return on domestic-currency accounts measured in domestic currency. If currencies can be freely traded, foreign for domestic, as in Turkey, the second motive dominates the first. Obversely, domestic money holders will prefer to hold domestic-currency accounts to the extent that they plan to make domestic payments or if the expected return is superior to that on foreign accounts. In other words, for given exchange rate, interest rate, and inflation expectations, domestic depositors have definite preferences as to how much of their liquidity holdings are to be held in domestic- or foreign-currency accounts.

Let expectations regarding the nominal exchange rate and interest rates be stable, and suppose, instead of DD and TD in equations (4.15) and (4.16) above, we have DCDs and FCDs (domestic- and foreign-currency-denominated deposits), each with its own required reserve ratio (like rd and rt). Given fixed shares of foreign and domestic currency deposits—the parameter b in equation (4.15)—the central bank will retain control over the money supply even if commercial banks are free to borrow abroad to satisfy the reserve requirement on FCDs. The central bank will determine the domestic-currency portion of reserve money based on its objective for the total size of the money supply and given the magnitude of b. Commercial banks may borrow needed foreign reserves on foreign capital markets (possibly an expensive option), but the central bank will continue to control the quantity of domestic-currency reserve money available to be held in support of domestic currency deposits. Since money holders do not regard domestic and foreign deposits as good substitutes in the short run, the central bank effectively controls the overall quantity of liquidity by controlling (only) the domestic component.

In fact, the central bank has strong influence over the preferred shares of domestic- and foreign-currency deposits. The central bank can choose to intervene or not in the foreign exchange market, with implications for the course of the nominal exchange rate. By making monetary policy tighter or looser, it can affect the nominal level of interest rates at home, and thus largely determine the spread between domestic and foreign interest rates. The central bank can thus influence whether the preferred shares of domestic-currency and foreign-currency deposits should change in coming periods. It can allow for predictable “endogenous” changes in these shares in setting the quantity of domestic-currency reserve money—in principle, to ensure that the level of overall liquidity is in line with the objectives of monetary policy.

If monetary policy becomes highly expansionary (relative to the recent past), so that money holders perceive that the rate of inflation may increase suddenly by a significant amount in the near future, the risk premium required for resident households and firms to prefer to continue to hold domestic assets may suddenly become very large and volatile. Domestic money holders may wish to exchange a large proportion of domestic-currency assets for foreign-currency assets. In this case, the control of the central bank over the size of the money supply will be more difficult in the short run because the preferred share of FCDs in the total money supply is unpredictable. See the discussion of currency substitution in Section c (3), below.29

(3) Special issues in monetary analysis

There are several issues that need to be kept in mind when the analytical tools of money supply and demand are applied to actual monetary developments in a country. These include (i) financial innovation and deregulation, (ii) currency substitution, (iii) the role of the exchange rate, and (iv) the complications introduced by capital flows.

