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1. Go to the ECB and FRED websites and download the time series
(monthly or quarterly is fine) of deposits, currency, excess reserves and
required reserves, for both the euro area and US, since 2005.
a)

Eurozone (EZ)1

c (EZ)
0.2500
0.2000
0.1500
0.1000
0.0500
0.0000

c (EZ)

1 http://sdw.ecb.europa.eu/browse.do?node=2018802 for reserves and liquidity

data.http://sdw.ecb.europa.eu/browse.do?node=2018810 for monetary aggregates and
counterparts data.

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e (EZ)
0.25
0.2
0.15
0.1
0.05
0

e (EZ)

RR (EZ)
0.080
0.060
0.040
0.020
0.000

RR

US

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c (US)
3
2.5
2
1.5
1
0.5
0

c (US)

e (US)
2000
1500
1000
500
0

e (US)

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RR (US)
0.1
0.08
0.06
0.04
0.02
0

RR

b)

Explain their behavior over time.

In general terms, the graphics clearly show not only, over time, the different
economic realities existent in both sides of the Atlantic but also the actions taken by
central banks (i.e. their policies).
For a better comparison, consider the following graphics that allow for a better
comparison between both series.

Currency Ratio
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Homework 2

Currency Ratio
3.000
2.500
2.000
1.500
1.000
0.500
0.000

c (US)

c (EZ)

From this first graph, one can draw some conclusions, based on what the currency
ratio represents. First, we can see that in the US, individuals are much fonder of
having currency in circulation as compared to their deposits: for each dollar in their
account, they have been holding more than one dollar in their pockets. There is a
downward trend, however, that started mid-2008, that actually counteracts the
upward one from January 2005 up to that date. It shows in a way that at a country
level, preferences on money held by Americans changed, starting to getting closer to
that of the Europeans2. Usually, one explanation for this can be the fact that
Americans, from 2009 onwards start gaining confidence in their banking system.
Another explanation can be the increasing number of people with more wealth, since
richer people are the one more prone to holding deposits that poorer people 3. Finally,
interest rates on deposits offered by banks influences people on whether or not, to

2 For a matter of simplicity, when one refers to Europeans, one is talking about the
ones living in the Eurozone
3 http://www.ibtimes.com/us-income-inequality-record-high-top-1-earned-fifthtotal-income-2012-1404335
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hold currency versus put the money in the bank. Data indicates that people have had
a lower incentive to hold currency compared to put the money in the bank.
The fairly stable values of the currency ratio in the Eurozone is the result of the
efforts by the European Central Bank (ECB) to keep Money Supply and other
aggregates stable over time in order to control inflation, their main goal, despite the
crisis that hit the region.
Note that M1 is directly affected by this ratio, and big changes in value may prompt
the central bank to take action by, for example, changing the money supply to
control inflation.

Excess Reserves Ratio

This ratio clearly reflects the two distinct situations in the financial systems of the US
and the Eurozone. By definition, this ratio shows how many dollars financial
institutions hold in excess of what is required them to hold, per dollar deposited 4.
In order to better show what happened before September 2008, an auxiliary graph is
presented below. The main graphic comes after, where the period after September
2008 will be addressed.

4 As suggested, the e (EZ) was calculated by subtracting currency and required

reserves to the money base: Money base - Currency ReqReserves.
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Excess Reserves Ratio (until Sept-08)

10

0.01
0.01

0.01

0.01

0.01
0

e (US)

e (EZ)

Before September 2008, when Lehman Brothers filed for bankruptcy and the turmoil
in the financial system began, this ratio can be characterized as being fairly stable
over time5. This means that banks kept their excess reserves evolving according to
the more or less deposits they had in their balance sheets.

5 Standard Deviation for the US series was 0,852 and for the EZ was 0,002 in that
period.
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Excess Reserves Ratio

2000

0.25
0.2

1500

0.15

1000

0.1

e (US)
500

0.05

e (US)

e (EZ)

