Economics Exam > Economics Videos > Banking : A Reserve Bank (Part -11) - Economics
Banking : A Reserve Bank (Part -11) - Economics Video Lecture
FAQs on Banking : A Reserve Bank (Part -11) - Economics Video Lecture
| 1. What is a Reserve Bank? |  |
Ans. A Reserve Bank is a financial institution that is responsible for managing a country's money supply, controlling interest rates, and maintaining overall stability in the financial system. It serves as the banker to the government and commercial banks, conducts monetary policy, issues currency, and regulates the banking sector.
| 2. What are the functions of a Reserve Bank? | |
Ans. The functions of a Reserve Bank include:
- Formulating and implementing monetary policy to control inflation and maintain price stability.
- Regulating and supervising commercial banks to ensure the stability and soundness of the banking system.
- Managing the country's foreign exchange reserves and conducting foreign exchange operations.
- Acting as a lender of last resort to provide liquidity to banks during financial crises.
- Issuing currency and maintaining its integrity and supply.
- Conducting economic research and providing economic analysis to support decision-making.
| 3. How does a Reserve Bank control the money supply? | |
Ans. A Reserve Bank controls the money supply through various tools of monetary policy. These tools include open market operations, reserve requirements, and discount rates.
- Open market operations involve buying or selling government securities to influence the amount of money in circulation.
- Reserve requirements determine the proportion of deposits that banks must hold as reserves, which affects their ability to lend.
- The discount rate is the interest rate at which banks can borrow funds from the central bank, and changes in this rate can encourage or discourage borrowing and lending.
| 4. Why is the independence of a Reserve Bank important? | |
Ans. The independence of a Reserve Bank is important for maintaining monetary and financial stability. It allows the central bank to make decisions based on economic considerations rather than political pressure. Independence helps in controlling inflation, managing interest rates, and ensuring the stability of the financial system. It enhances the credibility of the central bank and fosters public trust in its policies and actions.
| 5. How does a Reserve Bank regulate commercial banks? | |
Ans. A Reserve Bank regulates commercial banks through various measures:
- It sets prudential regulations and guidelines that banks must comply with, such as capital adequacy requirements, loan classification norms, and provisioning norms.
- It conducts regular inspections and audits of banks to assess their financial health and compliance with regulations.
- It has the power to issue licenses to new banks and revoke licenses of non-compliant banks.
- It monitors and supervises banks' lending practices, risk management systems, and corporate governance.
- It has the authority to impose penalties, fines, or corrective actions on banks that violate regulations or engage in risky practices.
Text Transcript from Video
Everything we've covered so far
dealt in a world of only
one bank and we all know that
there are more than one bank
in this world.
Let's see what happens
in that example.
So I've drawn the balance sheets
for three hypothetical
banks in a world where gold is
the reserve currency and let's
see what happens
in that world.
So let me show you all of the--
so that's the first one
and that's the last one.
They all didn't fit on the
screen, but just so you
understand and a bit of review
of what we covered in the last
several videos, in these balance
sheets, of course the
left side are the assets, the
right-hand side, up until
here, is liability.
So from here to here,
that's liabilities.
And what's left over
is the equity.
So in every balance sheet, just
to be consistent, I made
this blue color equal
to the equity.
Let me write that down.
And just to be consistent, I
made this little orange color
the building, brown
for building.
And this yellow or this gold
color-- that's actually the
gold reserves of that bank.
And each of these lines, these
divide the various other
assets of the bank.
In this case, they're just
loans, maybe to different
entrepreneurs.
And then these green lines
separate the different demand
deposits or checking accounts
that are with that bank and
then the green-- this filled in
green, for example, in this
middle bank-- that shows
its notes outstanding.
Remember, there's two ways that
you could essentially
give someone an IOU
from this bank.
One is to say, oh, you have a
checking account and you can
write checks against it.
The other way is to issue this
bank note and someone can come
back later with this bank note
and you should have to give
them an equivalent
amount of gold.
So in this middle bank, this
green area, that shows its
bank notes outstanding.
This purple area in this bank,
that's its bank notes
outstanding.
