THE DRAWING UP OF BALANCE SHEETS for the monetary system1 has received increasing attention in many countries during the past few years. These balance sheets are particularly useful in helping to make short-term projections—which might be described as Monetary Budgets—that will indicate the monetary developments likely to accompany probable future fiscal and balance of payments experiences. The purpose of this paper is to illustrate, by reference to a hypothetical example, the practical usefulness of such a projection.

Abstract

THE DRAWING UP OF BALANCE SHEETS for the monetary system1 has received increasing attention in many countries during the past few years. These balance sheets are particularly useful in helping to make short-term projections—which might be described as Monetary Budgets—that will indicate the monetary developments likely to accompany probable future fiscal and balance of payments experiences. The purpose of this paper is to illustrate, by reference to a hypothetical example, the practical usefulness of such a projection.

THE DRAWING UP OF BALANCE SHEETS for the monetary system1 has received increasing attention in many countries during the past few years. These balance sheets are particularly useful in helping to make short-term projections—which might be described as Monetary Budgets—that will indicate the monetary developments likely to accompany probable future fiscal and balance of payments experiences. The purpose of this paper is to illustrate, by reference to a hypothetical example, the practical usefulness of such a projection.

The illustration proceeds by means of tables arranged in balance sheet form. The figures have no relation to the data of any actual country; they are no more than materials with which to demonstrate methods of working. It should also be said that the example has been simplified, and that many of the problems that exist in such work in real life have been omitted, in order to keep the illustration from becoming too lengthy. The main elements needed in an exercise of this kind are patience and arithmetic.

For the purpose of the exercise, we imagine that we are in the Research Department of a Central Bank, and that we have been instructed to examine the monetary prospects for the coming fiscal year, say 1958–59, giving special attention to the measures needed to end the domestic price inflation that has been a constant source of trouble in the past few years. The low level of international reserves has also caused continual concern and has led to the erection of a complex structure of strict controls on international trade. It is hoped that the establishment of domestic price stability may be a first step toward easing and eliminating the restraints on trade. At the moment, the level of unemployment gives no particular cause for concern.

The first step is to review the performance of the banking system in the past few years, and for this purpose Tables IA, IB, and IC are prepared. These show the consolidated accounts of the banking system as a whole, arranged in a simple form that is suited to monetary analysis (Table IA), the accounts of the Central Bank (Table IB), and the consolidated accounts of the commercial banks (Table IC).

Table IA.

Consolidated Balance Sheet of the Banking System

(Data as of end of period)

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Table IB.

Balance Sheet of the Central Bank

(Data as of end of period)

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Table IC.

Consolidated Balance Sheet of the Commercial Bank

(Data as of end of period)

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Table IA shows a rapid growth in Money throughout the recent years: it multiplied almost 17 times between the end of 1952 and the end of 1957. This is clearly the dominant monetary fact in the economy in the period studied. The rate of growth of Money from 1956 to 1957 (about 30 per cent) was smaller than in the earlier years shown; nevertheless, it was much more substantial than was warranted by any increase in the community’s need for money, and it was accompanied by a substantial rise in the domestic price indices during 1957.

The major causes of the increase in Money were rapid increases in the banking system’s credits to the Government and to the private sector. The greater part of the increase in bank assets between 1952 and 1956 was due to the rapid rise of Claims on Government, but in 1957 the government sector reduced sharply its demands on the banking system for credit, and it even preserved unspent in its deposit accounts some of the funds newly borrowed during the year.

The reduction in 1957 in the net use by the Government of bank funds was not accompanied by a fall in the use of credit by the private sector. Claims on Private Sector increased at a sharper rate than in most previous years and were the major factor contributing to the rise in Money in 1957.

The remaining facts to note are the slight influence of the foreign sector in the domestic monetary expansion (this perhaps somewhat unreal assumption is made for the sake of simplicity) and the rise in Quasi-Money (probably more rapid in the example than might be expected in reality), which to a small extent absorbed some of the expansive influence of the increase in the system’s assets.

In this preliminary review of the system’s past performance, attention is next directed to the separate balance sheets of the Central Bank (Table IB) and the commercial banks (Table IC). These tables show clearly that the economy is one that uses more banknotes than checking deposits; the ratio varies from year to year, with a generally downward trend in the example given here, but Notes Held by Private Sector have in most years been rather more than double the amount of the private sector’s Checking Deposits. If this kind of ratio continues to apply, any further expansion by the commercial banks, if not accompanied by a continued expansion in the accounts of the Central Bank, will involve the banks in a heavy leakage of cash in the form of withdrawals of banknotes.

There has in fact been a rapid expansion in the accounts of the Central Bank over the years recorded. For the most part this has resulted from the Bank’s acquisition of government debt, but in 1956 and 1957 there were sharp increases in the Central Bank’s Claims on Banks. As shown in Table IC, the commercial banks hold almost no government debt.

