bain_y_howells__monetary_economics__policy_and_its_theoretical_basis

THE MONEY SUPPLY PROCESS 61
When it comes to banks’ decisions about their reserve ratios, therefore,
there are numerous influences at work. Remember that banks are profitseeking
firms, that the cash element of reserves yields no interest and that,
in most systems deposits at the central bank are also non-interest bearing.
This means that holding reserves acts like a tax on banking, an issue we
return to in the next chapter.
Banks’ decisions to hold reserves will depend firstly upon their cost.
Where reserves pay no interest then the cost can be proxied by the return on
alternative liquid assets, which might be proxied by the bond rate, i b. Where
reserves do pay interest, then the cost will be the return on reserves, i r relative
to the bond rate. The quantity of reserves held will depend also on the
cost of being short, that is upon the rediscount rate charged for lender of last
resort facilities, i d. This is the rate of interest announced periodically, usually
monthly, by the central bank. In the UK and the eurozone it is a rate of
interest charged by the central bank on short-dated repurchase deals with
banks, using government bonds as the underlying security. Reserve holdings
will also depend upon any mandatory reserve requirement, RR, and,
lastly, upon the variability of inward and outward flows to which banks are
subject, σ. This last factor is relevant because the primary purpose of
reserves is to enable individual banks to meet demands for cash or, more
importantly, for transfers of deposits as customers make payments to customers
of other banks or to the government. The majority of payments are
offsetting (payments from bank A to bank B will roughly cancel); reserves
are necessary to meet the balance. Provided this balance is predictable, the
need for reserves will be limited to the predicted net flow. If it is unpredictable,
then additional funds have to be held. The greater the variance (or
standard deviation) of the flows, the greater the margin that will be necessary.
In summary, then:
R
β ≡ = f( ir, ib, id, RR,
σ)
...3.10
Dp + − +
+ +
Given that we now have some idea of the sorts of influences, and the
direction of their effect, upon the ratios α and β, the next obvious question
is what effect will changes in α and β have upon the size of the multiplier
expression in 3.7 and 3.8. From there, we can see their effect on the money
supply.
The answer to the first question lies in the value ‘1’. Because the values
of α and β are fractions (in practice, very small fractions) it is the ‘1’ which
gives the expression a multiplier value: the numerator is bound to be larger