  • Financial innovation and deregulation. As noted earlier, the distinction between monetary and nonmonetary financial assets has become increasingly blurred in many countries, largely because of the innovations brought about by improved information technology and the development of new financial instruments and financial market techniques. In many countries, demand deposits earn interest comparable to the yields of other financial assets as stores of value.The ease with which money can be withdrawn from mutual funds that invest in stocks and bonds has made the latter more liquid than before. These near-money assets make the demand for money less predictable and more unstable thereby complicating monetary analysis and policy.If the velocity of money (either of M1 or M2) is variable, the quantity of money can be an unreliable guide to changes in aggregate demand. Some countries have responded to this problem by shifting to a broader definition of money that includes some near-money assets. However, this approach is an inherently unsystematic exercise, especially since the pace of financial innovation can cause the dividing line between broader monetary aggregates and other assets to shift continuously. More importantly, the broader the monetary aggregate, the less ability the monetary authorities have to control it, since many forms of near-money have no reserve requirement and are issued by institutions outside the banking system. The authorities therefore face a dilemma as they try to preserve the link between the intermediate and ultimate targets of policy. They may adopt a broader, “more relevant” monetary aggregate for targeting but will have less control over it. Relevance (the link with aggregate demand) and controllability therefore need to be finely balanced when intermediate targets of monetary policy are being chosen.As different measures of money begin to move in different directions because of financial innovation and deregulation, monetary policy is confronted with the problem of choosing appropriate indicators of monetary conditions. Policymakers may, of course, be tempted to use the aggregate that gives the most favorable data for a particular time. However, this technique can backfire, misleading policymakers and the public. Besides the monetary aggregates, other indicators of monetary policy have thus been found useful and should be taken into account: nominal and real interest rates, the structure of interest rates of different maturities (as captured by the yield curve), and even the behavior of the exchange rate.30 An economy undergoing rapid structural and behavioral changes needs to adopt an eclectic approach toward the choice of intermediate monetary targets and monetary indicators.
  • Currency substitution.31 High and variable inflation impairs a currency’s usefulness as a store of value, unit of account, and means of exchange. As a result, the domestic currency in high-inflation countries tends to be abandoned over time in favor of a stable-valued currency (often, but not always, the U.S. dollar), a phenomenon referred to as currency substitution or “dollarization.”32The phenomenon of currency substitution typically occurs in countries with high and variable inflation and has been pervasive in several Latin American economies.33 These economies have remained highly dollarized even when inflation fell substantially. Although dollarization has the positive result of providing citizens with a reliable store of value, it also poses formidable challenges to policymakers by hindering the monetary authorities’ control over money in periods of unstable inflation expectations.To the extent that currency substitution reflects a shift away from domestic money, it will exacerbate the inflationary consequences of a fiscal deficit, making fiscal discipline all the more important in highly dollarized economies. Despite the potential problems for the exercise of monetary policy, the Latin American experience suggests that combating dollarization with artificial measures, such as issuing indexed domestic financial instruments or forcing the conversion of foreign assets, merely magnifies the eventual inflation “explosion,” Normally, sound financial and fiscal policies will increase holdings of assets denominated in domestic currency without government mandates. In any case, foreign currency holdings by residents constitute a close substitute for local currency and should hence be included in the measure of the money stock.
  • Exchange rate regimes and monetary analysis. The discussion so far has not referred explicitly to the exchange rate regime. The nature of the exchange rate regime is, however, closely linked to the operation of monetary policy. Under a fixed exchange rate system, the monetary authorities stand ready to buy or sell the domestic currency for foreign currencies at a predetermined fixed price. Whenever the market exchange rate threatens to depart from this fixed rate, the monetary authorities buy or sell foreign exchange for local currency to ensure that the rate remains at the fixed level. In terms of the monetary authorities’ balance sheet, net foreign assets increase or decrease in line with foreign exchange intervention, and the monetary base and money supply adjust in line with net foreign assets if the intervention is not sterilized. Adopting a fixed exchange rate regime dedicates monetary policy to the goal of ensuring that the officially fixed level of the exchange rate is also the equilibrium level. The central bank is committed to adjusting the money supply to the level needed to ensure that the exchange market clears at the predetermined rate. Changes in the money supply will be determined by changes in net foreign assets unless the effects on bank reserves can be neutralized with other monetary instruments.Under a fixed exchange rate regime, the effects of the central bank’s efforts to expand domestic credit go beyond domestic prices and output. An increase in aggregate spending leads to a rise in the current account deficit and puts downward pressure on the exchange rate. The central bank must counter this pressure by selling foreign exchange, resulting in a drop in net foreign assets. The central bank’s attempt to increase the money supply is thereby frustrated unless it simultaneously buys domestic securities (to replenish bank reserves) or lowers required reserve ratios.To carry out sterilized intervention, a sale of foreign exchange that reduces the monetary authorities’ net foreign assets is offset by an open market purchase of securities that raises the monetary authorities’ net domestic assets, offsetting the impact on reserve money and the money supply. With sterilized intervention, the direct link between an external imbalance and a corrective change in the money supply is broken. But there are limitations on the extent and effectiveness of sterilization. A basic weakness is its dependence on the kind of broad and well-functioning securities market that is not available in many transition and developing economies. More fundamentally, sterilization is limited by the cost of interest payments on the government securities purchased, a cost that can escalate rapidly if the central bank sells many securities to offset a large foreign exchange inflow. The increase in the yield on securities that will result from aggressive selling by the central bank will tend to keep interest rates high and capital flowing in from abroad. The basic analytical sequence of the monetary impact of capital inflows under alternative exchange rate regimes is depicted in Figure 4.3.Despite the consequence of losing their independence to control the money supply, countries sometimes choose to tie their exchange rate to the currency of a low-inflation country. In doing so, they seek to impose an automatic discipline on domestic policy and thus to benefit from the credibility of the low-inflation country’s central bank. The costs of such an arrangement are the surrender of monetary control to the central bank of the country whose currency is used as the peg, and the relinquishing of the exchange rate as an instrument to adjust the balance of payments. Currency boards in transition economies (such as those adopted by Estonia, Lithuania, and Bulgaria) essentially create a fixed exchange rate system with no option for sterilization because reserve money can be created only if it is fully backed by holdings of foreign exchange. Since sterilization is ruled out, adjustments are automatic but not painless. In the case of an external deficit, adjustment will eventually raise nominal and real interest rates and put downward pressure on prices: if prices, and especially wages, are not flexible, output and employment fall.The primary argument for a floating exchange rate is that a float allows for autonomy in monetary policy and therefore can be used for purposes such as stabilizing demand or prices. Under a pure float, the monetary authorities do not intervene in the foreign exchange market. In practice, however, a “pure” float is largely hypothetical, because most countries that adopt a floating rate regime do intervene when the exchange rate threatens to move too far from its underlying equilibrium level, thereby making the float “dirty” (or “managed”). With a floating exchange rate regime, the monetary authorities have full control over the domestic money supply and therefore can determine the domestic inflation rate; however, they lose control of the competitiveness of tradable goods.
  • Role of capital (financial) flows. Capital flowing across national frontiers provides financial intermediation among countries that is similar to the financial intermediation services banks provide for savers and investors within a country. Capital flows strengthen the link between domestic economic policies and the balance of payments. As the world’s capital markets have become increasingly integrated in the past two decades, so too have domestic monetary policies with monetary developments in foreign countries. Under perfect capital mobility, the slightest difference between interest rates prevailing in domestic and foreign capital markets provokes large capital flows. In the case in which the exchange rate is fixed, a central bank cannot hope to influence the level of domestic interest rates. Any attempt by the central bank to tighten monetary policy would induce a huge capital inflow into the country, forcing the central bank to intervene in the exchange market in order to keep the domestic currency from appreciating. The increase in net foreign assets would offset the initial money contraction, forcing domestic interests rates down to the world level.