The main factor of expansion in the accounts of the commercial banks has been the growth of their Claims on Private Sector. Although the amounts they hold on deposit with the Central Bank have also grown rapidly, this growth reflects mainly the introduction during 1956 of a system of minimum reserve requirements. A required reserve ratio of 35 per cent against demand and time deposits was imposed at the end of 1956. The imposition of a higher reserve ratio, 40 per cent, at the end of 1957 increased total required reserves by 98, i.e., from 35 per cent of 394 (138) to 40 per cent of 590 (236).2 The banks did not check the expansion of their Claims on Private Sector following the introduction of minimum reserve requirements; with this new pressure on their available resources, they financed their needs by means of borrowings and rediscounts at the Central Bank. This appears in the liability entry, Credit from Central Bank.

The next step is to begin collecting data on expectations for the year that lies ahead. We may assume that we are now at the end of February 1958; the Government’s budget for the next fiscal year, which is usually presented publicly in April, is now being prepared for fiscal 1958–59. The Research Department at the Central Bank is in close contact with the Budget Office at the Treasury and is able to obtain estimates of revenues and expenditures for the year ending March 31, 1959. From this, and with data for previous years as a base, the Research Department makes an estimate of what the actual cash income and outgo of the Government will be in the fiscal year 1958–59, and hence of the cash shortfall (deficit) that will need to be financed from various sources in that period. The data are presented in the form shown in Table IIA, which compares the cash operations of the Government in the fiscal years 1956–57 and 1957–58 with the data that are estimated to be implicit in the draft government budget that is being prepared.

Table IIA.

Draft Government Budget, Fiscal Years1

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Converted to cash basis—i.e., shows amounts spent and (for 1958–59) expected to be spent, and amounts received and (for 1958–59) expected to be received.

The cash deficit to be financed during the year is estimated at 300. To meet this deficit, 10 of bonds may be placed outside the banking system. But since no foreign borrowing is contemplated, the amount of financing to be provided from the banking system is 290. The officials in the Budget Office are of the opinion that, if in fact there is such a cash deficit, it would be financed in the first place by drawing down the Government’s existing deposit balances to their lowest convenient working level—to, say, about 30; the remainder of the financing required could come only from the purchase of government debt by the banking system. At this point, inquiries in the Budget Office are suspended for a day or so.

Meanwhile, the Research Department has been active in two other fields—prospects for the balance of payments and the commercial banks. A rough sketch of the likely balance of payments for 1958 has been made, and present information indicates that its monetary effects in the coming year are likely to be neutral (Table IIB) and that no significant change is likely in the Central Bank’s holdings of reserves.

Table IIB.

Estimated Balance of Payments

(In millions of U.S. dollars)

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In addition, conversations have been held with commercial bankers and with businessmen to test the outlook of lenders and borrowers for the coming year. In this field, data in the form of figures are extremely difficult to acquire; however, from last year’s experience and the best information that can be gathered concerning this year’s expectations, a figure of 350 is chosen as the amount of the increase in banks’ Claims on Private Sector that may be expected during 1958, unless conditions change.

The first trial Monetary Budget can now be prepared (Tables IIIA, IIIB, and IIIC). The successive steps whereby the projections are constructed may be summarized as follows:

  • A. Steps leading from Table IA to Table IIIA

    1. Foreign Assets. With exports stable and imports controlled, no change is expected.

    2. Claims on Government. The government budget as drafted implies an increase of 180 in Claims on Government by the banking system.

    3. Claims on Private Sector. The banks’ ideas indicate that, if conditions remain unchanged, credit by the banks to the private sector will rise by 350, i.e., to 1,060.

    4. Other Assets. An increase of 10 is estimated.

    5. Government Deposits. The government budget as drafted implies a reduction of, say, 110.

    6. Other Liabilities. An increase of 5 is estimated.

    7. Money and Quasi-Money. If a balance is to be maintained, Money and Quasi-Money together must rise by the sum of the changes projected in steps 1 through 6, i.e., by (180+350+10)-(5-110), or 645. If it is assumed that the ratio of money to Quasi-Money will remain constant, Money will increase by 12091351×645, or 577, and Quasi-Money by 1421351×645, or 68.

Table IIIA.

Projected Consolidated Balance Sheet of the Banking System: First Trial

(Data as of end of period)

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Table IIIB.

Projected Balance Sheet of the Central Bank: First Trial

(Data as of end of period)

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Table IIIC.

Projected Consolidated Balance Sheet of the Commercial Banks: First Trial

(Data as of end of period)

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  • B. Steps leading from Table IB to Table IIIB and from Table IC to Table IIIC

    1. Foreign Assets. No change is expected.

    2. Claims on Government. It is estimated that the banks will absorb 12 of the newly issued bonds, leaving 168 (180—12) for the Central Bank.

