commercial and central banking

8/3/2019 Commercial and Central Banking

1/4


2/4

usually keep their total reserves above the required reserve amount. Excess reserves aredefined as total reserves minus required reserves. Both excess and required reserves aredeposited at the central bank.

Commercial banks do not earn interest on their reserves. Therefore, they will notwant to hold a large amount of excess reserves. Required reserves are relatively easy todetermine because they are a percentage of the bank's deposits. Each type of deposit willhave a required percentage called the required reserve ratio. For example, if savingdeposits are $100 and the required reserve ratio for saving deposits is 15%, then therequired reserves on such saving deposits is $15. The required reserve ratios aredetermined by the central bank.

While it is easy to determine required reserves, it is not easy to determine excessreserves. If the outlook for the economy is good, then banks may decide to hold lessexcess reserves. However, if the economy goes into recession, banks may become moreconservative and decide to hold greater excess reserves. Excess reserves can also beaffected by changes in interest rates.

Commercial banks can also use their resources to purchase securities. Usually,these securities include government debt, but some countries such as Taiwan allow banksto buy corporate bonds and stock. Private securities often involve greater risk, but theyalso have greater returns to compensate for this higher risk. In Taiwan, banks often buyT-Bills and CD's issued by the Central Bank of China. They also buy government bondsissued by the Ministry of Finance, the provincial government, and the city governments.These carry little risk of default, but there is still the problem of price risk associatedwith changes in interest rates.

Commercial banks also earn interest by making loans. These include business

loans, mortgage loans, and consumer loans. Consumer loans include credit extended bythe bank for credit card purchases. Mortgages are long term loans taken out for thepurchase of a house or land. The house or land acts to collateralize the loan. Firms oftenborrow funds to finance their inventories, and these inventories act to collateralize theloan. Loans which have collateral are called secured loans. Loans which do not havecollateral are called unsecured loans. Unsecured loans will have higher interest ratesassociated with them due to higher risk premiums.

III. The Role of the Central Bank

The central bank of an economy is often called the banker's bank. It acceptsdeposits from commercial banks (which we call reserves), it buys securities from andsells securities to commercial banks, and it makes loans to banks which are short offunds. Moreover, it facilitates the transfer of funds between banks. The central bank alsooversee the operation of banks, and it often helps to stabilize the foreign exchangemarkets.

The major goals of the central bank are to provide adequate funds to promotestable economic growth and a stable price level. It does this by regulating the amount of


3/4

loanable reserves in the banking system. The central bank has three major tools which itcan use to accomplish its goals. First, it can change the required reserve ratios. This willnot change the overall level of reserves, but it will affect the amount of excess reservesthat can be loaned out by banks. Second, it can change the interest rate charged banksfor loans from the central bank. This interest rate is called the central bank discount rate(sometimes called the rediscount rate). Changes in the discount rate can affect theoverall level of reserves in the banking system. Finally, it can buy or sell governmentsecurities. When it buys bonds from the banks, this is called an open market purchase.When it sell bonds to banks or the public, this is called an open market sale. We call thiskind of buying and selling of securities open market operations. Open market operationscan likewise change the overall level of reserves in the banking system. The centralbank's monetary policy consists of decisions on how best to use these three tools.

The central bank has a balance sheet, although it is not a corporation. The assetsof the central bank consists of foreign exchange reserves, loans to commercial banks,gold, and government bonds. It's liabilities consist of currency, reserves, and securitieswhich it has issued and sold to banks. Economists are particularly concerned with

changes in currency and reserves. The sum of these two items is called the monetarybase (or high powered money). Small changes in the monetary base can lead to largechanges in the money supply, which is defined as currency plus commercial bankdeposits. The central bank can use its three tools of monetary policy to affect the level ofthe monetary base, and thus change the money supply.

IV. Money Supply and Money Demand

Each person in the economy has an amount of wealth. The division of wealthbetween money and non-money assets is the basic idea underlying the demand formoney. When we talk about the demand for money, we are really discussing peoples'

decision to hold a certain percentage of their wealth in the form of money.

There are many factors which can affect the demand for money, but usually weconsider only two: income and interest rates. If incomes rise, then people will want tospend more of this income. Their demand for money will increase because they need theadditional money with which to transact. If interest rates on non-monetary assetsincrease, then people will reduce their demand for money and will try to hold other assetsinstead.

In deciding how fast the money supply should grow, the central bank will takeinto consideration how fast the demand for money is expected to increase. Suppose thatthe money supply grows faster than the demand for money. Then people will find theyhave too much of their wealth in the form of money. They will try to reduce their moneyholdings by purchasing goods and other assets instead.

In deciding how fast the money supply should grow, the central bank will takeinto consideration how fast the demand for money is expected to increase. Suppose thatthe money supply grows faster than the demand for money. Then people will find thatthey have too much of their wealth in the form of money. They will try to reduce theirmoney holdings by purchasing goods and other assets. This creates an inflation in goods


4/4

and asset prices. Conversely, if the supply of money grows slower than the demand formoney, then the prices on goods and assets will fall. There will be deflation.

Discussion Questions:

#1. What functions do banks serve in the economy?#2. What is a bank run and what causes it?#3. What are the assets and liabilities of banks?#4. What are total, required, and excess reserves?#5. What are the three tools of monetary policy?#6. What are the assets and liabilities of the central bank?#7. What is the demand for money and why is it important to monetary policy?#8. What is the difference between secured and unsecured loans?

commercial and central banking

Documents