    Figure 4.3.Monetary and Exchange Rate Effects of Capital Inflows

    Under a floating exchange rate regime, the absence of intervention by the monetary authorities implies no change in net foreign assets, and the current account deficit is equal to private and official capital inflows. The link between the money supply and the balance of payments is broken, and the central bank regains control over the money supply.Most or all real-world cases lie somewhere between the fixed and floating exchange rate regimes and full and zero capital mobility. In the case of large capital inflows, most countries have responded by undertaking a combination of actions involving (i) a partial intervention to buy some of the capital inflow, thereby allowing some nominal exchange rate appreciation; (ii) partial sterilization to offset part of the impact of the increased net foreign assets on the monetary base; and (iii) some increase in the monetary base and inflation and consequently real exchange rate appreciation.

d. The structure of the banking sector in Turkey34

There are 68 banks in Turkey. Of the 55 deposit money banks, five are state-owned, 31 are privately owned, and the remaining 19 are foreign; there are 13 investment and development banks, of which three are state-owned, seven are privately owned, and three are foreign owned. Deposit money banks are universal in Turkey. This means that they are allowed to engage in almost all financial activities, including managing mutual funds as well as underwriting and trading securities. Specialized investment banks also exist; they account for less than 7 percent of the total equity of the banking sector. Investment banks are not allowed to accept deposits, so they rely on borrowed funds and are not subject to as stringent regulations as the deposit money banks.

State banks continue to be important, though decreasing somewhat in size overtime. In 1991, almost 48 percent of total deposit money bank assets were accounted for by state banks, while in 1995 the state share was 44 percent. Private Turkish banks held 52 percent of bank assets in 1995, while foreign banks, holding 4 percent, played only a small role in general banking, focusing on activities related to foreign trade. Most private banks are owned by families and/or industrial groups as the legal framework in Turkey does not call for a separation of banking and nonbanking enterprises. The widespread cross-ownership of private banks with industrial conglomerates complicates the task of prudential supervision because of the additional risk of pressures on bank management to allocate credit to so-called related parties regardless of creditworthiness considerations.

Concentration ratios in the banking sector have declined over the years. The largest five of the deposit money banks accounted for about two-thirds of deposits and loans in 1980, down to about half by 1995.35

The financial condition of private banks has improved in Turkey, especially since the run on deposits in April 1994, which led to the closing of three banks. The run ended with a government decision to provide a 100 percent guarantee of all household deposits with domestic banks. The full backing of deposits remains in place despite widespread recognition of the associated moral hazard problems and distortionary effects on bank competition. Although banks have become on the whole better capitalized and more profitable in the period since April 1994, it is difficult to gauge asset quality because of monitoring deficiencies.

Banks in Turkey are subject to both reserve and liquidity requirements on their deposit liabilities and, more recently, nondeposit liabilities. From the early 1990s until April 1994, banks were required to hold 16 percent of lira sight deposits and 7.5 percent of time deposits as non-interest-bearing statutory reserves at the central bank. Banks were also required to hold 30 percent of deposits in the form of government bonds and treasury bills of longer maturities. Nondeposit liabilities were not subject to reserve requirments prior to April 1994.

Prior to April 1994, banks were required to hold 9.5 percent of foreign-currency sight deposits and 11.5 percent of time FCDs in the form of FCDs at the central bank, plus 8 and 3 percent in lira deposits at the central bank. That is, reserves on commercial bank FCDS were partly in the form of foreign currency deposits and partly domestic currency deposits at the central bank.