However, as we can see in this graph, the beginning of the crisis had a huge
impact in this variable, especially in the US. Excess reserves went from a pre-crisis
value of around $1,5 billion to over $900 billion in
Excess Reserves Ratio
January 2009, and still increasing afterwards. The
e (US) e (EZ)
following table details the evolution in the period before
Jul-08
3,001
0,009 and after September 2008.
Aug-08
3,014
0,010
Sept-08 88,161
0,008 The increase in reserves by banks was, in particular,
Oct-08 397,673
0,002 result of FED policies to comprise the impact of the
Nov-08 797,729
0,071 crisis. These policies were aimed basically at increasing
Dec-08 979,973
0,067 money supply in the economy. This expansionary
fashion of monetary policy, was conducted using usual
means (FED buying short-term government bonds), and more unconventional
means, namely the three Quantitative Easing seasons that instead of aiming to
government bonds, were targeted mainly to financial assets of commercial banks
and the like. Then, the values of excess reserves held by those financial
institutions is connected to the way and the speed at which they lend money to
the economy, or in other words, the amount of credit given to individuals and
companies. The more they lend, the lower the excess reserves, everything else
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constant. Also, the Federal Reserve Banks pay interest on excess balances 6 in order
to keep central banks influence over both market interest rates and ultimately
inflation, independent of the quantity if reserves created. In this case, facing the
crisis, they wanted to avoid very low market interest rates and a sudden increase in
inflation, with the increase in excess reserves.
A similar interpretation can be given to the EZ data, that is, values of the Excess
Reserves Ratio have been impacted by Central Bank measures. It is important to
remember that the financial crisis originated in the US, and hit first and foremost its
financial system. In Europe, the situation was a little bit different. Although, like in
America, different European countries had to bailout some banks to prevent further
damage in the financial system, the actions taken by the ECB up to July 2009 were
more conservative as the main goal kept being the control of inflation, and not a
direct intervention in the economy. Note that that intervention would be done via
financial institutions. After July 2009, and with the worsening of the debt crisis, then
the ECB started more unconventional programs, namely the Securities Market
Program. Despite being non-conventional, this program is different from Quantitative
Easing, and that helps to explain why the Excess Reserves Ratio didnt follow the
same magnitude as the American one. According to a press release by the ECB 7 the
objective of this program was to repair the transmission mechanism, and not inject
additional liquidity in the economy, as the QE did. Here it is shown the worry by the
ECB of maintaining price stability. Of course that one can still argue that the money
commercial banks asked to the central bank flowed well into the economy, in a
different fashion than the US, keeping the low values registered. The spike in the
value of e (EZ) in April 2012 matched the height of the European crisis.

Required Reserve Ratio

This ratio explains the minimum amount of cash, banks must have in relation to their
deposits on hand. This ratio represents one of the ways central banks have to
implement, indirectly, their monetary policy.

6 http://georgewashington2.blogspot.de/2010/03/m1-money-multiplier-stillcrashing-each.html
7 http://www.ecb.europa.eu/press/key/date/2011/html/sp111021_1.en.html
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Reserve Ratio
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%

RR (US)

RR (EZ)

This ratio, contrary to the other two analyzed so far, is quite stable in the US, with a
very slight upward trend since the beginning of the crisis. One can say that FED
decided not to use this tool to implement their monetary policy, but rather other
methods, already mentioned above.
The EZ data shows no significant changes except the drop occurred in January 2012
which is explained by the cut made in the reserve coefficient from 2% to 1% 8 that
had a direct impact in the ratio. The goal of this drop was to give incentives to banks
to give more credit to the economy as it liberates more liquidity that is no longer
required to be still in the banks.

c)

Also construct the money multiplier. Is it stable? What does it imply for
the conduct of monetary policy?

8 http://www.marketwatch.com/story/euro-zone-banks-overnight-ecb-depositsdive-2012-01-19
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Homework 2
The following graph shows the evolution of the money multiplier over time in both US
and the EZ.

Multiplier
4
3.5
3
2.5
2
1.5
1
0.5
0

m (US)

m (EZ)

There are three things that stand out in value of the Multiplier over time: First, the EZ
one is higher than that of the America; second, the crisis (beginning September
2008) brought variability, especially in the Eurozone (standard deviation of 0,41 vs.
0,36 in the US); third, despite that variability, the values of the multiplier are just
below the ones registered 8 years ago. It was possible for commercial banks in the
EZ to create more money for each ECB euro compared to their American
counterparts. In other words, commercial banks in the EZ were allowed to lend more
money based on their reserves then in the US 9. Another thing to point out of this
graphic is the fall of the multiplier to less than 1 in the US, meaning that a 1$
increase in the Monetary Base results in a lower increase in the money supply. This
actually makes sense given that banks kept increasing their excess reserves instead
of lending out money, and discussed before. So there is less money supplied to the
economy.
Although there is no agreement on this matter 10, I believe that in the end the
multiplier can influence monetary policy via reserve required by central banks. The
effect of the multiplier is linked to that type reserves. The lower the required reserves
9 Mm=1/RR, being RR the reserve requirement
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percentage, the higher the money supply, because banks can potentially lend more
money and spread it in the economy. Example: If the ECB says 5% as the Reserve
requirement and the bank has 1000 originally, it can lend up to 950 to another
bank. At the rate of 5%, that other bank will manage to lend up to 902,5, and so
on. This results in the formula for the multiplier (1/RR). In the end, it could be created
up to 20000, depending on the capacity for banks to lend. Note that this capacity is
out of control by central banks. They have to take into account the macroeconomic
factors that influence both the willingness of banks to lend money, and the eagerness
of borrowers to take out loans. We can see this effect in practice in the drop of
reserve coefficient from 2% to 1% by the ECB. It evaluated the macroeconomic
conditions and the several confidence indexes on the economy to see that there were
enough conditions to diminish the coefficient, despite inducing an inflationary
pressure in the economy.
In sum, it may happen that higher values of the money multiplier may influence
negatively the monetary policy in the future, that is, central banks will act cautiously
over the supply of money. The opposite also stands.
If we compare the multiplier with the other variables we can see that, in fact, it would
be normal for one to expect a different behavior of the multiplier, especially in the
US: the very large increase in reserves had little or none impact caught by the
multiplier, opposite to what it would be expected.

