Eurodollars and the U.S. Monetary Supply

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 precautionary 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 services 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 deposits 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. commercial bank demand deposits at U.S. banks, the money supply is unaffected since DDP declined and In the following discussion, four transactions are DDE rose by the same amount. Because DDP and used to typify the relationship between the Eurodollar and U.S. money markets.° Transactions 1 and 3 in- DDE have the same reserve requirements, excess reserves are not affected and no further contraction or volve the conversion of demand deposits into Euro- expansion of loans and deposits in the U.S. is possible. dollars. Transaction 1 assumes that Eurodollar institutions hold their reserve assets in the fonn of On the other hand, if money is measured either by demand deposits at U.S. banks; transaction 3 assumes M1A or M1B (which exclude foreign bank demand that these reserve assets are held in the form of bal- deposits at U.S. banks), then the money supply de- ances “due from” U.S. banks. Transactions 2 and 4 creases by the amount of the transaction since DDP involve conversion of other U.S. bank liabilities such declines while the increase in DDE is not counted. as certificates of deposit into Eurodollars. Transactions Because excess reserves are still unaffected, there will 2 and 4 maintain the same assumptions as transac- be no further change in the money stock. Thus, the tions 1 and 3, respectively, about the form in which initial effect of deposit outflows into the Eurodollar Eurodollar institutions maintain their reserves. market lowers the money stock, as currently mea- For convenience, two additional assumptions are sured, by an amount equivalent to the size of the made. First, the Federal Reserve System continues to transaction. supply the monetary base at some predetermined con- It is important to note that in this transaction Euro- stant rate. This assumption is necessary to distinguish banks collectively are assumed to hold total reserves the effect of Eurodollar transactions from policy- (in the fonn of demand deposit balances at U.S. induced changes in money stock. Second, the required banks) equal to the initial dollar outflow from U.S. reserve ratio is assumed to be 10 percent on demand banks. If, in the extreme, Eurobanks hold no reserves deposits and 5 percent on other bank liabilities. at all, the U.S. money stock, however defined, will be °Although they do not exhaust all possible asset substitutions, these four transactions are representative of the way in which lOThis Eurobank may be a foreign branch of some U.S. bank Eurodollar-related transactions affect the U.S. money stock. or an unaffihiated foreign bank, 4 FEDERAL RESERVE BANK OF ST LOUIS JUNE/JULY 1980

Transaction 2. Conversion of Certificates of Deposit into Eurodollars Public U.S. banks Eurobanks Assets Liabilities Assets Liabilities Assets Liabilities