The changes implemented in April 1994 reduced the favorable treatment for non-deposit, on-balance-sheet liabilities of commercial banks by extending reserve requirements to these assets. However, reserve requirements apply only to additions to stocks of these items relative to end-March 1994, at a required ratio of 8 percent, later 9 percent. Similarly, reserves on increases in both lira and foreign currency deposits, relative to levels that existed at end-March 1994, were reduced from 16 percent to 9 percent. Liquidity requirements were not changed.

These reserve and liquidity requirements impose costs on the banks that act as a tax on financial intermediation, reflected in a wide spread between borrowing and lending rates. The central bank estimates that these requirements add on average some 11 percentage points to the overall cost of deposits to banks. Explicit taxes on borrowing and transactions taxes are estimated to add a further 13 percentage points to the cost of loans to borrowers. There was a 39-point spread between average deposit and commercial borrowing rates toward end-1995.

High and variable inflation over the past decade in Turkey, resulting in large part from continuing fiscal deficits, has meant a lower demand for real money balances. In a financially liberalized economy, it becomes difficult to tax money balances through inflation since domestic currency can be shifted into foreign currency with relative ease. Figure 4.4 shows the increasing extent of currency substitution over the past decade.

The authorities have faced thin markets for domestic debt, primarily due to inflation uncertainty, which has contributed further to the monetization of fiscal deficits. Faced with fluctuations in financial market sentiment, the treasury has repeatedly resorted to borrowing heavily from the central bank. In recent years, these credits have varied from 3.4 percent of GDP in 1992 to about 4.7 percent of GDP in 1994 and 1995.

e. Exercises and issues for discussion

  • (1) The purpose of this exercise is to familiarize you with the construction of the monetary survey. Tables 4.1-4.2 present hypothetical illustrative data for the balance sheet of the monetary authorities and the consolidated balance sheet of the deposit money banks.

    Figure 4.4 TurkeyCurrency Substitution, 1986-95

    (Foreign currency deposits as a percentage of broad money including foreign currency deposits).

    Source: IMF, International Financial Statistics.

    • (i) On the basis of this information, construct the balance sheet of the banking system (the monetary survey). Use the format provided in Table 4.3 as a guide.
    • (ii) Does the sum of “other items, net” (OIN) of the monetary authorities’ balance sheet and that of the consolidated balance sheet of the DMBs yield OIN for the banking system?
    • (iii) Assume that there is a single required reserve ratio that applies to all deposit liabilities of the banking system (whether in domestic currency or foreign currency). Also assume that vault cash does not count toward banks’ required reserve holdings. In this case, what is the value of the required reserve ratio implied by the figures in Tables 4.1 and 4.2?
    • (iv) Suppose now that the reserve requirement on all foreign currency deposits is 10 percent. What is the implied reserve requirement ratio for the deposits in national currency?
    • (v) Assume again, as in (iii), that domestic and foreign deposits have the same reserve requirement. Using the value of the ratio of currency in circulation to all deposits, and the value of the required reserve ratio that was derived in part c, calculate the money multiplier using the expression for it that is implicit in equation (4.12), mm = (c + 1) / (c + r).
    • Calculate the money multiplier again, using the ratio of M2 to reserve money, as in equation (4.15). Identify the two factors that account for the difference in the results; are these factors offsetting or reinforcing? What determines which of the two types of estimate of the money multiplier is likely to be more accurate in an actual monetary expansion?
    • (vi) Suppose the central bank sells 40 million currency units worth of treasury bills to the public through an open market operation, against a check drawn on a commercial bank. Show what happens to the balance sheet of the central bank. What if the sale was against outright cash? Explain why reserve money is reduced in this case.

      Figure 4.5 TurkeyBroad Money, 1986-95

      (Percentage Change in year-end stock)