    3. Claims on Private Sector. No change is expected for the Central Bank, but an increase of 350 is estimated for the commercial banks.

    4. Other Assets. Increases of 5 for both the Central Bank and the commercial banks are estimated.

    5. Notes Held by Private Sector and Private Checking Deposits. If it is assumed that the ratio of Notes to Checking Deposits remains constant, the increase in Money, estimated in Table IIIA at 577, will be divided between these two categories as follows: Notes will rise by 7611209×577, or 363, and Checking Deposits 4481209×577, or 214.

    6. Other Liabilities. Increases of 3 for the Central Bank and 2 for the commercial banks are estimated.

    7. The remaining items (after entering the changes in Government Deposits and Time and Savings Deposits) relate to the accounts of the Central Bank with the commercial banks. The net of the changes in the Central Bank balance sheet items, Claims on Banks, Notes Held by Banks, and Deposits of Banks, will be equal to the algebraic sum of changes in all its other balance sheet entries, i.e., (363-110+3) - (168+5) = 83. This is also equal to the net of changes in the commercial bank balance sheet items, Cash and Credit from Central Bank.

    8. If the required reserve ratio of 40 per cent is maintained, commercial banks must hold at the Central Bank deposits of 40 per cent of (662+210), i.e., 349, which is 90 more than their Central Bank deposits at the end of 1957. Assume that Notes Held by Banks increase by 6. The total increase in Cash is then 90 + 6, or 96.

    9. To maintain equilibrium in the balance sheets, the total increase in Credit from Central Bank must be 83 (see step 7) plus 96 (see step 8), i.e., 179.

The first comment to make on the trial Monetary Budget is that it is grossly unbalanced. The situation at the time requires that, in the interest of stability, there should be no change (or at most a small increase) in Money during the year. However, the assumptions on which the Monetary Budget has been built (all representing fairly firm plans that are likely, if the Central Bank fails to call attention to their implications, to be carried out) imply that if such plans are implemented the community’s Money will rise by about 50 per cent over the year.

The Central Bank, therefore, needs to direct its attention to recalculating the Monetary Budget in a way that will indicate the kinds of change in existing plans which are necessary in order to make them consistent with monetary stability. Since the two major factors of disequilibrium are the planned government cash deficit and the expected increase in Claims on Private Sector, the Bank’s efforts must be applied toward reducing these factors.

The steps in the examination of the problem of balancing the Monetary Budget might be something like the following:

  • C. Selection of policies by entering acceptable projections for 1958 in Table IVA

    1. Enter the original estimates for Foreign Assets and Other Assets.

    2. Enter Money with the assumed maximum acceptable increase for the year, say, 5 per cent.

    3. Assume the increase in Quasi-Money to be half the increase recorded in the previous year, i.e., 36.

    4. Enter the original estimate of Other Liabilities.

    5. The total of increases in Claims on Government plus increases in Claims on Private Sector minus increases in Government Deposits must then equal (60+36+5)-10, or 91.

    6. This amount has to be distributed between the contributions of the banking system to financing the government deficit and to increasing its Claims on Private Sector; the performances of past years and the positions at the beginning of the year may be regarded as justifying an approximately equal division between these two. Claims on Private Sector would be allowed to increase by 46, while bank financing of the government deficit, 45, could be made effective by reducing existing Government Deposits.

Table IVA.

Projected Consolidated Balance Sheet of the Banking System: Second Trial

(Data as of end of period)

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  • D. Calculation of interbank accounts and selection of reserve ratio and rediscount policies

    1. Transfer the data on Foreign Assets, Claims on Government, Claims on Private Sector, Other Assets, Time and Savings Deposits, and Other Liabilities from Table IVA to Tables IVB and IVC.

    2. Assume the increase in Money to be distributed between Notes and Checking Deposits in the same proportions as the initial balances. Notes will then rise by 7611209×60, or 38, and Checking Deposits by 4481209×60, or 22.

    3. If the minimum required reserve ratio of 40 per cent is maintained, and the volume of excess reserves is not changed, Deposits at Central Bank will have to be increased by 40 per cent of (36+22), i.e., 23, to 282.

    4. Assume no change in Notes Held by Banks.

    5. The required increase in Credit from Central Bank is (23 + 46+5)-(22+36+2), or 14.

      The results of the further activities of the Central Bank’s Research Department are not so conveniently presented in tabular form, but the steps might be something like the following:

    6. On reviewing the events of the fiscal year 1957–58, the Central Bank might conclude that the banks had gone too deeply into its debt, and decide that it would like to establish a new situation where banks would owe it less but where the cost of their marginal borrowing would be higher.

