Banking Fundamentals & Central Bank Monetary Policy
Banking Fundamentals
Banking involves acquiring lawful money from savers to lend to operators requiring funding.
Fractional Reserve Banking
Fractional Reserve Banking refers to the practice where a percentage of total deposits received by a bank is held idle to deal with possible withdrawals from customers.
Statutory Cash Ratio
The Statutory Cash Ratio is the percentage of money, legally imposed by the central bank on various entities of the banking system, that must remain idle to deal with possible withdrawals.
Money Creation
Money Creation (or the proliferation of bank money) is the process by which the money supply within the legal system increases, primarily through bank deposits and lending.
How Money is Created:
- The central bank of each country puts into circulation a certain amount of money in the legal form of coins and banknotes.
- The banking system, by granting loans, increases the money supply. This occurs because funds are not physically removed from the system but rather circulate through clearing accounts. The public's decision to withdraw or keep money within the banking system determines the ultimate amount of money generated.
Money Supply
Money Supply: This refers to the total amount of legal money held by the public.
Monetary Policy
Monetary Policy: This encompasses all measures taken by a central bank (e.g., the European Central Bank) to achieve the objectives of the monetary authority. This is done by extending or reducing the amount of money in circulation and altering interest rates.
European System of Central Banks (ESCB)
The European System of Central Banks (ESCB) is responsible for maintaining price stability in the Euro area.
ESCB Functions:
- Decide and implement the monetary policy of the European Union.
- Conduct foreign exchange operations.
- Promote the smooth operation of payment systems.
- Supervise credit institutions.
- Guarantee financial system stability.
Monetary Policy Variables, Targets, and Instruments
Monetary Policy Variables:
- The quantity of money circulating.
- Interest rates.
Monetary Policy Targets:
- Economic growth control.
- Inflation rate management.
- Full employment.
Monetary Policy Instruments:
- Minimum Reserve Requirements: Mechanisms to increase or reduce the minimum reserves that the banking system must maintain.
- Open Market Operations: The main instrument of monetary policy, involving the buying and selling of government securities to control the money supply.
- Interest Rate Controls: Managing key interest rates to influence borrowing and lending.
- Standing Facilities: Permanent facilities that commercial banks can use to borrow from or deposit with the central bank overnight, influencing short-term interest rates and managing liquidity.
Monetary Policy Effects
Expansionary Effects:
- Increased bank lending.
- Lower interest rates.
Restrictive Effects:
- Decreased bank lending.
- Higher interest rates.