      Source: International Financial Statistics

      Table 4.1.Consolidated Balance Sheet of the DMBs
      Foreign assets2,400Demand deposits5,000
      Claims on nonresident banks2,000Checking accounts4,400
      Claims on nonresident nonbanks400Foreign currency deposits600
      Reserves850Time and savings deposits3,700
      Cash in vault200Time deposits1,000
      Deposits at central bank650Savings deposits1,500
      Of which: Required550Foreign currency time deposits1,200
      Claims on government600Money market instruments900
      Treasury bills300Promisory notes400
      Other government securities200Certificates of deposits500
      Other claims100
      Foreign liabilities1,280
      Claims on nonmonetary financial300Claims on nonresident banks520
      institutionsClaims on nonresident nonbanks760
      Claims on nonfinancial private sector7,650Government deposits100
      Discounts4,000Credit from monetary authorities200
      Loans and advances2,000
      Mortgages1,280Capital accounts600
      Other170Unclassified liabilities220
      Unclassified assets200
      Table 4.2.Balance Sheet of the Monetary Authorities
      Foreign assets1,200Reserve money2,850
      Gold20Currency issued2,200
      Foreign exchange467Deposits of DMBs650
      Reserve position in the Fund340
      Holdings of SDRs160Government deposits200
      Foreign correspondent banks213Foreign liabilities400
      Claims on government1,500Deposits of foreign central banks250
      Loans and advances400Swap facilities50
      Treasury bills560Use of Fund credit75
      Other government securities450Other short-term debts25
      Other claims90
      Capital account150
      Claims on nonfinancial public enterprises300Capital100
      Loans and advancs200Reserves50
      Bills and securities100
      Other claims0Unclassified liabilities400
      Claims on the private sector30
      Claims on deposit money banks200
      Rediscounts and secured advances60
      Loans and overdrafts100
      Other claims40
      Claims on nonmonetary financial institutions100
      Rediscount and secured advances20
      Loans and overdrafts60
      Other claims20
      Unclassified assets670
      Table 4.3.Balance Sheet of the Banking System (Monetary Survey)
      Net foreign assetsM2 total
      MAM2 national currency
      DMBsM2 in foreign currency
      Net domestic assets (NDA)Ml total
      M1 national currency
      Net domestic credit (NDC)Currency outside banks
      MAsDemand deposits
      DMBsForeign currency (DD)
      Net claims on government (NCG)Quasi money
      MAQM in national currency
      DMBsForeign exchange time deposits
      Claims on the rest of the economy (CPS)
      Other items, net (OIN)
    • (2)
      • (i)How are foreign-currency-denominated deposits classified if they are held by (i) residents, and (ii) nonresidents? Why are residents’ and nonresidents’ deposits treated differently?
      • (ii) Why are government deposits excluded from the money stock while those of the private sector are included?
      • (iii) What factors might account for differences between the growth rates of reserve money, narrow money, and money plus quasi-money?
    • (3) Discuss how changes in net foreign assets and net claims on government in the monetary survey are related to developments in the balance of payments and the budget.
    • (4) Tables 4.4 and 4.5 present the Monetary Survey and the Accounts of the Monetary Authorities for Turkey. With reference to Table 4.4, discuss the impact of an exchange rate change on the monetary survey.
      • (i) Calculate the change in the valuation adjustment for 1991-95 in the sum of Turkey’s foreign and foreign-currency items.
      • (ii) Where would you classify the counterpart of such a valuation change?
    • (5) Using Tables 4.4 and 4.5, calculate the following items for 1995:
      • the change in foreign reserves of the monetary authorities in U.S. dollar terms, where reserves are defined as convertible assets less short-term liabilities; how does this compare with the change in net official reserves in the balance of payments?
      • the amount of net credit extended by the banking system as a whole to the public sector; how does this compare with the amount of bank financing reported in the fiscal accounts?
      • the increase in broad money (M2X) and the so-called contributions to the growth of broad money from net foreign assets (NFA), domestic credit (DC), and other items, net (OIN); the following identity may be used for this purpose:
    • (6) From the liabilities of the monetary authorities accounts in Table 4.5, calculate reserve money in 1995.
    • (7) Discuss how volatile financial flows complicate the conduct of monetary policy in an open economy. Can monetary policy still retain its ability to influence the rate of inflation in the face of volatile capital inflows? Explain, highlighting the role of the exchange rate.
    • Table 4.4.Turkey: Monetary Survey, 1991-95(End of period; in trillions of Turkish liras)
      Net foreign assets8.6932.2035.89184.21397.30
      Central Bank-0.4413.6916.51-25,30119.46
      Commercial banks9.1318.5119.38209.51277.84
      Domestic Credit135.73261.55507.54972.922,123.35
      Public sector33.9474.32162.18381.29733.79
      Claims on central government (net)20.0055.60125.61307.97687.55
      Central Bank11.2837.4590.89174.89418.06
      Commercial Banks8.7218.1534.72133.08269.49
      Claims on local governments0.
      Claims on public enterprises13.9418.7236.5770.5641.49
      Central Bank4.8511.6012.5225.931.20
      Commercial banks9.097.1224.0544.6340.29
      Private Sector101.79187.23345.36591.631,389.56
      Claims on nonfinancial private sector98.78182.23336.62571.521,356.67
      Claims on nonbank financial institutions3.015.008.7420.1132.89
      Other items, net 1/27.5012.48-40.1077.58-6.63
      Monetary Aggregates
      Currency outside banks17.4130.2451.36101.40188.51
      Demand deposits27.3846.1374.50127.01195.88
      Time and savings deposits76.19126.64186.85441.29971.67
      Residents’ foreign-currency deposits50.94103.23190.62565.011,157.97
      Memorandum items
      M2 (M1 plus time and savings deposits)120.98203.01312.71669.701,356.06
      M2X (M2 plus residents’ foreign currency
      Liras per U.S. dollar, end of period5,0808,56414,47338,72659,650
      Liras per U.S. dollar, period average4,1726,87210,98529,60945,845
      Source: Central Bank of Turkey, Quarterly Bulletin, 1996, and IMF, Turkey—Recent Economic Developments, November 1996.

