Banking

Bank:
An intuition which deals in money. Banks draw savings of the people and lend to others who can use it productively. Banks thus collect deposit lend to others, Banks deal, in other people’s money.
Central Banking: 
Every country has a central Bank-A symbol of financial sovereignty and stability of the country. It holds the ultimate reserves of the nation, controls the flow of purchasing power-whether currency or credit and as a banker to the state
Central Banking principles:
1) Unlike commercial banks, Central banks profit is a secondary consideration; public interest and welfare of the country is the primary consideration.
2) It is primarily concerned with the maintenance of the solvency of the entire banking.
3)It’s a reservoir of credit and a lender of last resort.
4) It’s must follow an active policy. It acts quickly when something goes wrong with the credit machinery of the nation. It has to foresee or smell anything that may go wrong. Two weapons (a) Manipulation of the bank rate policy (b) the open market operations.
5) For the efficient discharge of functions the central bank is equipped with sufficient power and autonomy. It is independent of political influence.

Functions of Central Bank:
 A Central bank usually acts in the following capacities:
As the note-issuing agency.
As the banker to the state.
As the banker’s bank.
As the guardian of the money market, through control of credit.
As the lender of last resort.
It undertakes to maintain the external value of the domestic currency.
It ensures the stability of the internal value of the currency i.e. the price level.
It undertakes exchange control operations
It fights economic crises and fluctuations and ensures economic stability of the country.

Central Banking:
A Central bank is a bank for bankers. Its objectives are to allow sustainable economic growth, maintain a high level of employment, and ensure orderly financial markets and above all to preserve reasonable price stability.
 
The Central bank has three policy instruments:
Open- market operations
The discount rate on bank borrowing.
Legal reserve requirements on depository institutions

Using these instruments, the fed affects intermediate targets, such as the level of bank reserves, market interest rates, and the money supply. All these operations aim to improve the economy’s performance with respect to the ultimate objectives of monetary policy: acheiving the best combination of low inflation, low unemployment, rapid GDP growth, and orderly financial markets. In addition, the central bank along with other federal agencies must backstop the domestic and international financial system in times of crisis.


The three major instruments of monetary policy are-
  Open-market operations
  buying or selling of government securities and bonds in the open market to influence the level of reserves.
Discount-rate policy
setting the interest rate, called the discount rate, at which commercial banks and other depository institutions can borrow reserves from a regional central bank
Reserve-requirements policy
setting and changing the legal reserve ratio requirements on deposits with banks and other financial institutions.


 The nuts and bolts of Monetary Policy
Open Market operation: The Central Bank’s most useful tool is “Open market operations”. By selling or buying government securities in the open market, the Central Bank can lower or raise bank reserves. These so called open-market operations are a central bank’s most important stabilizing instrument.
In setting policy, the central bank decides whether to pump more reserves into the banking system by buying Treasury Bills (i,e.,short-term bonds) and longer-term government bonds or whether to tighten monetary policy by selling government securities.
To the open market, this includes dealers in government bonds, who then resell them to commercial banks, big corporations, other financial institutions and individuals.


 Discount- Rate Policy: A second instrument: 

  When commercial banks are short of reserves, they are allowed to borrow from the central banks. Their loans were included under the asset side. Sometimes the central bank may raise or lower the discount rate, which is the interest rate charged on bank borrowings.
The discount rate is a relatively minor instrument of monetary policy. Sometimes, a change in the discount rate is used to signal markets of a major policy change in the discount rate simply follows market interest rates to prevent banks from making windfall profits by borrowing at a low discount rate and lending at a higher rate on the open market.

Changing Reserve Requirements: If there were no government rules,
banks would probably keep only a small fraction of their deposits in the form of reserves. In fact, commercial banks are today required to keep substantially more reserves than necessary for meeting customer’s needs. These legal reserve requirements are a crucial part of the mechanism by which the central bank controls the supply of bank money. This subsection describes the nature of legal reserve requirements and shows how they affect the money supply.
The central bank can change reserve requirements if it wants to change the money supply quickly. For instance, if central bank wants to tighten money overnight, it can raise the required reserve ratio for the big banks to the 14% statutory limit. It might even raise reserve requirements on time deposits.

The Money market:

  The demand for money depends primarily on the need to undertake transactions households business and governments hold money so that they may buy goods, services and other items. In addition some part of the demand for M derives from the need for a super safe and highly liquid asset. The supply of money is jointly determinate by the private banking system and the nation’s central bank. The central bank through open – market operations and other instruments, provides reserves to the banking system. Commercial banks then create deposits out of the central bank reserves by manipulating reserves, the central bank can determine the money supply a narrow margin of error.

Supply and demand for money: 
  The supply of and demand for money jointly determine the market interest rates. Figure-2(a) shows the total quantity of money) on the horizontal axis and the nominal interest rate(i) on the vertical line on the assumption .


 Money market shifts: 
To understand the monetary transmission mechanism, we need to see how changes in the money market affect interest rates. Suppose that the Federal Reserve becomes worried about inflation and tightens monetary policy by selling securities and reducing the money supply.
Summary: The money market is affected by a combination of figure(1) the public’s desire to hold money (represented by the demand for money DD curve) and figure (2) the fed’s monetary policy (which is shows as a fixed money supply, SS). The interaction determines the market interest rate, i.e.A tighter monetary policy shifts the SS to the left, raising market interest rates. An increase in the nations output or price level shifts the DD curve to the right and raise interest rates. Monetary easing or a money- demand decline has the oppos ite effects.