CD—$1 00 CD—$100 DDE+$100 ED+$1 00 ED 00 DDE+$1 00

unaffected.11 However, to the extent that Eurobanks ary reserves in the form of demand deposit balances hold some precautionary reserves in the form of de- at U.S. commercial banks.’2 The effect of Eurodollar- mand deposits at U.S. banks, the qualitative effect of related transactions on the U.S. money stock will be the Eurodollar transactions is the same as outlined somewhat different if Eurobanks hold their precau- above. tionary reserves in a different form. For instance, the Eurobank receiving the initial deposit transfer from In transaction 2, the owner of a certificate of deposit a U.S. bank will, on the day of the transaction, actu- (CD) at a U.S. bank fails to renew a maturing CD ally receive a credit referred to as balances “due and deposits the funds as a Eurodollar deposit at from” the U.S. bank. The U.S. bank initially carries some foreign bank. On the public’s balance sheet, the transaction as balances “due to” a foreign bank. CDs fall and Eurodollar deposits rise. At the Euro- This part of the transaction is analogous to the initial bank, Eurodollar liabilities increase and, when the transaction clears, the foreign bank’s deposits at the book entries made by domestic banks when funds transferred between them are in the process of col- U.S. bank rise. At the U.S. bank, domestic CDs fall lection. Transactions 1 and 2 assume that these “col- while liabilities to foreign banks rise. If money is lection balances” are cleared quickly with offsetting measured as Ml, then the increase in DDE implies changes to U.S. demand deposit balances of the Euro- an immediate increase in the money supply. On the banks. This assumption is appropriate if the Eurobank other hand, if M1B (or M1A) is used, the money wishes to lend to non-bank borrowers. stock does not change since neither CDs nor DDEs are included in the definition of money. In both cases, On the other hand, if the Eurobank continues to however, bank excess reserves decline. Because the carry the “due from” item on its balance sheet, the DDE reserve requirement is 10 percent and the CD U.S. bank will record a corresponding liability item reserve requirement is 5 percent, an increase in DDE, “due to” a foreign branch or commercial bank in- offset by an equivalent decrease in CDs, raises banks’ stead of recording a demand deposit.’3 The Federal required reserves by 5 percent of the transaction. Reserve defines the net amount of these “due tos” Since banks must contract loans and deposits, the (gross “due tos,” less the U.S. bank’s “due froms”) as money stock will decline. Thus, in the case of Ml, Eurodollar borrosvings.” In this case, Eurodollar bor- the net effect is an expansion (an immediate increase rowings increase and, because these borrowings are in Ml plus a subsequent, less than fully offsetting, subject to different reserve requirements than demand contraction caused by a decrease in excess reserves). 2 In the case of M1B, there is a net contraction (no ‘ In the event that the Eurodollar banking system held no immediate change in M1B — only the subsequent reserves, the final effect of this second transaction would be contraction). to increase the money stock under any definition of money. 3 ‘ The Eurobank may consider these funds to be either pre- These results are derived from the assumption that cautionary reserve balances or an earning asset like any the Eurodollar banking system maintains precaution- other loan, depending on the nature of its relationship with the U.S. bank and on whether the “due from” credit ex- liThe Eurobank would create a new loan equal to the full plicitly earns interest and is of some specific duration. Whether these funds are regarded as reserves or an eaming amount of DDE, thereby drawing down such balances. The asset, their impact on the U.S. money stock is the same as borrower would have to acquire a U.S. demand deposit be- described in the text. fore he could spend the proceeds of this loan. This transaction then restores the balance sheet of the U.S. bank to its “For foreign commercial banks that are not branches of U.S. original position. Note that this intermediation through the banks, only those gross ‘due to” balances not designated as Eurodollar market generates a greater extension of credit demand deposits are treated as Eurodollar borrowings. F’or than would have occurred if generated through the U.S. branches of U.S. banks, all gross balances “due to” the banking system only. branch enter into the calculation of Eurodollar borrowings.

5 FEDERAL RESERVE SANK OF ST. LOUIS JUNE/JULY 1980

Transaction 3. Conversion of Demand Deposits into Eurodollars Public U.S. banks Eurobanks Assets Liabilities Assets Liabilities Assets Liabilities DDP—$100 DT+$100 DF+$100 ED+$100 ED+$100 DDP—$100

deposits, the money stock is affected differently. The lion in CDs into a Eurodollar deposit at a foreign two transactions outlined above are now re-examined bank. The change in the public’s balance sheet is under the assumption that the Eurobank chooses to identical to transaction 2. Eurobank liabilities rise by carry an asset in the form of a “due from.” $100 million, as do balances “due from” the U.S. bank. In transaction 3, as in transaction 1 above, $100 mil- Upon clearing the transaction, U.S. bank liabilities in lion in demand deposits at a U.S. bank are converted the form of CDs fall, while funds “due to” its foreign into Eurodollars. Balance sheet entries in the public’s branch rise by $100 million. Since neither CDs nor account are identical to those in transaction 1. Unlike DTs are included in the definitions of money and that example, however, the Eurobank records its assets since both, by assumption, have the same reserve re- from the transaction as balances “due from” (DF) U.S. quirement, the money stock is unaffected. banks. At the U.S. bank, DDP declines and funds “due As this discussion illustrates, Eurodollar transac- to” (D’fl its own branch or other foreign banks rise by tions can affect the U.S. money supply even when the $100 million. This transfer has two immediate effects. monetary base remains constant, The extent to which First, Ml, M1A, and M1B decline by $100 million Eurodollar transactions affect the money stock de- since DDP falls by $100 million and DT is not in- pends partially on how money is measured.’5 Differ- cluded in either measure of the money stock. Second, ential reserve requirements combine with Eurodollar since banks are assumed to hold reserves equal to 10 flows to produce an additional effect on the money percent on demand deposits and 5 percent on all other stock. The transactions outlined here, however, have liabilities, including Eurodollar borrowings, the U.S. essentially the same impact on the money stock as bank’s excess reserves rise by $5 million. These excess do transfers from demand deposits into domestic reserves permit an expansion of loans and deposits, time deposits or other near-money assets. Conse- partially offsetting the initial decline in the money quently, the problems that such transfers might create supply. for monetary control are not unique to Eurodollar In transaction 4, the U.S. public converts $100 mil- transactions,