2. Go to the ECB website and download the Q&A that followed the last ECB
meeting. Choose a question and give an answer instead of Mario Draghi (no
more than 10 lines).
The question chosen was the following: Mr President, I know that sometimes you
dont answer questions on specific countries, like Italy, but maybe you have a
message to send to the markets about what is needed to avoid the destabilizing risks
to growth and to recovery?
10 http://ftalphaville.ft.com/2010/08/12/313756/%E2%80%98there-is-no-moneymultiplier/http://voices.yahoo.com/the-money-multiplier-effect-federal-reserve-policy8223059.html?cat=3
http://soberlook.com/2013/01/low-money-multiplier-does-not-justify.html
http://bilbo.economicoutlook.net/blog/?p=10733

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My answer would be: The whole euro-area needs to go back to economic growth, and
as you know, bailed-out countries are facing an increased challenge in doing it. Those
countries, in particular, because of their current, unique situations, need to ensure
the proper conditions in order to restore growth. In my opinion, uncertainty created in
their own countries can have Political, Social, and Regulatory roots. When I say
political risks, I refer to level of commitment from parties to guarantee wide
parliamentary-agreed policies and strategies for each country. When I refer to Social
risks, I refer to the increased or reduced ability for each society to accommodate
structural reforms induced by governments. This is expressed for example, by the
number and magnitude of strikes, or other ways that allow markets to assess this.
When I talk about Regulatory roots, I am pointing out, for example, to the ease to
make business, to the law system in each country, and to simpler and stable tax
codes that allow for increase in confidence and investment.
3. In a short 1-page essay (written in your best English!) explain how the
central bank controls the overnight interbank market. How can the
control of the overnight interbank market influence/transmit to the rest
of the term structure? Do you think this transmission works in the euro
area? Why?
The ECB implements monetary policy mainly via open market operations in order to
drive the EURIBORs, manage liquidity in the EZ, and signaling the monetary policy
stance. The overnight interbank market is the first step in the monetary policy
transmission policy.11 In other words, it is the primary source of liquidity given by the
ECB to major financial banks and institutions.
The control of the overnight interbank market is made by making Euros available for
banks to buy or sell (as they are trying to meet their reserve requirements), and this
way, the ECB controls the liquidity, and, indirectly, the money available in the
economy. The euro overnight index average rate (EONIA) marks the beginning of the
yield curve. One can say that the EONIA is the opportunity cost of banks to hold their
required reserves. Banks want to hold on to reserves when EONIA is low, and the
opposite when it is high, in relation to future expected overnight rates within the
maintenance period.12 So, current and past conditions, together with this expectation
will influence banks behavior. The ECB will influence this market through its current
and past actions that will influence expectations and therefore effective buying and
11 http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp983.pdf
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selling of money.13 Controlling the EONIA is important because of its transmission to
longer term maturities of lending. Indeed, there seems to be a long-run equilibrium
relationship between overnight rates and corresponding 1-month and 3-month
rates14.
If banks increase their reserves - borrowed at a rate x in excess to the
requirements, that money in excess they want to lend, say, to another bank,
obviously, at a higher rate. The maturity of this second lending is higher than that of
the EONIA. This process continues to longer maturity dates, and the as more levels of
transmission exist, then the impact of the first rate exists, but gets lower the farther
one goes in the term structure.
In the subject of the question, there is a before and after the crisis 15, with the
appearance of the default risk to the counterparty risk. As the perceived
counterparty risk changed, and liquidity got scarce, it got less clear of a connection
between EONIA and longer-term interest rates.

12 One can compare this with the acquisition of any asset: if we see its value is
going up in the future, we want to buy it today to sell it later at a higher price.
13 http://www.ecuactivities.be/documents/publications/publication/2000_1/bindseil.html
14 http://www.opf.slu.cz/kfi/icfb/proc2011/pdf/39_Mutu.pdf
15http://www.clsbe.lisboa.ucp.pt/resources/Documents/PROFESSORES/SEMINARIOS
/FilipovicTrolle%20The%20term%20structure%20of%20interbank%20risk.pdf
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