CENTRAL BANK ACCOUNTING - MIT … Transactions among consumers Increase money supply Taxes and...

CENTRAL BANK ACCOUNTING

Monday, February 14, 2011

Central BankCentral Bank

CENTRAL BANK ACCOUNTS

R = International Reserves

M = Money supply

D = Domestic Credit

Central BankCentral Bank

Assume we are in an emerging market

Assume that exchange rate is fixed to one peso is one dollar

Central BankCentral BankCentral BankCentral Bank

R 4 M 4

ConsumersConsumersConsumersConsumers

Cash 4

Bond 2

GovernmentGovernmentGovernmentGovernment

Bond 2

TRANSACTIONS

Transactions among consumers

Increase money supply

Taxes and Government expenses (fiscal responsibility)

Fiscal expenditures and borrow from consumers

Fiscal expenditures and borrow from central bank

Fiscal expenditures and foreign borrowing

Export services

CONSUMERS

Any transaction between consumers does not change the balance sheet.

Can all the pesos be converted to dollars at the prevailing rate?

R 4 M 4

Cash 4

Bond 2

TRANSACTIONS

M/R DD FD

Transactions among consumers 0 0 0

Export services

INCREASE MONEY

Central bank purchases from consumers the bonds

R 4 M 4

Cash 4

Bond 2

INCREASE MONEY

Central bank purchases from consumers the bonds

R 4 M 4+2

Cash 4+2

Bond 2-2

Bond 2

INCREASE MONEY

Printing without backing

R 4 M 6

Cash 6

Bond 0

Bond 2

TRANSACTIONS

M/R DD FD

Increase money supply 0 0

Export services

IMPACT ON THE INTEREST RATE

Pb = 1

1 + ib

Demand

Supply

Supply is given by the treasuries

decision to borrow

Demand includes 3 agents:

•How many bonds do consumers want?

•How many do foreigners want?

•How many the central bank wants?

Pb = 1

1 + ib

Demand

Supply Pb

TAXES AND EXPENDITURES

Tax consumers and spend money

R 4 M 4

Cash 4

Bond 2

Tax consumers - taxes are paid in cash

R 4 M 4

Cash 4-2

Bond 2

Cash 2 Bond 2

When the government spends the money they buy services from consumers and pay the cash

R 4 M 4

Cash 2+2

Bond 2

Cash 2-2 Bond 2

Fiscal policy with balance budget has no impact on the aggregate balance sheet.

R 4 M 4

Cash 4

Bond 2

TRANSACTIONS

M/R DD FD

Taxes and Government expenses (fiscal responsibility) 0 0 0

Export services

EXPENDITURES AND BORROW FROM CONSUMERS

Now the government borrows from the consumers (sells bonds in exchange of cash)

And then it spends the cash

R 4 M 4

Cash 4

Bond 2

Selling the bond

R 4 M 4

Cash 4-2

Bond 2+2

Cash 2 Bond 2+2

Total cash out of the central bank does not change with the transaction.

R 4 M 4

Cash 2

Bond 4

Cash 2 Bond 4

Spend taxes

R 4 M 4

Cash 2+2

Bond 4

Cash 2-2 Bond 4

Government debt increases. The consequence is that domestic interest rates increase. That is exactly what happens in the ISLM.

R 4 M 4

Cash 4

Bond 4

TRANSACTIONS

M/R DD FD

Fiscal expenditures and borrow from consumers 0 0

Export services

Pb = 1

1 + ib

Demand

Supply Pb

EXPENDITURES AND BORROW FROM CENTRAL BANK

The government borrows from the central bank (sells bonds in exchange of cash)

And then it spends the cash

R 4 M 4

Cash 4

Bond 2

Borrowing from the Central Bank (selling the bond to the Central Bank)

The Central Bank pays with cash (in other words we are printing money again).

R 4 M 4+2

Cash 4

Bond 2

Cash 2 Bond 2+2

Debt of the government has increased

Cash out of the central bank has also increased

R 4 M 6

Cash 4

Bond 2

Cash 2 Bond 4

Spending

R 4 M 6

Cash 4+2

Bond 2

Cash 2-2 Bond 2+2

Debt increases and there is an imbalance between domestic currency and reserves.

R 4 M 6

Cash 6

Bond 2

Bond 4

TRANSACTIONS

M/R DD FD

Fiscal expenditures and borrow from central bank 0

Export services

EXPENDITURES AND BORROW FROM FOREIGNERS

The government issues debt in foreign currency (US$) to foreigners and get dollars for it.

They convert the dollars into pesos in the central bank

Then the spend the money in the consumers

R 4 M 4

Cash 4

Bond 2

Cash 0 Bond 2

$’s 0 For. Bond 0

ForeignersForeignersForeignersForeigners

$’s 10

For. Debt 0

Borrow from Foreigners

R 4 M 4

Cash 4

Bond 2

Cash 0 Bond 2

$’s 0+2 For. Bond 0+2

$’s 10-2

For. Debt 0+2

For the moment there is no impact on the domestic economy.

R 4 M 4

Cash 4

Bond 2

Cash 0 Bond 2

$’s 2 For. Bond 2

$’s 8

For. Debt 2

Change the dollars to pesos in the central bank

R 4+2 M 4+2

Cash 4

Bond 2

Cash 0+2 Bond 2

$’s 2-2 For. Bond 2

$’s 8

For. Debt 2

Change the dollars to pesos in the central bank

R 6 M 6

Cash 4

Bond 2

Cash 2 Bond 2

$’s 0 For. Bond 2

$’s 8

For. Debt 2

Spend the money

R 6 M 6

Cash 4+2

Bond 2

Cash 2-2 Bond 2

$’s 0 For. Bond 2

$’s 8

For. Debt 2

Notice that credibility is not affected!

Foreign debt increases. That’s all! This is why a lot of countries prefer to borrow in international markets. Very small consequences to the local economy.

R 6 M 6

Cash 6

Bond 2

Cash 0 Bond 2

$’s 0 For. Bond 2

$’s 8

For. Debt 2

TRANSACTIONS

M/R DD FD

Fiscal expenditures and foreign borrowing 0 0

Export services

EXPORTS OF SERVICES

Consumers sell services to foreigners. Foreigners pay with dollars.

The consumers go to the central bank and exchange the dollars for pesos.

R 4 M 4

Cash 4

Bond 2

$’s 0

Cash 0 Bond 2

$’s 10

EXPORTS OF SERVICES

Sell services and goods to foreigners (the act of exporting)

R 4 M 4

Cash 4

Bond 2

$’s 0+2

Cash 0 Bond 2

$’s 10-2

EXPORTS OF SERVICES

Exchange of dollars for pesos

R 4+2 M 4+2

Cash 4+2

Bond 2

$’s 2-2

Cash 0 Bond 2

$’s 10

EXPORTS OF SERVICES

Reserves increase

Credibility of the currency is unafected

R 6 M 6

Cash 6

Bond 2

$’s 0

Cash 0 Bond 2

$’s 8

TRANSACTIONS

M/R DD FD

Export services 0 0 0

TRANSACTIONS

M/R DD FD R

Transactions among consumers 0 0 0 0

Increase money supply 0 0 0

Taxes and Government expenses (fiscal responsibility) 0 0 0 0

Fiscal expenditures and borrow from consumers 0 0 0

Fiscal expenditures and borrow from central bank 0 0

Export services 0 0 0

MIT OpenCourseWarehttp://ocw.mit.edu

15.012 Applied Macro- and International Economics Spring 2011

For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms.

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