Commercial banks are required to hold reserve accounts with the central bank for which reason
Answer: (c) To ensure that all daily transactions in the economy that involve claims between banks can be resolved without any cheques bouncing.
Answer: Option (c).
Each commercial bank has to have a reserve account with the central bank with sufficient balances each day, to ensure that all cross-bank transactions clear and no 'cheques bounce'.
A Bank A customer might send a cheque to a supplier who banks with Bank B. Bank B must be able to get the funds from Bank A.
These transfers are all accomplished by adjusting balances in the respective reserve accounts.
Reserve account funds have typically not earned a competitive return, although since the GFC, many central banks offered such returns on reserve balances.
Prior to that, if there were excessive reserves in the system, the banks with excesses would try to make loans in the interbank market (a market for overnight or very short-term loans between banks) to other banks, which might have shortfalls on any particular day.
In the absence of central bank intervention, this process would drive the interbank market down towards zero because any return is better than none.
To avoid losing control of its monetary policy target, the central bank conducts daily liquidity or reserve management operations.
When there is a system-wide shortfall in reserves, then the central bank will always make the necessary reserves available to the banks.
When excess reserves arise, the central bank would exchange interest-bearing government bonds for bank reserves and thus eliminate any excesses.
This would ensure the interbank interest rate would remain aligned with the central bank's policy target rate.
Economists call this an Open Market Operation.
It allows you to understand one function of government debt - to stabilise short-term interest rates so they are consistent with the monetary policy target rate.
Since the GFC, many central banks just pay interest on excess reserves, which accomplishes the same outcome. So, there is no need for government to issue debt at all.
The tie in with fiscal policy then arises because when government spends, bank reserve holdings at the central bank increase.
Tax payments do the opposite.
If government spending exceeds taxes, overall bank reserves grow and if fiscal deficits are of any significant size, excess reserves in the banking system will result.
Banks do not want to hold more than they need for cheque clearing and to meet required reserve ratios (if they exist).
Thus, the central bank and treasury must coordinate their daily operations closely to ensure that the impact of fiscal policy on bank reserves is anticipated and central bank liquidity management is effective to maintain the target interest rate.
That is enough for today!
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