      Assets net of liabilities

      Source: Central Bank of Turkey, Quarterly Bulletin, 1996, and IMF, Turkey—Recent Economic Developments, November 1996.

      Assets net of liabilities

      Table 4.5.Turkey: Monetary Authorities Accounts, 1991-95(End of period; in trillions of Turkish liras)
      Foreign assets37.2273.52124.91372.84888.77
      Of which: Convertible assets24.0351.3988.37277.05740.46
      Gold, SDRs, IMF reserve position8,0413.1722.1756.4685.54
      Foreign exchange15.9938.2266.20220.59654.92
      Claims on the public sector22.9463.35119.95223.31522.37
      Central government18.0951.75107.43197.38521.17
      Short-term advances13.5930.9870.42122.28192.00
      Government securities (excl. repo’s)4.5020.7737.0175.10329.17
      State economic enterprises4.8511.6012.5225.931.20
      Claims on financial institutions5.7110.1818.8620.5728.71
      Banks, advances and discounts3.977.9216.8612.2512.22
      Lending in interbank market (net)0.420.740.008.2516.46
      Other assets36.9042.7043.27161.62100.41
      Revaluation account32.4234.7431.93133.4225.94
      Foreign liabilities37.6659.83108.40398.13769.31
      Short-term (incl IMF, Dresdner)2.834.909.6545.43100.09
      Other deposits (incl. Dresdner)34.8354.9398.75352.70669.22
      Currency issued21.5037.3063.82121.44226.48
      Residents’ Lira demand deposits16.9228.8340.9277.37123.97
      Central government2.545.293.6011.3712.46
      Other public sector0.260.541 101.162.46
      Private sector0.
      Residents’ Lira time and saving deposits0.721.982.946.7712.43
      Residents’ foreign currency deposits13.3426.8044.53109.78272.65
      Central Government4,269.0212.9411.1190.65
      Other public sector1.051,843.833.1312.15
      Other liabilities12.6335.0146.3864.85135.42
      Memo item:
      Banks’ required reserves16.8530.7851.48122.54250.87
      Sources: Central Bank of the Republic of Turkey, Quarterly Bulletin, and IMF, Turkey—Recent Economic Developments, November 1996.
      Sources: Central Bank of the Republic of Turkey, Quarterly Bulletin, and IMF, Turkey—Recent Economic Developments, November 1996.
      Table 4.6.Turkey: Analytical Balance Sheet of the Monetary Authorities, 1991-95(End of period; in trillions of Turkish liras)
      Net foreign assets-0.4413.6916.51-25.29119.46
      Net international reserves21.2046.4978.72231,62640.37
      Other foreign assets, net-21.64-32.80-62.21-256.91-520.91
      Claims on the public sector16.1449.04103.41200.83419.26
      Net claims on central government11.2937.4490.89174.90418.06
      Gross claims on other public sector4.8511.60125225.931.20
      Gross claims on banks4.398.6616.8620.5028.68
      Other items, net1/25.599.21-1.1196.84-34.98
      Reserve money45.6880.60135.67292.88532.42
      Source: Based on Table 4.5, “Monetary Authorities Accounts.”

      Assets net of liabilities.

      Source: Based on Table 4.5, “Monetary Authorities Accounts.”

      Assets net of liabilities.


Susana Almuina, David Marston, and Armida San Jose contributed helpful comments on technical points in this chapter.


However, not all banking systems are reasonably managed at all times. A survey of significant banking system problems since 1980 in IMF member countries is given in Carl-Johan Lindgren, Gillian Garcia and Matthew I. Saal, Bank Soundness and Macroeconomic Policy (Washington: International Monetary Fund, 1996), Annex to Part 1.


However, in some countries banks hold longer-term items, including corporate stocks and bonds, in their portfolios.


DMBs are often commercial banks but may also be financial institutions, such as savings banks, whose liabilities include appreciable deposits against which checks can be written to settle obligations. For more details, see International Monetary Fund, A Guide to Money and Banking Statistics in International Financial Statistics, Draft, December, 1984. A new draft of this document has been prepared to bring guidelines into step with current monetary and financial practices. In the new draft version, a change is proposed in the name of DMB’s; banks are to be called “depository corporations.” This change is meant to allow for the fact that, currently, the word “bank” is applied in some countries to institutions that do not accept liquid deposits. See International Monetary Fund, Manual on Monetary and Financial Statistics, revised draft (Washington: IMF, Department of Statistics, March, 1999).


