Douglas R. Mudd

Geoffrey E. Wood

English

Research Papers in Economics

Do Foreigners Control the U.S. Money Supply?
GEOFFREY E. WOOD and DOUGLAS R. MUDD
‘A,
-I —
a. l-IERE have recently appeared claims that de-
velopments in the Eurodollar market have contributed
substantially to the current expansion of the U.S.
money supply (M )J These claims imply that the
Eurodollar system is a source of monetary disttmrb-
ances which the Federal Reserve System cannot offset.
On the basis of these claims, it is sometimes then
assem-ted that the recent weakness of the dollar in
foreign exchange markets has been due to an expan-
sion of M1 caused by transactions in the Eurodollar
market.
In fact, the extent to which transactions in the
Eurodollar market can affect M~,and thereby make
more difficult the Federal Reserve’s task of monetary
control, is at immost very somalI. Further, any effect on
NI from Eurodollar transactions can he fulI~’offset
by Federal Reserve’aetious. Therefore, if Eurodollar
transactions do affect N-I , it must he with the concur-
rence of the Federal Reserve System.
I
Eurodollar deposits are dollar-denominated deposit
liabilities of banks, incbmdmng branches of U.S. banks,
located outside the U.S.:’ These dollar-denomuinated
‘See, for examnpie. “Economic Diary: Solving the Riddle of
Mommetany Growth,” Business Week, Novemnhcr 7, 1977, p. 14
am md ‘‘A Reader Writes : F tmroinai’kct I-las C;~s~ neml Comdnol of
U.S. Money Supply,” lime Money Manager, October 17, 1977,
p. 8. Mi is defined as demmmammd deposits phis currency and in—
eludes holdings of these by foreign governments, finammeial
immstitutinus, and immcimviduals. as well as those of U.S. residleni mc
m
Fltmi’orlollar deposits are therefmmre not U.S. dollars owned ex-
clusively by foroigmmers. It should also be noted that Euro—
claims are owned not only by foreign citizens and
corporations hut also by U.S. citizens and corpora-
tions, international organizations, and by national
governments.
Funds can be transferred from a U.S. bank to a
Eurodollar account for a variety of reasons. It may be
that a U.S. citizen sees that a higher rate of interest
can lie earned at a Emmrobank (any bank outside the
U.S. whiclm has dollar-denomninated assets and liabili-
ties), or tbat a foreign corporation receives a check
from a U.S. corporation in payment for goods, audi
decide-s to keep those hmcls in dollars, although at a
bank outside the 1,1.5.
In any event, the Eurobank now owns a demand
deposit at a U.S. bank. The effect on the U.S. banking
system of establishing the Eurodollar deposit has been
to transfer ownership of a demand deposit from a U.S.
resident to a Eurobank. Thus, the “creation” of the
Eurodollar deposit has no effect on the money stock
of the U.S.
The Eurobank receiving the deposit can subse-
quently extend dollar loans based on the demand
deposit which it holds at a U.S. bank, maintaining
some portion of the demand deposit at the U.S. hank
as “precautionary reserves.”3
dollars are dollar—denominated claims 0mm banks outside the
U.S., not bnmnnlles of U-S. cnmrrency. (Just as the bulk of tho
U.S. money stock comprises claims on banks in the U.S., and
mot actual ennrc,icr in cire ilatiom i.
:mThere is no reasmm in primiciple why the loamm should be a dol-
lar loam!; it could be in somne other currency. We have dealt
only with a dollar loan so as to focus on the particular point
at issue.
Page 8FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1977
The loan might take the form of a dollar loan to a
European corporation, executed by transferring some
portion of the deposit which the Eurobank holds in
the U.S. to a demand deposit account held by the
borrowing corporation at the same or another U.S.
hank. The net effect on the U.S. banking system of
this Eurodollar loan again would be a transfer of
ownership of demand deposit accommnts without chang-
ing the level of total U.S. demand deposits.
The foreign-based corporation receiving the Euro-
dollar loan in this example could use the demand
deposit account which it now owns in the U.S.to make
final paymnent for goods and services purchased in the
U.S. Alternatively, it could1 decide to deposit part or
all of the Eurodollar loan in another Eurohank. In this
case, the Eurohank could extend further Eurodollar
loans, pending the use of the funds by the corporation.
The “creation” of Eurodollar deposits is thus a
process identical to the “creation” of bank deposits in
the U.S. banking system. Eurobanks are, insofar as
they deal in dollars, part of the U.S. banking system,
just as Missouri banks are, in that all require U.S.
dollar deposits before they can grant U.S. dollar
loans.4
In the case of the Eurodollar market, the expansion
of Eurodollar deposits is based, in effect, on the
transfer of ownership of demand deposits held by
Eurobanks at U.S. banks.5 The total level of demand
deposit liabilities held by the U.S. banking system,
however, is not changed by the multiple expansion of
Eurodollar deposits.’ The process is identical to that
which would follow if a deposit is withdrawn from one
bank in the U.S. and transferred to another. The first
bank would lose reserves and have to reduce its earn-
ing assets, for example its loans, while the second
-‘This was first pointed out by Milton Friedman, ‘The Enro-