      A plan to achieve this purpose might provide that the required reserve ratio would be reduced in one substantial step; that banks would then be told that they were expected to use the funds released by the reduction to repay part of their debt to the Central Bank; and that fresh rediscounts beyond the lower level thus established would be at a sharply increased cost.

      Suppose that after full examination some such plan is adopted, and it is desired to reduce Claims on Banks to 300 by the end of the year, i.e., to 64 less than in Table IVB. This means a corresponding reduction of 64 in Deposits at Central Bank, from 282 to 218. To make this possible, and with allowance for 20 in excess deposits, the required reserve ratio should be reduced to, say, 30 per cent (200470+178×100=about31percent). The increased rediscount rates, applied perhaps to marginal borrowings, could be designed to impose substantial profit penalties on banks that overexpanded their loans. A suitable alternative program on these lines (not shown in Table IVC) could be worked out for presentation to the banks.

    7. Two major policy presentations could then be prepared, one for the Government and one for the commercial banks, designed to put into effect the revised Monetary Budget:

      • a. Present Table IIIA, and possibly Tables IIIB and IIIC, to the Government. Indicate the consequences of the changes implied in present plans. Present Table IVA and suggest a review of the draft government budget to ensure the stability of the currency (see the last column of Table IIA). Assure the Government that the steps necessary to carry out the reduction in private sector credit will be taken by the Central Bank, but that the plan can succeed only if the Government does its part. Work with the Budget Office toward preparing an alternative Table IIA.

      • b. Present Tables IIIA and IVA to a meeting of general managers of commercial banks. Ask for a virtual halt to expansion of credit to the private sector. Present details of proposed action on discount rates and reserve ratios. Indicate that, because of penal marginal rediscount rates, severe profit disadvantages will confront any individual bank which expands loans to the private sector.

Table IVB.

Projected Balance Sheet of the Central Bank: Second Trial

(Data as of end of period)

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Table IVC.

Projected Consolidated Balance Sheet of the Commercial Banks: Second Trial

(Data as of end of period)

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From the foregoing, the type of calculation involved in making a Monetary Budget will be evident. However, some further points deserve mention:

1. The development of the actual balance sheets of the monetary system and its components needs to be watched carefully each month throughout the period under review—with due account taken of the normal pattern of seasonal changes—in order to check that the outcome of the operations of the year will be reasonably in accord with the Monetary Budget. If not, further adjustment to the policy action may be required.

2. Developments in other areas linked to monetary policy need to be kept under careful scrutiny for any changes in, for example, export volume, export prices, or other balance of payments elements; the velocity of circulation of bank deposits; the level of international reserves; and the level of employment. Any substantial changes evident in the statistics may call for adjustment of the original policy.

3. It is most unlikely that the actual figures at the end of 1958 will in fact be very close to the projected figures. However, the setting of a reasonable objective for the increase in Money, the adaptation of this objective to changing circumstances, reasonable continuity in the efforts of the Central Bank to achieve this objective, and the expression of the Central Bank’s ideas in terms of balance sheet projections, are likely to lead to far better monetary policy than would emerge in the absence of such conscious guidance of the system.

4. The foregoing discussion avoids dealing with the extent to which policy changes that alter the expected level of domestic credit from the banking system to the private and government sectors will have secondary effects on the balance of payments. It has long been known that loose policies in relation to domestic credit weaken the balance of payments, whereas tight domestic credit policy can work toward balance of payments strength, but only recently has a beginning been made in forging tools that may make possible quantitative estimates in this field.3

5. The usefulness, as a guide to policy, of calculations such as those set out above depends upon having available, frequently and currently, the sources on which they are based—i.e., (a) time series of complete balance sheets, grouped to show the accounts of the relevant sectors of the economy, for each subgroup of banks (Central Bank, commercial banks, etc.) and (b) government finance accounts on a cash basis. The balance sheets of banks are normally obtainable in suitable form with negligible cost and effort. Although the construction of suitable government finance accounts on a cash basis does not, in principle, present difficulties, many countries have not, in practice, given this work the attention that it merits.

*

Mr. Knight, until recently Assistant Chief of the Statistics Division, is a graduate of the University of Melbourne, Australia. He has now rejoined the service of the Commonwealth Bank of Australia.

This paper is an English version of one of a series of introductory lectures originally given in Spanish to a group of central bank technicians at the Center for Latin American Monetary Studies, Mexico City, in May 1958.

1

A large number of sets of such balance sheets, simplified, rearranged, and relabeled, are published regularly in the group, “Monetary Survey,” on the country pages in International Financial Statistics.

2

The effects of changes in required reserve ratios may be conveniently presented in tabular form as follows:

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3

See J. J. Polak, “Monetary Analysis of Income Formation and Payments Problems,” Staff Papers, Vol. VI (1957–58), pp. 1–50.