For a comprehensive discussion of the role and objectives of a central bank, see Stanley Fischer, “Modern Central Banking,” Chapter 2 in The Future of Centra! Banking, The Tercentenary Symposium of the Bank of England, by Forrest Ca∏, Charles Goodhart, Stanley Fischer and Norbert Schnadt, (New York: Cambridge University Press, 1994). See also Stanley Fischer, “Central Banking: the Challenges Ahead,” Statement at the 25th Anniversary Symposium of the Monetary Authority of Singapore, May 10, 1996.


The central Bank also obtains seigniorage from this process. See the discussion in Appendix 1 to Chapter 2.


Foreign-currency-denominated deposits of foreigners, if any, are foreign liabilities; FCDs of residents are domestic liabilities even though denominated in foreign currency.


For many countries, including Turkey, only the central government has access to central bank credit; other components of general government, in particular local governments, do not. In such cases, deposits of local governments in the banking system are not separated from other deposits in defining money nor are they subtracted from “credit to government.” For local governments, and also for state enterprises, it is likely that deposit balances do tend to influence spending. These deposits, whether held in the central bank or in commercial banks, are included with household and enterprise deposits in calculating the value of the money stock.


In Turkey, the practice in the central bank is to include all nonbank, non-central-government domestic deposits in reserve money.


It may seem counter-intuitive to include foreign currency deposits as part of reserve money. In many countries, including Turkey, commercial banks have considerable scope to borrow abroad. Banks can use the proceeds of foreign loans to increase their foreign currency balances with the central bank. Thus, it might appear that the commercial banks, themselves, determine the quantity of a part of reserve money in the domestic banking system by their foreign borrowing activities, and the central bank’s attempts to control the growth of liquidity and credit in the system can be avoided. This is discussed in Sections c(2) and c(3), below.


If the purchase of an asset by the central bank from residents (for example, government securities or foreign exchange) is matched by the selling of another asset to residents, the monetary base will not change. In this case the initial action (the purchase of an asset) has been sterilized, in the sense that its impact on the monetary base, and hence on overall liquidity conditions in the economy, has been offset.


transactions with the IMF do not affect the stock of reserve money. See Box 4.4.


Other important features include stipulation of the types of financial asset that the central bank is permitted to acquire in ownership or as collateral when it makes the credit available, and the maximum amount of credit that the central bank makes available to any one borrower.


In most countries with established financial markets, this type offending is limited to providing short-term financing to smooth out temporary liquidity needs of banks or to provide strong support during a bank crisis (“lender of last resort”). In either case, this lending often takes the form of collateralized loans against government or other securities.


Nonresident deposits in any currency and any maturity are included under foreign liabilities.


For further discussion, see Chapter 3 on balance of payments accounts and analysis.


Even in a system with low or zero required-reserve ratios, banks will hold prudential reserves according to their perceptions of the outlook for withdrawals and deposits, and will usually retain an account in the central bank—to accommodate central bank credit operations and possibly to clear checks. As long as banks need reserves, at least occasionally, to satisfy unpredictable withdrawal demands of depositors and to finance check-clearing balances (reserves of cash, deposits in correspondent banks, and deposits in the central bank), the central bank can continue to have a major impact on the maximum size and growth of the money supply through its role in determining the stock of reserve money. It does this through open market operations in securities or other assets and through the availability of credit to banks.

Lowering required-reserve ratios potentially reduces intermediation costs to banks. This result occurs because the central bank typically pays no or little interest on DMB deposits (although it could do so). By reducing the share of banks’ assets that earn zero interest, the decrease in required-reserve ratios will cause an increase in the share of bank assets that earns market-related interest rates. With an improved flow of interest earnings relative to their asset holdings, banks are able to reduce lending rates and increase deposit rates. A narrowing of the spread between the two arguably increases the efficiency of the banking system. In practice, however, greater supervisory problems can arise if individual banks misjudge the volume of voluntary reserves they need, requiring a larger role for the central bank as lender of last resort if confidence in the system is to be maintained.


Vault cash is certainly part of banks’ reserves in the more general sense, whether or not it may be counted toward meeting the required-reserve level. A bank can make payment on a withdrawal in the form of vault cash (and, of course, would normally do so) without touching its central bank reserves, so that one is a substitute for the other. Similarly, a bank could in principle deposit vault cash in its central bank account at any time to raise its official reserve holdings. On these topics, see Daniel C. Hardy, “Reserve Requirements and Monetary Management: An Introduction,” Chapter 2 in Tomas J. Baliho and Lorena M. Zamalloa, eds., Instruments of Monetary Management (Washington: International Monetary Fund, 1997), and Zamalloa, Appendix 1 to Chapter 2, “Reserve Requirements in Selected Countries,” p. 67.