Transaction 4. Conversion of Certificates of Deposit into Eurodollars Public U.S. banks Eurobanks Assets Liabilities Assets Liabilities Assets Liabilities CD—$100 CD—$100 DF+$100 ED+$100 ED+$100 DT+$100

5 ‘ Additional transactions would have to be examined if the U.S. action balances. On the other hand, to the extent that such money supply is measured by broader aggregates, such as transfers occur because differential reserve requirements en- M2. For instance, if the demand deposit transfer outlined courage banks to raise funds in this way, the differential in transaction 1 were channeled to a Caribbean branch of a effects on the various monetary aggregates could be elimi- U.S. bank, MIA and M1B would decline as before, but M2 nated by unifonnly applying reserve requirements to branch would not change. An increase in the magnitude of such Eurodollar deposits of non-bank institutions. transfers might suggest the desirability of redefining trans-

6 FEDERAL RESERVE BANK OF ST LOUIS JUNE/JULY 1980

EFFECTS OF EURODOLLAR TRANSACTIONS Table 1 Although the foregoing analysis of balance sheets Definitions of Ratios Used in the Money can illustrate the effects of a single transaction, it Multipliers overlooks other portfolio changes that often accom- pany the transaction. The transactions described above Ratio iii the followiim~items to demand Ititin deposits of the non—bank public involved a change in preferences for Eurodollar de- svn bul (the demand deposit cinnpont. it of Ml 4) posits relative to domestic bank deposits. By holding other asset balances constant, however, these transac- r Large dciiomir ration ccrt fk’ates of deposit tions also implicitly altered preferences for all other ci IJer ia’ ii clt’posits of I bc I . S. Treas try at conmiercial banks assets relative to demand deposits (or Eurodollars). e re,en-es An alternative analytical model provides a more I )‘“imaiid deposits of forcig, C otnmc, cial banks convenient framework for investigating the effect of and official ii stitut loris at U.S. tommercial banks relative shifts in preferences between only two assets. 1 • Net ~ lar borrowi,i A money multiplier model can analyze directly the k inc lit’s’ held 1 my t I LI’ 001 I— If’ i L public mm In tr‘i-i~,t—bc’a,log clxtkal dl’ rieposi ts effect on the U.S. money stock of a change in port- (Al S and NOW accounts, and share drafts at folio preferences between any two assets while hold- credit wimnns ing constant the relative preferences for all other as- lime and savmgs rlcposit component of tIme sets. The next section develops such a model and Input’ stork provides some quantitative estimates of the impact of ri fle,c’rve ratios against various bank liabilities ( . c’, d, h, and t I Eurodollar transactions on the U.S. money stock.