And then down here, this
off-white color is its bank
notes outstanding.
Fair enough.
We've created a world
with three banks
Now what is the problem here
or, are there any problems?
Well, there are a couple
that I see immediately.
The first is, all of
them might have
different reserve ratios.
In the last video, I kind of
talked about a world with
regulation, but let's say in
this world, since every bank
is kind of a separate
entrepreneur, maybe it was
originally the goldsmith, they
all just made their own rule
of thumb that if I have this
amount of demand deposits
based on how my customers act
or whatever or based on my
liabilities or however it works,
I'm going to keep this
amount of gold.
So maybe this guy's reserve
ratio-- I don't know what the
ratio of this to this is, but
maybe his reserve ratio is 8%.
So for every 100 gold pieces
of demand deposits and bank
notes, he keeps eight gold
pieces on reserve.
Maybe this guy is 10%.
Looks a little bit better.
Maybe this guy up here is
keeping a 12% reserve ratio.
So there's no consistent
reserve ratio.
So let me write that down.
And there's a couple things
that that might lead to.
Maybe this guy right here, he
was the first bank to start--
or maybe this guy.
This guy had a 12% reserve
ratio-- and people really
trusted it for a long time.
Every time they deposited money
and then they came back
later, they were able
to find it.
He really lent money
really well.
So that there was never any
scare on this bank.
No one ever felt afraid to
keep their deposit there.
But as the banking business got
more and more profitable,
more and more risky people
showed up and this guy only
has an 8% reserve ratio.
And maybe one day, 9% of their
checking accounts want their
money back and this guy's
not good for it.
This guy up here, the 12% guy,
he knew that 9% could happen.
That on any given day 9% of
your demand deposits might
want their gold back.
So that's why he kept 12%.
But this guy kept an 8% so he
could get extra interest on
more loans.
So one day, he can't
give his gold back
and that scares everyone.
So everyone comes and you have
a run on this bank, but he's
not the only bank.
Everyone starts having less
trust in the banking system as
a whole and so there are runs
on all of these banks.
And that's unfortunate
for two reasons.
One, these guys were
safe to begin with.
They kept enough reserve
ratio so that people
could get their gold.
And then the other sad thing
about it is, if this guy just
needed another 1%-- I keep going
off the video screen--
if this guy just needed another
1% of gold, he could
have borrowed it from that top
guy and then you would have
prevented this whole
banking crisis.
He could have borrowed it
from either this guy
or that guy, right?
If this guy's gold gets depleted
and more people still
want money, this guy would
clearly rather lend the money
to this guy as long as he's
still solvent than have a
systemic run on all banks.
Bank runs affect everyone.
So in this world that we're
dealing with right now, just
one weak link in the chain can
break the whole chain.
If you just have one
irresponsible bank, it'll
create a bank run on all of them
even though some of the
more capital rich banks could
have lent to the other ones.
And then finally-- and I did
this here and this is a
situation that we're not
familiar with today, but it's
a situation that's happened
many times in history.
It happened in the colonies
before we had our
independence.
Is that you had a bunch of
different banks each issuing
their own bank notes as
a form of currency.
So this one up here issues the
purple bill, this bank here
issues a green bill, and this
bank here issues this
off-white bill.
Besides the confusion, you're
always going to have all these
exchange rate differences,
et cetera, et cetera.
You don't know ahead of time--
this guy's the riskiest bank
so maybe his bills should be
worth a little bit less than
this guy up here.
But you don't have-- it really
just becomes a big mess to the
economy for someone in a cash
register to keep track of.
In this case, I only have three
banks, but imagine if
all 13 colonies each had their
own banks that were each
issuing their bank notes and
you always had to translate
between them.
And then one bank defaults and
their bank notes are worth
nothing and you have to
worry about that.
So you have another problem;
inconsistent currency.
Inconsistent paper currency.
And I think you know where
I'm going with this.
So what's the solution
to all of this?
Well, what if there were a way--
and I guess you could do
this without any extra
institutions.
You could just regulate
reserve ratios.