Dollar Market: Some First Principles,” this Review (July
1971), pp. 16-24, and later re-emphasixed by John William-
son, “Review of The Economies of the Euro-Currency Sys-
tem by George W. McKenzie,” The Manchester School
(March 1977), pp. 86-88, and by Michael J. Hamburger and
Geoffrey E. Wood, ‘Interest Rates and Monetary Policy
in Open Economies” (paper presented to Federal Reserve
Committee on Financial .kuaiysis, November 16-18, 1977).
3
Only to the extent that Eurobanks hold “precautionary me—
serves” in the form of tiuse deposits, rather than demand de-
posits, at U.S. banks will U.S. Mi change. This change in
Mn could, however, he entirely offset by Federal Reserve opeu
market operations, as descm’ihed later in this paper.
CThis abstracts, for expository simplicity, from the existence of
different reserve requirements at different banks. For a discus-
sion of the consequence of this, see Albert E. Burger amid
Robert H. Rasche, “Revision of the Monetary Base,” this
Review (July 1977), pp. 13-23.
hank would acquire reserves and thus he able to
expand loans. In the absence of a change in the
monetary base on which the loans are pyramided, the
total of loans which could be extended will not change.
In summamy, the reason why movements between
M1 and Eurodollars do not affect M1 is that one
acquires a Eurodollar asset by supplying U.S. dollars.
This transfers the ownership of some U.S. dollars, but
does not affect the total.
One qualification is in order. A U.S. hank may
have the ability to affect demand deposits, and hence
M1, by changing the composition of its liabilities be-
tween demand deposits and funds borrowed from the
Eurodollar market. An example of this would be when
a large bank in the U.S., which was holding a demand
tIe-posit due to a hank in Lomidon, has that deposit
converted to a loan from that hank. The immediate
effect of this is a fall in M1, but it does release re-
serves, since the reserve requirement on Eurodollar
borrowings is 4 percent, while that on demand de-
posits is 16,25 percent at the largest banks. If the
entire amount of reserves which have been freed is
used to make loans \vhich suhsequently he-come de-
mand deposits at banks with a smaller marginal
reserve requiremnent, and these banks then extend
loans which remain as demarmd deposits at banks with
the samue reserve requiretuent as themselves, an ex-
pansion of M5 is possihle.~Ilowever, as Eurodollar
transactions tend to lie eommcentrated in the larger
banks, such an effect is not likely. But even should
such an effect occur, as is shown below it can he
fullq offset by Federal Reserve action.
So far we have examnined the effect of an owner
of a part of M1 moving his deposit to a Eurobank. It
is also necessary to consider a movement from an
interest earning asset, such as a time deposit, to a
Eurodollar deposit. In this case, the dollars held as
time deposits would initially be shifted into demand
deposits, and subsequently transferred to a Eurodollar
deposit. The initial shift from a time to a demand
deposit would increase M,, just as would a shift from
a time deposit to a demand deposit made for any
~Currently, reserve reqmmirements on net demand deposits
which apply to member banks are: 7% for banks having less
than $2 million in demand deposits, 9.5% for $2-Sb million
in demand deposits, 11.75% for $ 10—100 million in demand
deposits, 12.75% for $100—400 million in demand deposits,
and 16,25% for banks having demand tIe-posit liabilities in
excess of $400 million. It can be seen that for the effect on
Mm of a deposit moving from one bank to another to be non-
trivial, the deposit would have to mnove from a bank with
deposits in excess of $400 million to one with deposits of
less than $10 million.
Page 9FEDERAL RESERVE BANK OF ST. Lours DECEMBER 1977
other reason. Flowever, this increase in Mm could also
be fully offset by Federal Reserve open market
operations, that is, hr the ptmrchase or sale of U.S.
Government securities hv the Federal Reserve.
It is useful to set out the sequence of events
through which Eurodollar transactions are vie-we-cl as
afl’ecting N--I,. Ommee that has been clone, it can he see-it
how the Federal Re-serve, shommlcl it choose to do so,
can counteract these eff ’cts. Thc-’ sequence of events
thrommgh which Emmroclollar market transactions are-
suppose-cl to resmmlt imi inc ‘eases in the U.S. money sup-
ply can be set otmt as follows. The continue-cl decline
in the foreign exchange value of the U.S. dollar has,
the argument i’immis, encommragecl Eurodollar holders to
convert their Eurodollars into Deutsche marks, Swiss
francs, French francs, etc. Thus, as the value of the
dollar in terms of mnost Emmropean currencies declines,
foreigners holding rlollar-denominated deposits in
European banks “. ..have- he-en selling dollars to buy
German marks and the like
European central banks, it is further asserted, take
part in these transaction.s by selling their domestic
currencies for U.S. dollars. Sonic portion of the in-
creased dollar balances held by European central
hanks is then used to purchase U.S. Treasury securi-
ties from U.S. residents. These U.S. residents subse-
quently deposit the proceeds from these sales in their
checking accounts. As a resmilt U.S. demand deposits,