A Multiplier Model c’xainining the itirplicatiomis oF various Eurodollar tr~ws— actions. For convenience, table 1 defines the ratios that The money multiplier framework can be used to comprise the multipliers. analyze how changes in the portfolio decisions of commercial banks and the public affect the domestic Eurodollar transactions may affect the multiplier money supply. Such changes are typically described either through domestic banks’ net balances “due to” by changes in the various ratios that comprise the its own branches and to other Eurobanks (i.e., through money multiplier. For instance, a shift in the public’s Eurodollar borrowing) or through foreign commer- preferences for time deposits relative to demand de- cial banks’ deposits with U.S. banks. Shifts in pref- posits is characterized by a change in the desired erences toward Eurodollars similar to those described t-ratio.” Money multipliers for three definitions of by transactions 1 and 3 are represented in the multi- money — Ml, M1A, and M1B — are derived in the plier model either by changes in the ratio of foreign appendix and reproduced here. commercial bank deposits to domestic demand deposits (the f-ratio) or by changes in the ratio of _1+f+k A Eurodollar borrowing to domestic demand deposits (the h-ratio). Asset shifts like those detailed in trans- (2)m,,= 1+k actions 2 and 4 entail a shift in preferences from certificates of deposit to Eurodollars. Thus both the ratio — 1+k+n (3) mm— A of CDs to domestic demand deposits (the c-ratio) and either the f- or h-ratio change simultaneously. where ~ = rd[(l+f+d) + n] + r~t+ r0c + rhh + e + k.1~These multipliers provide the framework for Changes in the portfolio decisions of the public and 16 commercial banks affect the money stock. These effects When the initial substitution results in a reduction in demand deposits, all other actual ratios will rise momentarily. Be- can be analyzed by differentiating these multipliers cause its desired ratios for other assets have not changed, with respect to changes in the relevant preference the public will reduce its holdings of other liabilities to ratios. These partial differentials can be translated restore these ratios to their desired levels. An increase in the t-ratio, for example, will be accompanied by an increase easily into elasticities. in time deposits and a reduction in demand deposits, currency, etc. 17 tic. Nevertheless, the present model retains the assumption The denominator (A) of each multiplier includes four differ- that all checkable deposfts are subject to a single, uniform ent required reserve ratios, in contrast to the simplifying reserve reqnirement. Under current regulations, checkable assumption of two reserve requirements made in the preced- deposits are subject to different reserve requirements, de- ing section. This approach makes the analysis more realis- pending on bank size and the type of deposit.

7 FEDERAL RESERVE BANK OF ST. LOUIS JUNE/JULY 1980

m1 with respect to the f-ratio is positive. That is, an Table 2 increase in fisassociated with an increase in the U.S. money stock as measured by Ml. In contrast, the Elasticities of Money Multipliers with elasticity of the M1B multiplier (m11,) with respect Respect to Changes in Selected to changes in the f-ratio is negative. The difference Preference Ratios between the m, and mie elasticities results from cx- cluding foreign commercial bank deposits from the new measures of the U.S. money stock. Further, for plausible values of m1 and r~,the absolute value of the elasticity of m2 with respect to f exceeds that of mie.

Changes in the h-ratio reflect a preferential shift in the composition of U.S. bank liabilities toward Euro- dollar borrowing. As shown in table 2, elasticities for each multiplier with respect to the ratio of Eurodollar borrowing to domestic demand deposits (h) are identical. Thus, changes in Eurodollar borrowing by U.S. Elasticities were determined for each multiplier banks have a similar effect on the money stock re with respect to changes in the f-, h-, and c-ratios and gai-dless of how money is defined. (Note that if rb is are presented in table 2. Because the elasticities for zero, as is currently the case, these elasticities are M1A and M1B are identical, only the analysis for zero.) M1B — the broader measure of transactions balances

