Chapter 10: The Monetary System (Part 2) – Commercial Banks, Money Supply, and Central Bank Tools

Commercial Banks and the Money Supply

Bank Capital, Leverage, and the Financial Crisis of 2007–09

This section explores the role of commercial banks in the monetary system, focusing on bank capital, leverage, and regulatory requirements. Understanding these concepts is crucial for analyzing financial stability and the transmission of monetary policy.

• Bank capital: The resources a bank's owners have put into an institution (owner's equity).

• Leverage: The use of borrowed money to supplement existing funds for investment purposes.

• Leverage ratio: The ratio of assets to bank capital.

• Capital requirement: Government regulation specifying a minimum amount of bank capital.

• High leverage increases vulnerability to asset declines.

• Example: If a bank's assets fall by 5% (from $1000 to $950), and liabilities remain at $950, capital becomes zero, indicating insolvency.

Assets	Liabilities	Liabilities
Reserves $200	Deposits $800
Loans $700	Debt $150
Securities $100	Capital $50

Active Learning: Banks and the Money Supply

Money Multiplier and Reserve Requirements

Banks play a key role in determining the money supply through the process of accepting deposits and making loans. The reserve requirement and the money multiplier are central concepts in this process.

• Reserve requirement: The fraction of deposits that banks must hold as reserves.

• Money multiplier: The amount of money the banking system generates with each dollar of reserves.

• Formula: $\text{Money Multiplier} = \frac{1}{\text{Reserve Ratio}}$

• Example: If the reserve ratio is 20% ($0.2$), the money multiplier is $\frac{1}{0.2} = 5$.

• If $50 is deposited, the maximum increase in deposits is $5 \times 50 = $250, but the money supply increases by $200$ because the $50 in currency is now in deposits.

Quick Quiz

Application of Reserve Ratio and Leverage

These questions test understanding of the reserve ratio, money multiplier, and leverage effects on bank capital.

• Question 1: If the reserve ratio is 1/4 and the central bank increases reserves by $120, the money supply increases by $120 \times \frac{1}{0.25} = $480.

• Question 2: If a bank has capital of $200 and a leverage ratio of 5, a 10% decline in assets ($200 \times 5 = $1000$ assets, $100$decline) reduces capital to $100$.

The Bank of Canada’s Tools of Monetary Control

Central Bank Instruments

The Bank of Canada uses several tools to control the money supply and influence economic activity. These include reserve requirements, open-market operations, and the overnight rate.

• Changing reserve requirements and bank capital requirements:

  • Increasing reserve requirements raises the reserve ratio, lowers the money multiplier, and decreases the money supply.

  • Regulations such as Basel III set standards for bank capital.

• Open-market operations:

  • Purchase or sale of government bonds by the Bank of Canada.

  • To increase money supply, the BoC buys bonds; to decrease, it sells bonds.

  • Quantitative easing: Central bank purchases of long-term securities to inject liquidity.

• Changing the overnight rate:

  • The overnight rate is the interest rate on very short-term loans between commercial banks.

  • BoC can change the rate to influence borrowing and the money supply.

  • Higher overnight rates discourage borrowing, reducing the money supply.

Open-Market Operations

Foreign Exchange Market Operations and Sterilization

Central banks also intervene in foreign exchange markets and may use sterilization to offset the impact on the domestic money supply.

• Foreign exchange market operations:

  • Purchase or sale of foreign currency by the Bank of Canada.

  • Buying foreign currency increases Canadian money supply; selling reduces it.

• Sterilization: Offsetting foreign exchange operations with open-market operations to neutralize effects on the money supply.

Figure: The Bank of Canada’s Overnight Rate since 2008

Trends in Policy Interest Rate

The overnight rate has fluctuated in response to economic conditions, reflecting the Bank of Canada’s monetary policy stance. Lower rates are typically used to stimulate borrowing and economic activity, while higher rates are used to restrain inflation.

• Example: The figure shows periods of low rates following the financial crisis, with increases and decreases corresponding to policy changes.

Summary Table: Bank of Canada’s Monetary Control Tools

Tool	Mechanism	Effect on Money Supply
Reserve Requirements	Change minimum reserves banks must hold	Increase (lower req.), Decrease (raise req.)
Open-Market Operations	Buy/sell government bonds	Buy: Increase, Sell: Decrease
Overnight Rate	Change interest rate on interbank loans	Lower rate: Increase, Higher rate: Decrease
Foreign Exchange Operations	Buy/sell foreign currency	Buy: Increase, Sell: Decrease
Sterilization	Offset FX operations with open-market ops	Neutralizes effect

Additional info: Basel III is an international regulatory framework to strengthen bank capital requirements and reduce risks in the banking sector.