So that's easy to do.
That's just government
intervention.
Just say, if you want to be a
bank in our world, you have to
keep at least 10%
reserve ratios.
But we have to think about who
regulates that and who sets
that reserve ratio, but it's
fair enough that we need
someone to regulate it.
We don't need a separate
institution.
But how could we do this
mechanism where we can
prevent bank runs?
Especially when there's
money to lend from
one bank to the other.
And if we could use a mechanism
that prevents this
and provides a consistent
currency, then we're all set.
Well, the only way you can
provide a consistent currency
is if you only had one bank
issuing currency.
So let's call that bank
a reserve bank.
There you go.
So let's say these three banks
get together-- all the banks
in this world get together and
say, let's start a new
institution where we all keep
our gold reserves there.
So what happens is, this guy,
this guy, this guy, they all
keep their gold reserves
at this central bank.
And now with these guys,
instead of having gold
reserves here, what
do they have?
They have checking accounts
with the reserve bank.
Let me write that down.
Let me erase the top of that
balance sheet just because I
don't want to make
things confusing.
So that's the balance sheet that
our reserve bank now has.
Now what does this do?
Well, it definitely solves that
bank run problem because
now in this world-- and of
course we're regulating it
now-- and I kind of threw that
out there because this guy
will be the regulator.
This central bank will be the
regulator, but what you could
say now-- is if for some
reason-- let's say 11% of
these demand deposits come due,
11% of these people want
their money all of a sudden--
this guy, he just has to go to
his reserve bank account and he
can borrow from one of the
other players.
The gold is all centrally
in one place.
Now the notes issue-- how
do we solve that?
Well, what if by government law,
from now on only one bank
can issue bank notes and that's
this central bank.
Let's say this middle guy--
instead of having just a
checking account, maybe he took
half of it as a checking
account and half of his gold
deposits, he gets in these
bank notes of this
reserve bank.
So now these turn into bank
notes of the reserve bank and
these bank notes of the reserve
bank are the only
currency that's allowable.
So we've already solved two
problems. We've solved an
inconsistent currency.
And now think about what
starts to happen.
The reserves of these banks
no longer become gold.
The reserves at the banks that
people actually interact with
now become these bank notes, the
bank notes of this central
reserve bank.
And this gold is just sitting in
some big vault someplace in
this world right now.
So let's just-- I know it's a
little bit disjointed-- so
reserve ratios.
Now you have a central banking
authority where they all
chipped in a little bit of
money, created this big vault,
and this central bank dictates
reserve ratios.
It prevents bank runs because if
for whatever reason-- let's
say on some day all of this
bank's customers get scared
and want their gold back, this
bank can just go to its
checking account and borrow gold
from the other banks and
it'll get transferred to it.
But if you think about it, in a
world where people get used
to enough of this one central
bank note, then people
probably won't even want
that gold back.
They'll probably start viewing
this one currency as the
equivalent of gold.
So when people actually want
their money back, they don't
even have to give gold.
They can just give bank notes,
but there's this one
consistent bank note now from
this central reserve bank.
Anyway, I think I said the word
central and reserve too
much, but I will see you
in the next video.
Hopefully it wasn't too
complicated and I think you
see where this is going.
We'll slowly extend this to
getting off the gold standard
and how this relates to the
Federal Reserve or central
banks as we know them today.
See you soon.
dealt in a world of only
one bank and we all know that
there are more than one bank
in this world.
Let's see what happens
in that example.
So I've drawn the balance sheets
for three hypothetical
banks in a world where gold is
the reserve currency and let's
see what happens
in that world.
So let me show you all of the--
so that's the first one
and that's the last one.
They all didn't fit on the
screen, but just so you
understand and a bit of review
of what we covered in the last
several videos, in these balance
sheets, of course the
left side are the assets, the
right-hand side, up until
here, is liability.
So from here to here,
that's liabilities.
And what's left over
is the equity.
So in every balance sheet, just
to be consistent, I made
this blue color equal
to the equity.
Let me write that down.
And just to be consistent, I
made this little orange color
the building, brown
for building.