— is discussed below. A shift in the preferences of the U.S. non-bank public away from domestically issued CDs is represented In transaction 1, the public’s shift from U.S. demand by a change in the ratio of CDs to domestic demand deposits toward Eurodollars was associated initially deposits (c). If this shift is accompanied by an off- with an increase in foreign commercial banks’ demand setting change in either the f- or h-ratio, then the im deposits at U.S. banks. In the multiplier framework pact on the U.S. money stock will be the result of the this transaction would be characterized by an increase combined elasticities of the multipliers with respect to in the f-ratio. This change assumes that Eurohanks the c- and f- (or c- and h-) ratios. This is the multiplier hold precautionary reserve balances in the form of counterpart to transactions 2 and 4 above. As shown demand deposits at U.S. banks and that these reserves in table 2, all multipliers have the same negative are proportional to the total volume of Eurodollar de- elasticity -~withrespect to the c-ratio. posits.18 The initial deposit shift toward Eurodollars increases Eurodollar reserves, thereby allowing an ex- Table 3 reports numerical values for these elastici - pansion of Eurodollar loans and deposits. Although ties, calculated from monthly data over the period Eurobanks have not changed their desired ratio of Eurodollar reserves as a share of total Eurodollar deposits, Eurodollar reserves as a percent of U.S. tie- Table 3 rnand deposits have risen. Calculated Elasticities of Money Table 2 indicates that the sign of the elasticity of Multipliers with Respect to Changes in the Ml multiplier (m1) with respect to changes in the Selected Preference Ratios (1973-1979) f-ratio depends upon the relationship between m and 1 1 the average reserve ratio against demand deposits ~.h~1tipltei I—ratio L—rdth’ c—ratio (ru). Over the past two decades, m has rarely fallen 1 rn .021 .001 1)4! below 2.5, and the highest marginal reserve require- m ,—.00(5 — .001 tIN ment has never exceeded .17. Clearly then, for even rn .1)06 — .1)0.1 .1141 these extreme values of r8 and m1, the elasticity of tm llasetl no the pt’rinrl from 197.3 thrcotgi• Scptenrtmer I 9Th. t8 This simplifying assumption probably overstates the extent 1rr i;’g -c~’liit’li I’.nr~jcliiIIar Ix)ro)’t~irrcisWi Ti’ ‘.nI’r’._t to ~mnI’ !r’qnmft’flic’i.ts. lc,Ir’r,tI lb cr’, a, ho!, ai.1.rnJnt’ccl ii to which such deposits serve as reserves for the Eurodollar .~ncmuq PiTS Io~s‘ri’’ rc’.,c’r’-e rc’quiu nu mit’ noah ‘si..i’,di system and consequently overstates the effect that Euro- bum ow i,,~sto Ytic’, begi.iairig iii dk’toht’r 19Th. dollars have on the U.S. money stock. 8 FEDERAL RESERVE BANK OF ST. LOUIS JUNE/JULY 1980 from January 1973 through December 1979.19 These ginal effective cost of funds from various sources tends elasticities indicate that a 1 percent increase in the toward equality. (For convenience, this discussion f-ratio would cause a .021 percent increase in m1 and focuses on only two bank liabilities — U.S. CDs and a .006 percent decline in both m,~and luIb. Further borrowings from Eurobanks.) Under current regula- these calculations reveal that, although the multipliers tions, CDs are subject to a higher marginal reserve re- are more sensitive to fluctuations in the c-ratio, even quirement than are Eurodollar borrowingsYl Assum- those elasticities are small. Therefore, unless changes ing no reserve requirement against Eurodollar in the ratios are large, they would have little impact borrowing, the cost of these liabilities to U.S. banks on the money stock. For instance, suppose that m~,is is equalized when the following condition is satisfied: 2.5, that the monetary base is $160 billion, and that

