Macroeconomic analysis and key concepts

Central Bank Deposit Requirements and the Chinese Economy

China's announcement that its central banks need to hold more deposits will effect the balance sheets of both the central and commercial banks quite strikingly. In order to preserve the current value of its currency, the central banks are manipulating the required deposits in order for the banks to have more cash on hand. The higher deposit rates will reflect positively upon the analyses of the countries' central banks because it will show a much higher level of capital available for both internal investment and lending. In effect, the banks' reserves ("R") are tools that can be used to further manipulate the financial sector of the Chinese economy as well as the interest rates and currency strength. This occurs through increased reserve requirements, which helps to stem the possibility of inflation by keeping the banks' assets and capital locked up and illiquid (McConnell, Brue, and Flynn, 2008).

This increased capital in turn influences the balance sheets in a way that suggests the Chinese economy is stronger than it would have been had it not made the announcement. During the global economic recession, every major economy in the world was looking to offload toxic and unappreciative assets from their central and commercial banks' books. China has been able do this in a way that both helps its own economy and helps to secure the de-valued currency that has helped prop the economy up for over a decade. The effects of such a requirement are also indicative of a government that wants to have more power over the money supply. Since the United States has been printing trillions of dollars in its attempts at quantitative easing, the Chinese are fearful that interest rates may not be entirely effective at stopping widespread inflation in the money supply. The accepted influence of "R" on the money supply is quite clear, and is a function of other factors such as the monetary base (Mb), monetary supply (MS), the savings rate (percentage above or below 100) of the country's citizens (c), and the money multiplier (mm). Mathematically, this can be represented in the following formula:

MS = Mb x mm whereas mm = (1+c)/(c+R)

By demanding higher deposits levels, the Chinese government is exacting more influence over the end product, the money supply (MS) (McConnell, Brue, and Flynn, 2008).

The economic impact of the Chinese Central Bank's decision to require more deposits is quite clear and is best understood as a potential influence on the country's overall economic health and position within the world's economic system. The potential impact on GDP could be quite convoluted, since the Chinese government is bent on keeping the current value of its currency devalued. However, a clearer picture of the influence on GDP emerges when both aggregate and equilibrium expenses and their effects on GDP are considered. First of all, by tightening the country's money supply (MS), the Central Bank is helping to keep interest rates low. The greater the MS, the higher interest rates tend to move since the higher MS value tends to lead to inflation (McConnell, Brue, and Flynn, 2008). The Central Bank's announcement is well timed to help prevent inflation in the near to medium term for the Chinese economy. This will positively affect its GDP since it will help keep the currency devalued and the trade imbalances intact. The Chinese GDP depends largely on its currency valuation.

The future demand or future GDP numbers are predicted within the aggregate expense function. If the cost of borrowing money is higher (higher interest rates and inflated economy), the Chinese economy (GDP) will likely grow more slowly. This is because as firms and businesses demand loans and credit to grow, there is less and less motivation to borrow at higher interest rates (McConnell, Brue, and Flynn, 2008). By keeping rates low, firms and businesses, which impact production and GDP are more likely to borrow money to grow and expand, all the while the Central Bank has a higher reserve (R) to keep liquidity outside of the banks and within the general, GDP producing economy under control as well. This is another way to help control inflation. Since the future cost of borrowing (aggregate demand) is in effect lowered, or kept artificially attractive to Chinese businesses, internal growth and GDP output is positively influenced (McConnell, Brue, and Flynn, 2008). Instead of the "invisible hand" of the market creating an money supply/interest rate equilibrium, the Chinese government is doing so by requiring banks to hold more deposits on their balance sheets.

China's announcement will likely affect interest rates quite dramatically in that banks will have more cash on hand to help pad their balance sheets while the money supply stays relatively low. This helps to keep the potential for inflation low, where interest rates begin to rise. As long as there is less money to be lent, or in effect, more money tied up within the banking system that cannot be lent to borrowers, the interest rates will likely remain relatively low (McConnell, Brue, and Flynn, 2008). This helps to combat inflation, or the potential for inflation since other economies like the United States have been printing money to help boost their own economies. These actions by the U.S. will likely result in inflation since the money supply has been increased to levels where interest rates are no longer able to be held at low levels. The Chinese, in making their announcement, are in effect working against the U.S. economic interests. The Chinese are continuing to keep their currency devalued in the face of overseas demands. This helps to boost internal growth, GDP, economic strength, and keep the potential for inflation and higher interest rates low.

Since the money multiplier (mm) is a reciprocal of the bank's reserves (R), the effect of the Chinese announcement will undoubtedly effect the mm directly (McConnell, Brue, and Flynn, 2008). The spending and investment multipliers within the Chinese economy will be affected because when the banks have less money to lend and higher deposit rates, they keep interest rates low and liquidity relatively low as well. This encourages real growth, not the kind of credit-driven growth that the U.S. experienced shortly before the economic meltdown of 2008. Since the money multiplier and interest rates affect other sectors of the economy like the MPS and MPC, just to name two, the results of such an announcement are profound indeed.

The Chinese MPC, or marginal propensity to consume is much less when less money is being lent out due to higher deposit requirements (McConnell, Brue, and Flynn, 2008). This is not something that will affect the Chinese like it would the U.S. economy, which is largely based upon consumption. However, the MPS (marginal propensity to save) will also be affected. In China, where people are more accustomed to save than the average U.S. consumer, a tighter money supply and influenced money multiplier (mm) will help to increase savings (McConnell, Brue, and Flynn, 2008). Though interest rates remain low, the less the country consumes (MPC), typically, the more it saves (MPS). This has the effect of keeping the banks' balance sheets stacked with deposits and the flow of liquidity low, which helps to stave off inflation through credit creation and a higher money supply.