And this yellow or this gold
color-- that's actually the
gold reserves of that bank.
And each of these lines, these
divide the various other
assets of the bank.
In this case, they're just
loans, maybe to different
entrepreneurs.
And then these green lines
separate the different demand
deposits or checking accounts
that are with that bank and
then the green-- this filled in
green, for example, in this
middle bank-- that shows
its notes outstanding.
Remember, there's two ways that
you could essentially
give someone an IOU
from this bank.
One is to say, oh, you have a
checking account and you can
write checks against it.
The other way is to issue this
bank note and someone can come
back later with this bank note
and you should have to give
them an equivalent
amount of gold.
So in this middle bank, this
green area, that shows its
bank notes outstanding.
This purple area in this bank,
that's its bank notes
outstanding.
And then down here, this
off-white color is its bank
notes outstanding.
Fair enough.
We've created a world
with three banks
Now what is the problem here
or, are there any problems?
Well, there are a couple
that I see immediately.
The first is, all of
them might have
different reserve ratios.
In the last video, I kind of
talked about a world with
regulation, but let's say in
this world, since every bank
is kind of a separate
entrepreneur, maybe it was
originally the goldsmith, they
all just made their own rule
of thumb that if I have this
amount of demand deposits
based on how my customers act
or whatever or based on my
liabilities or however it works,
I'm going to keep this
amount of gold.
So maybe this guy's reserve
ratio-- I don't know what the
ratio of this to this is, but
maybe his reserve ratio is 8%.
So for every 100 gold pieces
of demand deposits and bank
notes, he keeps eight gold
pieces on reserve.
Maybe this guy is 10%.
Looks a little bit better.
Maybe this guy up here is
keeping a 12% reserve ratio.
So there's no consistent
reserve ratio.
So let me write that down.
And there's a couple things
that that might lead to.
Maybe this guy right here, he
was the first bank to start--
or maybe this guy.
This guy had a 12% reserve
ratio-- and people really
trusted it for a long time.
Every time they deposited money
and then they came back
later, they were able
to find it.
He really lent money
really well.
So that there was never any
scare on this bank.
No one ever felt afraid to
keep their deposit there.
But as the banking business got
more and more profitable,
more and more risky people
showed up and this guy only
has an 8% reserve ratio.
And maybe one day, 9% of their
checking accounts want their
money back and this guy's
not good for it.
This guy up here, the 12% guy,
he knew that 9% could happen.
That on any given day 9% of
your demand deposits might
want their gold back.
So that's why he kept 12%.
But this guy kept an 8% so he
could get extra interest on
more loans.
So one day, he can't
give his gold back
and that scares everyone.
So everyone comes and you have
a run on this bank, but he's
not the only bank.
Everyone starts having less
trust in the banking system as
a whole and so there are runs
on all of these banks.
And that's unfortunate
for two reasons.
One, these guys were
safe to begin with.
They kept enough reserve
ratio so that people
could get their gold.
And then the other sad thing
about it is, if this guy just
needed another 1%-- I keep going
off the video screen--
if this guy just needed another
1% of gold, he could
have borrowed it from that top
guy and then you would have
prevented this whole
banking crisis.
He could have borrowed it
from either this guy
or that guy, right?
If this guy's gold gets depleted
and more people still
want money, this guy would
clearly rather lend the money
to this guy as long as he's
still solvent than have a
systemic run on all banks.
Bank runs affect everyone.
So in this world that we're
dealing with right now, just
one weak link in the chain can
break the whole chain.
If you just have one
irresponsible bank, it'll
create a bank run on all of them
even though some of the
more capital rich banks could
have lent to the other ones.
And then finally-- and I did
this here and this is a
situation that we're not
familiar with today, but it's
a situation that's happened
many times in history.
It happened in the colonies
before we had our
independence.
Is that you had a bunch of
different banks each issuing
their own bank notes as
a form of currency.
So this one up here issues the
purple bill, this bank here
issues a green bill, and this
bank here issues this
off-white bill.
Besides the confusion, you're
always going to have all these
exchange rate differences,
et cetera, et cetera.