MIB is $400 billion. Holding the base constant, a 1 ~ = percent increase in the c-ratio would lower M1B by where ~us., ~a, and r are, respectively, the domestic approximately $176 million, while a 1 percent increase 0 CD rate, the Eurodollar iuterbank lending rate, and in the f-ratio would lower M1B by only $24 million, the marginal reserve requirement against CDs.22 Interest Rate Effects The spread, 5, between Eurodollar and U.S. interest rates is defined as: Since these ratios are intended to reflect the portfolio behavior of the public and the commercial bank- (5) S = ii—ion, ing system, the)’ should vary with interest rates. Thus, which upon substitution from equation (4) produces if the ratios reflecting Eurodollar activity are suffi- ciently interest-sensitive, changes in interest rates will 2 i~s.. If U.S. interest rates rise, the spread be- change the money stock. ° tween Eurodollars and domestic CDs will widen. Dif- The interest-sensitivity of Eurodollar flows depends ferentiating equation (5) with respect to ~us. yields upon the extent to which Eurodollars are substitutes (6) dS r’ for domestic deposits. Term Eurodollars are Eurodol- diu.~ I lar liabilities of a specified maturity, usually 90 days or less. The relative attractiveness of these deposits Since -~-~-- is positive, an increase in U.S. market in- should vary with their interest rate differential against terest rates will be associated with an increase in the domestic CDs. If both assets were perfect substitutes, Eurodollar/U.S. interest rate differential which, in they would require the same yield. On the other hand, turn, will stimulate a flow of funds from domestic CDs if depositors considered domestically issued CDs to be to the Eurodollar market. safer or more convenient, Eurodollar deposits would yield a higher interest rate, implying that a positive Equation (6) implies that the elasticity of the in- interest rate spread would prevail even in equilibrium. terest rate spread with respect to the level of U.S. Any momentary widening of this spread would attract interest rates should be 1 ~‘r ~ Using the U.S. funds to the Eurodollar market. Thus, Eurodollar 0~ flows should vary directly with changes in the equi- certificate of deposit rate as the representative U.S. in- librium interest rate spread. terest rate, this elasticity was estimated to he 1.08 over the period from 1973 through 1979.23 This value did The equilibnum spread itself will vary with changes not differ significantly from unity, indicating that a 1 in market interest rates if U.S. bank liabilities are percent rise in the level of U.S. interest rates is asso- subject to different reserve requirements. For example, as U.S. banks bid competitively for funds, the mar- 21 Both domestic CDs and net Eurodollar borrowings, as part of a bank’s “managed liabilities,” were snbject to a marginal 9 reserve requirement on the total amount of managed liabil- I The elasticity expressions from table 2 were calculated for ities above some base. This reserve requirement was im- each month in the sample and then averaged over the period. posed, in addition to any other reserve requirements, against For the f-ratio elasticities, a9percent average reserve re- the liability. At present, this separate reserve requirement is quirement against demand deposits was assumed. For the zero against net Eurodollar borrowings and is 6 percent h- and c-ratios, actual mai-ginal reserve requirements in against domestic CDs. effect during each month were used. 20 22Jf there are reserve reqnirements against Eurodollar borrow- The positive (and larger) elasticity of the Ml multiplier, with respect to the f-ratio, suggests that Ml would Iluctuate ing, the equal cost condition becomes 1 I’~~= more than either M1A or M1B when the f-ratio changes. If 3 the f-ratio is interest-sensitive, then Ml would show greater This elasticity was also estimated using the U.S. Treasury volatility dime to interest rate changes than woulrl either of bill rate by regressing the logs of the spread against a con- the new definitions of money. stant and the logs of the interest rate, Results were similar.

