B. Central Banking. The Bank and the Money Supply

In this section we study the ways in which a central bank can affect the supply of money in the economy. The narrowest measure of the money supply is currency in circulation outside the banking system plus the sight deposits of commercial banks against which the private sector can write cheques. Thus money supply is partly a liability of the Bank (currency in private circulation) and partly a liability of commercial banks (chequing accounts of the general public).

*We now describe the three most important instruments through which the Bank might seek to affect the money supply: reserve requirements, the discount rate, and open market operations.

Reserved Requirements

A required reserve ratio is a minimum ratio of cash reserves to deposits that the central bank requires commercial banks to hold.

If a reserve requirement is in force, commercial banks can hold more than the required cash reserves but they cannot hold less. If their cash falls below the required amount, they must immediately borrow cash, usually from the central bank, to restore their required reserve ratio.

Suppose the commercial banking system has 1 million in cash and for strictly commercial purposes would normally maintain cash reserves equal to 5 per cent of sight deposits. Since sight deposits will be 20 times cash reserves, the banking system will create 20 million of sight deposits. Suppose the Bank now imposes a reserve requirement that banks must hold cash reserves of at least 10 per cent of sight deposits. Now banks can create only p. 10 million sight deposits against their cash reserves of p. 1 million.

Thus, when the central bank imposes a reserve requirement in excess of the reserve ratio that prudent banks would anyway have maintained, the effect is to reduce the creation of bank deposits, reduce the value of the money multiplier, and reduce the money supply for any given monetary base. Similarly, when a particular reserve requirement is already in force, any increase in the reserve requirement will reduce the money supply.

When the central bank imposes a reserve requirement in excess of the reserves that banks would otherwise have wished to hold, the banks are creating fewer deposits and undertaking less lending than they would really like. Thus a reserve requirement acts like a tax on banks by forcing them to hold a higher fraction of their total assets as bank reserves and lower fraction as loans earning high interest rates. Can the banks do anything about it?

*Although there are profitable lending opportunities, the banks can take advantage of them only if they can increase their cash reserves. In principle, they could try to borrow cash from the central bank. If the point of a reserve requirement is to reduce the money supply, the central bank will be reluctant to lend banks the cash they want to make additional loans, increase deposits, and expand the money supply. *With lucrative lending opportunities around - the banks may be able to induce the private sector to exchange cash in circulation for bank deposits. Banks can offer more generous interest rates on time deposits or stay open later to encourage people to make greater use of chequing facilities.

One form of reserve requirement that has been especially popular in the UK is the use of special deposits. Commercial banks were required to deposit some of their cash reserves in a special deposit at the Bank, and this money could not be counted as part of the banks'cash reserves in meeting their reserve requirements. Varying the amount required as special deposits gave the Bank another level for controlling deposit creation by the banking system and the size of the money multiplier.