Bank Reserves and its Role on Money Supply Research Paper

Bank Reserves and its Role on Money Supply - Research Paper Example Ignoring this function is like assigning financial intermediaries merely a passive role in the financial system (FRBSF, 2001). In recent days, in the midst of the economical crisis, it has become more and more apparent that such a passive perception of banks is unwarranted. Also, the volume of broad funds in the financial system is due to the interaction of the banking system (counting the central bank) with the money-holding segment, comprising of non-financial organizations, households, the general government instead of the central government and non-monetary financial institutions (Gerali et al., 2010). Broad funds include currency in circulation, along with close substitutes, like bank deposits, and are instructive for aggregate spending and inflation (Lipsey & Chrystal, 2011). It, therefore, goes past those assets, which are mainly recognized means of payment to incorporate instruments, which work mainly as a store of value (FRBSF, 2001). Before we move forward, it is vital to u nderstand the concept of bank reverses, and then after that we will learn the importance of these reserves in money supply. This paper is divided into two sections, one which centers on the operations of commercial banks and their banking reserves and that other which dwells on the bank reserves and their roles on money supply. Bank Reserves Bank reserves refer to currency deposits that are not loaned out to banks’ customers. A small portion of the entire deposit is held within the bank or deposited to the Federal Reserve (central bank) (Gerali et al., 2010). Minimum reserve obligations are dictated by the central bank so as to make sure that banks and other financial institutions are able to offer clients cash upon their request (Levin & Wieland, 2005). The main goal of banking reserves, also known as holding reserves, is to avoid bank runs and mainly appear solvent (Schwartz, 2008). The Federal Reserve and central banks of other nations place such restrictions on banking in stitutions since they can earn a much greater return on their capital through loaning out money to customers instead of holding cash in their deposits or depositing it to other financial institutions or the Federal Reserve. Bank reserves drop during times of economy expansion and enhance during recessions (Gerali et al., 2010). The amount of funds kept in bank reserves or the Federal Reserve is dictated by the Reserve Requirement. This is the amount of funds, which a depository institution (bank) should hold in their reserve against specific deposit liabilities (Levin & Wieland, 2005). The obligatory reserve ratio is, at times, utilized as a tool in monetary principles, influencing a nation’s interest, as well as borrowing rates, through amending the amount of money available for banking institutions to offer as loans (White, 2008). Western central banks hardly alter the reserve requirements since it would lead to instant liquidity issues for banking institutions with small e xcess reserves (Gerali et al., 2010). They mainly opt to use open market operations such as buying and selling government-granted bonds in order to execute their monetary policy (Lipsey & Chrystal, 2011). In the U.S., their reserve requirement, which they also refer to as liquidity ratio, is the least amount value, determined by the Federal Reser