9 FEDERAL RESERVE BANK OF ST. LOUIS JUNE/JULY 1980

ciated with a 1 percent increase in the spread. In other words, the spread was some constant fraction Table 4 of the level of U.S. interest rates. Values of Selected Preference Ratios Over much of this period, reserve requirements against CDs and Eurodollars were identical, implying (Annual Averages of Monthly Data) that any observed spread would correspond to some Year fT ratio h ratio c-ratio risk or preference premium on Eurodollar deposits. Thus, the estimated unitary elasticity of this premium, 1973 029 .038 .299 with respect to the level of U.S. interest rates, sug- 1974 037 045 -388 gests that the risk premium varies directly with in- 1975 036 026 .402 terest rate levels. Interestingly, for the subperiod from 1978 0313 .019 313 September 1978 through December 1979, after reserve 1977 042 .004 278 requirements against Eurodollar borrowings were low- 1978 043 008 .347 ered to zero, the estimated interest rate spread elasticity of 1.57 differed significantly from unity at the 199 039 -096 359 10 percent confidence level. This result is consistent with the effective risk spread remaining a constant f-ratio, ranging from .029 to .043, shows the least ratio to the level of U.S. interest rates. amount of year-to-year variation, while the c- and If the money multipliers are more interest-sensitive h-ratios are more volatile. Using annual averages of due to Eurodollar activity, the Fed’s ability to restrain the c- and h-ratios, however, masks much of their money and credit expansion could be affected, as some intra-year variability. For instance, despite an appar- critics of the Eurodollar market have asserted. For ent increase in 1979 over its 1978 value, the c-ratio example, if Federal Reserve policy temporarily raises actually declined substantially during most of the year domestic interest rates, the volume of CDs could be and, by year end, was 11 percent lower than it had expected to decline relative to Eurodollar borrowings been at the beginning of the year. The h-ratio, on the by U.S. banks. Such Eurodollar-related flows would other hand, began to rise sharply after Federal Re- affect both the c- and h-ratios and, consequently, the serve Board action in August 1978 lowered the reserve multipliers. The net impact on the U.S. money stock requirement on net Eurodollar borrowing to zero in depends on both the interest elasticities of these ratios August 1978.25 and the elasticities of the multipliers with respect to Table 5 reports the estimated interest elasticities of changes in the ratios. these ratios and provides another perspective on their behavior over the past eight years.26 All interest elas- POTENTIAL IMPACT OF ticities are positive and differ significantly from zero at least at the 10 percent confidence level. The estimated EURODOLLAR TRANSACTIONS interest elasticities for both the f- and h-ratios exceed ON THE US. MONEY STOCK that of the c-ratio, reinforcing the view that the pres- Two critically important results are evident in the ence of differential reserve requirements induces more foregoing discussion. First, Eurodollar transactions 5 affect the behavior of the U.S. money supply primarily For a discussion of the extent to which Eurodollar borrow- 24 ings are substituted for domestic CDs, see David H. Resler, through their impact on the money multipliers. Sec- “Does Eurodollar Borrowing Improve the Dollar’s Foreign ond, Eurodollar transactions respond to changes in Exchange Value?” this Review (August 1979), pp. 10-16. 26 interest rate differentials that are related to interest Data reported in table 5 were computed by estimating equations of the general form In x a + a. in i + u, where x rate levels. The behavior of the three relevant ratios designates the ratio, i the market0 yield on three-month is examined to assess the importance of these Euro- Treasury bills, and uarandom error term. This equation was estimated by a Cochrane-Orcutt iterative regression tech- dollar-related effects for the 1973-79 period. nique to correct for the presence of serially correlated re- siduals in the ordinary least squares regression. For the cross Table 4 reports the annual averages (of monthly elasticities, In c was substituted for in i in this general data) for the f-, h-, and c-ratios from 1973-79. The expression. Although it would be desirable to estimate the elasticities of these ratios with respect to the interest rate 24 spread, such estimates would require the specification of a Even if these Eurodollar transactions have a sizeable impact full structural model. Consequently, the estimates provided on the money stock, they would not pose an insurmountable here should be considered to be crude approximations of the barrier to controlling the money stock. To the extent that interest elasticities that are useful for a rough determination such effects are predictable, the monetary authority could of the importance of Eurodollar activity in the U.S. money offset them in its conduct of monetary policy. supply process.

10 FEDERAL RESERVE BANK OF ST LOUIS JUNE/JULY 1980

(Ml) that would be less than 0.2 of 1 percent higher. Table 5 Because the assumptions used in this analysis exag- gerate the effect that Eurodollar transactions have on Elasticittes of Selected Preference the money stock, it is apparent that Eurodollar trans- Ratios (1973-79) actions have only a small effect on the U.S. money supply. Further, the Federal Reserve could easily Wi lire pectto: offset this effect with appropriate open-market Ratio Intere t rates e ratio transactions.