A financial instrument is included as part of money if it can serve as means of payment, store of value, unit of account, has a fixed nominal value, and is liquid (it is immediately available for use).


Currency in circulation (CY) refers to the currency in general use outside banks, not to the total stock of currency issued.


Since the monetary survey is typically presented in terms of domestic currency, any items denominated in foreign currency (including foreign assets and liabilities) will change value both with transactions of the banking system and with changes in the exchange rate. The accounting offset to a change in valuation related to exchange rate changes will be included in other items, net. See Box 4.8.


Strictly speaking, this comment refers to the stability of the money-demand relationship, which is introduced in the following section.


Income velocity is similar to a related concept called the transactions velocity of money, which is defined as the ratio of total money transactions in the economy in a given period to the money stock. Transactions velocity is generally higher than income velocity, because a dollar of GDP typically requires transactions (for example, the purchase of inputs) worth several dollars. Transactions velocity, unlike income velocity, is difficult to calculate precisely, but has been estimated to be around three times as large as income velocity for some industrial countries.


This equation is only approximate since it omits the cross product of changes in the variables (for example, ΔP/PΔY/Y). These cross products are very small for small changes in variables.


If the income elasticity of the demand for money is one, changes in real income do not affect velocity. Velocity will increase (decrease) if the elasticity is less than one (greater than one).


An initial increase in reserve money is typically associated with an increase in commercial banks’ deposits somewhere in the system. If suitable borrowers can be found, the bank or banks with larger deposits expand their loans in order to increase interest income. Spending of the loan proceeds leads to further deposit increases and to an additional increase in credit, potentially, as banks again increase lending out of larger deposits, and so on. At each stage, a part of the extra deposits is held as increased reserves (reserve money) with the central bank, so that there is a limit to the monetary expansion. Ultimately, the amount of extra deposits created will be a multiple of the original increase in reserve money, as equations (4.13) and (4.14) in the text imply.


Reserve money is defined in Section b(3), above. Recall that it may include nonbank, nongovernment deposits (if the central bank accepts such deposits, typically zero or small).


The question may be asked whether it is necessary or useful for banks to hold the reserves against their FCDs in the form of foreign currency deposits at the central bank—instead of domestic currency deposits at the central bank. It is typical for the central bank to require that deposit money banks holds the reserves against their FCDs also in foreign currency denominated accounts. This common practice is probably based on the traditional assumption that, in holding foreign currency reserves, banks are enabled to participate and assist the central bank by providing foreign assets in case of a sudden withdrawal of foreign currency deposits (or a conversion of domestic currency deposits to foreign currency deposits).

As we have seen, so-called foreign currency deposits are denominated in foreign currency but do not contain foreign currency. Banks’ foreign assets and liabilities give the true indication of their ability to redeem depositors’ “foreign currency accounts” in actual foreign currency. The central bank makes an explicit choice as to the size of its net, liquid foreign assets, which determines its range of choices—to intervene or to let the rate float—in the case of an unexpected, large outflow of capital (finance). On this basis, arguably central banks lose little if all commercial bank reserves are held in the form of domestic currency, whether the reserves are required with respect to domestic currency deposits or foreign currency deposits.


The yield curve depicts a relationship between the maturities of financial assets with similar characteristics and the rates of return on these assets. Depending on expectations concerning future interest rates, the yield curve can be upward sloping (with longer maturities fetching higher interest rates) or downward sloping.


Adapted from World Economic Outlook (Washington: International Monetary Fund, October 1994).


See Ratna Sahay and Carlos A. Vegh, “Dollarization in Economies in Transition: Evidence and Policy Issues,” IMF Working Paper 95/96 (Washington: International Monetary Fund, 1995), and Guillermo A. Calvo and Carlos A. Vegh, “Currency Substitution in Developing Countries: An Introduction,” Revista de Andlisis Economico, Vol. 7 (Washington: International Monetary Fund, June, 1992), pp. 3-27.


In the absence of data on foreign cash held by the public and on foreign exchange deposited in banks abroad, estimates of the extent of dollarization are based on domestic foreign currency deposits only. For this reason, dollarization ratios frequently underestimate the phenomenon of currency substitution.


This section draws on International Monetary Fund, Turkey—Recent Economic Developments, IMF Staff Country Report No. 96/122 (Washington: IMF, November, 1996), Chapter III and on earlier unpublished staff papers.


See IMF, Turkey, Recent Economic Developments, 1996, p. 32.

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