Eurodollars and the U.S. Monetary Supply
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Eurodollars and the U.S. Money Supply ANATOL B. BALBACH and DAVID H. RESLER INTRODUCTION is frequently asserted that the Eurodollar mar- ber of studies’ Despite this research effort serious ket has contributed substantially to worldwide infla- questions remain about whether or not the volume of tion and general economic instability. Eurodollars Eurodollar balances should be included in any aggre allegedly move with ease from country to country, gation of the world money stock disrupting national credit and money markets and This article however addresses a different but re creating fears about the inflationary consequences for lated question by focusing on the relationship be- the U.S. economy if all these “dollars” pour back into the U.S. banking system. tween the Eurodollar market and monetary control. It assumes throughout that the Federal Reserve Sys- Inflation results when spending grows faster than tem does not engage in Eurodollar transactions or real output. If excess spending occurs because the alter its monetary policy as a result of such transac- quantity of money grows faster than people’s desire tions. The first section of the article describes the to hold money, then Eurodollar transactions can in- Eurodollar market. The second section illustrates, crease inflation only if they reduce the growth of through the use of balance sheets, how Eurodollar output, reduce people’s desire to hold money, or in- transactions may affect the U.S. money supply. The crease the amount of money in existence. There is no third section investigates the effects of Eurodollar theoretical or empirical evidence that Eurodollar trans- transactions on the U.S. money supply in the context actions have reduced output growth. The extent to of a money multiplier model. which the Eurodollar market has reduced the de- 1 mand for domestic currencies remains uncertain. Con- For representative studies on this question that make use of sequently, if the Eurodollar market contributes to in- a multiplier framework, see John Ft. Makiri, “Identifying a Re- serve Base for the Eurodollar System,” Journal of Finance flation, it does so either by increasing the amount of (June 1973), pp. 609-17; and Boyden E. Lee, ‘The Eurodollar Multiplier,” Journal of Finance (September 1973), pp. 867- money in existence or impeding control of domestic 74. For an alternative portfolio balance approach that chal- money stocks. The extent to which the Eurodollar mar- lenges the relevance of the multiplier framework as applied ket has independently contributed to an expansion of to the Eurodollar market, see John Hewson and Eisuke Sakakibara, The Eurocurrency Markets and their Implications the world money supply has been the focus of a num- (Lexington, Mass. Lexington Books, 1975). 2 FEDERAL RESERVE BANK OF ST LOUIS JUNE/JULY 1980 6 A Brief Descriptive History of the rising U.S. interest rates. Finally, differences in re- Eurodollar Market serve requirements across bank liabilities often rein- force U.S. banks’ incentive to secure funds from Euro- A Eurocurrency market consists of banks that ac- dollar sources. cept deposits and make loans in currencies other than those of their own country.2 The modem Eurodollar market evolved from the special circumstances of The Eurodollar Banking System the post-World War II international finance system.3 Because Eurobanks intermediate between lenders Early in this period, many foreigners found it con- and borrowers, the Eurodollar market, like any other venient to deposit dollar balances with banks in Eu- fractional reserve banking system, can expand the rope. As in the post-World War I period, these funds amount of Eurodollar liabilities. Since not all deposi- were generally repatriated to the U.S. as European tors will withdraw their funds simultaneously, Euro- banks acquired dollar assets directly through the U.S. banks can lend these deposits, and the transferral of money market.4 By the end of the 1950s, however, these funds from one bank to another produces a Eurobanks began lending dollar-denominated funds, multiple expansion of deposits and credit. In national and this activity spawned the modem Eurodollar banking systems, this multiple expansion is limited by market. the extent to which banks hold required or precau- tionary reserves. The potential expansion of dollar- The primary reason for this market’s development denominated credit occurring through the Eurodollar and subsequent expansion is that, like other financial system is limited only by the amount of precautionary market innovations, it reduces the costs of inter- reserves that Eurobanks hold in order to meet their national trade by offering traders an efficient means short-term liquidity needs. of economizing on transaction balances in a world Eurobanks do not issue demand deposits, even where most trade is denominated and transacted in dollars. Regulation Q ceilings and differential reserve though some deposits are of very short duration — requirements for various categories of U.S. bank lia- frequently overnight — and can be transferred from bilities also contribute to further Eurodollar inter- one individual to another easily and conveniently. mediation. U.S. banks periodically encounter difficulty Despite this rapid transferability, Eurodollars are not in attracting and retaining corporate deposit balances generally acceptable as payment for goods and serv- ices in any country and therefore are excluded from because of effective Regulation Q interest rate ceil- 7 ings.5 Foreign branches of U.S. banks, however, do current definitions of money. Borrowers of Eurodol- not face these restrictions. Consequently, as interest lars who wish to buy goods and services with the rates rise and the yield differential between Eurodol- proceeds of a loan must first convert, them into some national currency.8 Viewed in this light, Eurodollar lar and domestic deposits widens, corporate depositors deposits channel fimcls into Eurodollar accounts. Foreign are similar to savings and time deposits that branches of U.S. banks then can re-lend the funds serve as a “temporary abode of purchasing power.” back to the parent institution. In this way, many U.S. In summary, the Eurodollar system can expand banks are able to mitigate some of the consequences credit by some multiple of its reserves, but it cannot of the disintennediation that accompanies periods of create money since its liabilities, unlike those of banks, are not generally acceptable as a means of payment. 2 Although U.S. banks are prohibited from accepting deposits Although the Eurodollar market does not create or making loans in currencies other than U.S. dollars, banks money directly, it may generate some important in- in other countries, including foreign branches of U.S. banks, direct effects if Eurodollar transactions affect domestic are not, 3 money stocks. For a detailed discussion of the history of this market see Paul Einzig, The Eurodollar System, 5th ed. (New York: St. OUntil these borrowings by U.S. banks were subjected to re- Martin’s Press, 1973). 4 serve requirements, banks bad an additional incentive to Some authors have attributed a special role in the develop- acquire such funds. 7 ment of the Eurodollar market to Communist bloc countries. The Federal Reserve Board of Governors does include “over- It is argued that these countries feared that their assets night Eurodollars held by U.S. residents other than banks at would be frozen by the U.S. government as part of Cold War Caribbean branches of member banks” in its current defini- political strategy. tion of M2. This article, however, focuses on the transaction- 5 The emergence of the large denomination certificate of de- based definitions of money — old Ml and the newly defined posit (CD) market can be traced to the early 1960s, when MIA and M1B. corporate financial officers began managing cash positions ~This process is analogous to that which occurs when an indi- more carefully to take advantage of the higher interest rates vidual bwows from a savings and loan institution. Before offered on short-term time deposits. (Banks have not been spending these funds, he too must first convert the loan into permitted to pay explicit interest on demand deposits.) currency or demand deposits at a commercial bank. 3 FEDERAL RESERVE BANK OF ST. LOUIS JUNE/JULY 1950 Transaction 1. Conversion of Demand Deposits into Eurodollars Public U.S. banks Eurobanks Assets Liabilities Assets Liabilities Assets Liabilities DDP—$100 DDE+$100 DDE+$100 ED+$1 00 ED+$100 DDP—$100 Can Eurodollar Transactions In transaction 1, a holder of demand deposits at a Affect the [1,5. Money Stock? U.S. bank transfers $100 million into Eurodollar depos- its at a Eurobank.b0 On the public’s balance sheet, The Eurodollar market and the U.S. monetary sys- demand deposits (DDP) decline and Eurodollar de- tem are linked by those transactions in which holders posits (ED) rise by the same amount. At the Euro- of U.S. dollar-denominated assets deposit dollars in bank, the individual’s account is credited and the Eurobanks, or in which holders of Eurodollars spend bank’s Eurodollar liabilities rise by $100 million. When these funds in the United States. The majority of such the check clears, the U.S. bank’s demand deposit lia- transactions involves the exchange of short-term as- bility to the public (DDP) declines and the demand sets. For example, an individual or a corporation that deposit liability to the Eurobank (DDE) increases. owns demand deposits, certificates of deposit, repur- The Eurobank’s balance sheet will record this trans- chase agreements, Treasury bills, or commercial paper action as an increase in assets. may convert these assets into Eurodollars. Similarly, holders of Eurodollars, or borrowers in the Eurodol- The impact of this transaction on the U.S. money lar market, may convert these funds into domestic stock depends on how money is measured. Using the financial instruments or buy goods and services old definition of money (Ml), which includes foreign outright.