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6.2. Central banks

6.2.1. Introduction

A central bank is a public authority that is responsible for monetary policy for a country or a group of countries. Two important central banks are the European Central Bank (for countries that are members in the European Monetary Union) and the Federal Reserve of the United States.

Central banks have a monopoly on issuing the national currency, and the primary responsibility of a central bank is to maintain a stable national currency for a country (or a stable common currency for a currency union). Stability is sometimes specified in terms of inflation and /or growth rate in the money supply.

Other important responsibilities include providing banking services to commercial banks and the government and regulating financial markets and institutions. In this sense, a central bank is the "bankers’ bank" - other banks can borrow from or lend money to the central bank. Therefore, all banks in a country have an account in the central bank. When a commercial bank orders currency from the central bank, the corresponding amount is withdrawn from this account. This account is also used for transfers between commercial banks. Central banks also manage the country’s foreign exchange and gold reserves.

6.2.2. Monetary base

The monetary base is defined as the total value of all currency (banknotes and coins) outside the central bank and commercial banks’ (net) reserves with the central bank. The monetary base is a debt in the balance sheet of the central bank. Its assets are mostly comprised of the foreign exchange and gold reserves and bonds issued by the national government. Currency inside the central bank has no value -it is comparable to an "I owe you" written by yourself and held by yourself.

Since the central bank has a monopoly on issuing currency, it is in complete control of the monetary base. In section 7.4.2 we will describe exactly how they change the monetary base. However, the central bank does not completely control the money supply. This is due to the second component of the money supply - bank deposits - which it cannot control. Fortunately, it has methods of influencing the total money supply and these methods will be discussed in chapter 7.

In many countries, the central bank imposes reserve requirements. This means that commercial banks are obliged to hold a certain percentage of deposits as reserves either as currency in their vaults or as a deposit at the central bank. Reserve requirements are usually rather small (typically between 0% and 10%) which means that the monetary base is quite close to the value of all currency outside the central bank.

6.3. Commercial banks

6.3.1. Currency inside banks is not money

The fact that currency inside commercial banks is not money may strike you as odd, but it is an important principle. The 100 dollar bill in the ATM will become money only at the instant you withdraw it. The reason is this. We want the money supply to measure how much is available for immediate consumption. But currency inside a bank cannot be used for consumption and this is why it is not counted in the money supply. Cash in the bank is not money, but the binary bits in the bank’s computer system representing the balance in your checking account are!

An example may also illustrate this important fact:

• Eric has 100 euro - this amount is obviously part of the money supply as it is immediately available for consumption.

• Eric deposits 100 euro into his checking account. He still has 100 euro available for immediate consumption using his debit card and the money supply should not be changed by this deposit (it is not - deposits are included in the money supply).

• Eric’s bank now has 100 euro more than before deposit. If we count currency inside the bank as money, the money supply would have increased by 100 euro by his deposit. This does not make sense as the amount available for immediate consumption has not changed.

• In the same way, withdrawing money from the ATM does not affect the money supply. When you withdraw money, currency outside banks increases while your checking balance decreases by the same amount.

Even though currency inside a bank is not money, it is still part of the monetary base. 100 euro inside the bank is obviously still worth 100 euro to the bank even though we do not include it in the money supply.

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