You don't know ahead of time--
this guy's the riskiest bank
so maybe his bills should be
worth a little bit less than
this guy up here.
But you don't have-- it really
just becomes a big mess to the
economy for someone in a cash
register to keep track of.
In this case, I only have three
banks, but imagine if
all 13 colonies each had their
own banks that were each
issuing their bank notes and
you always had to translate
between them.
And then one bank defaults and
their bank notes are worth
nothing and you have to
worry about that.
So you have another problem;
inconsistent currency.
Inconsistent paper currency.
And I think you know where
I'm going with this.
So what's the solution
to all of this?
Well, what if there were a way--
and I guess you could do
this without any extra
institutions.
You could just regulate
reserve ratios.
So that's easy to do.
That's just government
intervention.
Just say, if you want to be a
bank in our world, you have to
keep at least 10%
reserve ratios.
But we have to think about who
regulates that and who sets
that reserve ratio, but it's
fair enough that we need
someone to regulate it.
We don't need a separate
institution.
But how could we do this
mechanism where we can
prevent bank runs?
Especially when there's
money to lend from
one bank to the other.
And if we could use a mechanism
that prevents this
and provides a consistent
currency, then we're all set.
Well, the only way you can
provide a consistent currency
is if you only had one bank
issuing currency.
So let's call that bank
a reserve bank.
There you go.
So let's say these three banks
get together-- all the banks
in this world get together and
say, let's start a new
institution where we all keep
our gold reserves there.
So what happens is, this guy,
this guy, this guy, they all
keep their gold reserves
at this central bank.
And now with these guys,
instead of having gold
reserves here, what
do they have?
They have checking accounts
with the reserve bank.
Let me write that down.
Let me erase the top of that
balance sheet just because I
don't want to make
things confusing.
So that's the balance sheet that
our reserve bank now has.
Now what does this do?
Well, it definitely solves that
bank run problem because
now in this world-- and of
course we're regulating it
now-- and I kind of threw that
out there because this guy
will be the regulator.
This central bank will be the
regulator, but what you could
say now-- is if for some
reason-- let's say 11% of
these demand deposits come due,
11% of these people want
their money all of a sudden--
this guy, he just has to go to
his reserve bank account and he
can borrow from one of the
other players.
The gold is all centrally
in one place.
Now the notes issue-- how
do we solve that?
Well, what if by government law,
from now on only one bank
can issue bank notes and that's
this central bank.
Let's say this middle guy--
instead of having just a
checking account, maybe he took
half of it as a checking
account and half of his gold
deposits, he gets in these
bank notes of this
reserve bank.
So now these turn into bank
notes of the reserve bank and
these bank notes of the reserve
bank are the only
currency that's allowable.
So we've already solved two
problems. We've solved an
inconsistent currency.
And now think about what
starts to happen.
The reserves of these banks
no longer become gold.
The reserves at the banks that
people actually interact with
now become these bank notes, the
bank notes of this central
reserve bank.
And this gold is just sitting in
some big vault someplace in
this world right now.
So let's just-- I know it's a
little bit disjointed-- so
reserve ratios.
Now you have a central banking
authority where they all
chipped in a little bit of
money, created this big vault,
and this central bank dictates
reserve ratios.
It prevents bank runs because if
for whatever reason-- let's
say on some day all of this
bank's customers get scared
and want their gold back, this
bank can just go to its
checking account and borrow gold
from the other banks and
it'll get transferred to it.
But if you think about it, in a
world where people get used
to enough of this one central
bank note, then people
probably won't even want
that gold back.
They'll probably start viewing
this one currency as the
equivalent of gold.
So when people actually want
their money back, they don't
even have to give gold.
They can just give bank notes,
but there's this one
consistent bank note now from
this central reserve bank.
Anyway, I think I said the word
central and reserve too
much, but I will see you
in the next video.
Hopefully it wasn't too
complicated and I think you
see where this is going.
We'll slowly extend this to
getting off the gold standard
and how this relates to the
Federal Reserve or central
banks as we know them today.
See you soon.
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