£ 198 (2.017) .081 (— 448) lx 715(1966) —441 ( .649) c 147 (2.534) Summary and Conclusions This article has examined the extent to which it statistics appear in parentheses. Eurodollar transactions can affect the U.S. money supply, as measured by current and past Federal Re- substantial Eurodollar flows during periods of rising 27 serve Board versions of narrowly defined money. Us- interest rates. ing both T-accounts and a money multiplier frame- Table 5 also reports estimates of the cross elastici- work, Eurodollar transactions were shown to affect ties of the h- and f-ratios against the c-ratios. Although the U.S. money stock in two ways. First, regardless these elasticities were of the predicted sign, they did of the chosen definition of money, Eurodollar flows not differ significantly from zero, indicating that sub- may affect the U.S. money stock indirectly through stitutions between Eurodollar transactions and domes- their impact on the portfolio composition of U.S. tic CDs have not had an important effect on these banks’ liabilities. Changes in this portfolio composi- ratios during the period. tion, whether due to Eurodollar flows or simply domestic asset shifts, may affect the money supply The potential effect of interest-induced Eurodollar through differential reserve requirements. Second, transactions on the money stock can be evaluated by Eurodollar flows may affect foreign commercial bank using estimates reported in tables 3 and 5. Assuming demand deposits at U.S. banks. To the extent that a constant monetary base of $160 billion, the potential these deposits serve as reserves for the Eurodollar effect that Eurodollar transactions would have on Ml system, they will vary directly with flows between the and M1B was calculated for a 1 percent change in the U.S. Eurodollar and the U.S. money markets. Because level of interest rates (10 basis points if interest rates these deposits are excluded from the new definitions are initially 10 percent) 28 These calculations indicate of money, but not from the old Ml definition, Euro- that if old Ml were used to measure money, the U.S. dollar flows will affect the various transactions-based money stock would be about $68 million higher than definitions differently. Analysis based on the multi- it would have been otherwise. On the other hand, if plier model indicated that old Ml would be slightly measured by M1B, the money stock would have been more sensitive to Eurodollar flows than either M1A only about $44 million higher. In each case, these or M1B. changes are less than two one-hundredths of 1 percent of the money stock. Even a 10 percent monthly in- Since Eurodollar transactions have some impact on crease (100 basis points) in domestic interest rates narrowly defined money, the question of whether snch would result in an average monthly money stock transactions impair the monetary authorities’ control 27 of monetary aggregates merits investigation. The mul- Elasticity estimates for the h-ratio were derived indirectly. Since calculations of the elasticities were based on logarith- tiplier framework presented in this paper was used to mic transformations of the actual ratios and since the h-ratio examine systematically Etu-odollar-induced effects on was negative during some months of the sample period, it was necessary to first transform the h-ratio by adding one the money stock. Based on estimates over the period to all values for h. The estimated elasticity of 1 ± h was for 1973-79 — a period of rapid growth in the Euro- then converted into an elasticity for hbymultiplying the estimated coefficient of (1 + h) by (1 + h)/h, evaluated dollar market — Eurodollar flows were shown to have at the mean values of h over the sample period. only minor effects on the U.S. money stock. This evi- 25 These calculations were based on average values of the mul- dence warrants the conclusion that the Eurodollar tipliers and the estimated elasticities of the three ratios, even though the t-statistics for some coefficients did not differ market does not pose a serious threat to the ability of significantly from zero. the Federal Reserve to control the money supply.

11 FEDERAL RESERVE SANK OF ST. LOUIS JUNE/JULY 1950 (ii

APPENDIX: Derivation of Money Multipliers

A. Definitions of Symbols (8) lCD =nD, Ratio Relevant (9) E=eF~ as to reserve Description Variables Dl’ ratios (10) C=kD0 (11)Rzzro(D +Dr+Dg+[ICD])+r,T Bank Liabilities 0 Time Deposits T t r, +r,CD+rhH+E Demand Deposits Government d r,, Substituting into equation (11) from equations (3) Non-bank public I ru through (10) produces: Foreign Commercial bank D f 0 = (1 + f + d ±n) Large CDs CD c (12) R Era + rt rhh + e] Net Eurodollar borrowings H h r,, + roc + D,, Interest-bearing checking deposits lCD n Thus (1) can be rewritten as: NOW accounts NOW Credit union drafts DCU (13) B = Era (1 + f + d ±n) + r,t + r,c + r~h+ e + ki D, AD ATS accounts ATS 0 Excess reserves E e where ~ equals the bracketed term on the right hand Currency held by public C k — side of (13). Source base B Money Stock Measures Ml Similarly, the three money definitions can be written M1A as ratios to M1B

(14) Ml = (1+f+k)D, B. Derivations MIA= (1+k)D, (1) B~R+C M1B= (1+k+n)Dp (2) Ml miBDp+Dr+C The three multipliers are derived by dividing all expres- M1A m,, B = D + C 0 sions in (14) by (13) producing: M1B = mu, B = D + C + NOW DCU + ATS 0 + = D + C + lCD 0 1 +f+k (3) T=tTh (15) m, A (4) DgdDp 1+k (5) D,=fD A 0 (6) CD=cD,, and mu, 1 + k + n, as in the text. (7) H=hD — A 0