and consequently M1, have he-en increased.
Now, as was shown above, that analysis is incom-
plete. It neglects that the Eurodollars had as their
base deposits within the U.S. banking system. When
holders of Eurodollar deposits instruct the banks at
which these deposits are held to convert the deposit
from dollars to some other currency, the effect may
indeed he to transfer the ownership of a U.S. demand
deposit from the Eurobank to a foreign central bank.
If it so desires the foreign central hank may then use
this U.S. demnand deposit to purchase U.S. Govern-
ment securities. This transaction \voulcl transfer own-
ership of the U.S. demnand deposit fromu the foreign
ce-mitral hank to the U.S. residents from which the
securities were purchased.
Thus, Eurodollar deposit holders can convert these
deposits into foreign currencies, ultimately resulting
in foreign central bank purchases of U.S. Government
5
Business Week, p. 14.
securities, with no substantial change- in the- level of
U.S. demand deposits occurring. Insofar as it affects
M1, the process in the end re-suit is exactly like that
tif one U.S. resident huying U.S. Government secmmri-
ties from another; no matter how many intermediate
steps the-re are, there- is ultimately no effect on Mm, ex-
cept in the- case where- reserves are- released by the
transactions, and that effect is. as shown above, minor.
Eve-n should that minor effect occur, the Federal
Reserve can offset it in two ways.°
First, when the Eurodollar holders se-il their dollars,
they do not go along and offer the-in to foreign central
banks; rather, they se-il them on the foreign exchange
market to whomever will buy them. There- is nothing
to stop the Federal Re-serve- System from using its for-
eign exchange reserves to buy the dollars at that point,
thus bringing the process to a quick end, for there
would be no increase in foreign central banks’ holdings
of dollars. Alternatively, the “reappearance” of Euro-
dollar deposits as U.S. demand deposits could be off-
set domestically. Changes in the U.S. money supply
can be offset by Federal Reserve open market opera-
tions. lmm this present case, the- Federal Reserve- System
svoulcl sell some- of its holdings of Government secu-
rities. This’ action would re-clime-c both hank reserves
amid N--I
Thus, any increase in the U.S. money supply which
might conceivably result from investors converting
Eurodollar deposits into foreign currency holdings can
readily be offset by the U.S. monetary authorities.
They can offset the increase in M1 by operating either
in the foreign exchange market or in the- market for
U.S. Government deht, or both. Far from being Lmn-
able- to offset this monetary impulse-, the- Federal
Re-serve- actually has two instrmmme-nts by which it
cami do so.
It is some-times claimed that the dollar’s recent
weakness has be-en due to self-fulfilling expectations
“It is mmseful to note that even if the Federal Reserve- does not
try to offset these effects omi Mi, they may he only transitory.
Suppose the Federal Reserve is controlling an interest rate,
such as the Federal funds rate. Smmppose further that there is
an increased desire to borrow diollars ann se-Il them for some
other currency. This increased denmand for credit raise-s interest
rates. In attenipting to offset this rise the Federal Reserve
increases bank reserves by buying Treasmmry hills. The money
supply thereby expumids. Smmppose that those who sell foreign
currency to dollar holders wish to buy U.S. Treasury bills.
Page 10FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1977
operating in the Eurodollar market. The argument for
this position is that the dollar has bee-n weak only
because- NI, has lice-mi growing unduly rapidllv, and
that N-I1 has he-en growing lie-cause of Emmrodollar
transactions undertake-n in the- expectation of further
weakness of the dollar.
Eve-n if the argument that Eurodollar transactions
could substantially affect N-41 \vere- correct, it is easy to
see that the Federal Re-serve- can offset such influ-
ences on the U.S. money stock. Eurodollar transac-
tions cannot be blamed for the slide in the U.S.
dollar’s foreign exchange value.
This increased demnannI for Treasury bills lowers interest rates.
The Federal Reserve now sees interest rates falling, anti reacts
by supplying Treasury bills, thus offsetting its original action.
The- net effect of transactions in the Euromarke-t on
the- U.S. mnoney supply is virtually negligible. Trans-
actions in the Eurodollar market cannot have con-
tributed significantly -to the- re-cent growth in M1.
Ftmrther, the argmmme-nts in the- second section of this
paper show that the U.S. monetary authorities have- the
ahility to offset whatever effects on N-I, Eurodollar
transactions may have. The- existence of that market
has not re-dmmce-d the- ability of the Federal Reserve-
System to comitrol the U.S. money stock, It there-fore-
also foliows that any elaimu that the foreign exchange-
vahme of the U.S. dollar is dee-lining because of self-
fulfilling expectations operating through the Euro-
dollar market is totally false.
/~I /
Page 11

Do foreigners control the U.S. money supply?

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Do foreigners control the U.S. money supply?

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