aturity) with other banks and depositors to meet their short-term liquidity needs. Sometimes, government bonds are also used as collateral in the interbank market. A bank may hold excess reserves over and beyond the required reserves by considering the advantages and the disadvantages.Advantage: It avoids cash deficiency/short-term liquidity problem that compels the bank to incur expenses by raising cash quickly, by calling in loans, selling securities (G-bonds/T-bills), borrowing from other banks in the interbank market or through the discount window.Disadvantage: Opportunity cost of holding excess reserves is the foregone interest income that could have been earned if the bank used these funds elsewhere. These funds could have been used for investment in loans and securities (G-Bonds and T-Bills) earning interest income for the bank.Instruments of Monetary Policy for the Central BankA central bank is responsible for low inflation, high unemployment, and the regulation of the banking system so as to ensure smooth operation of the financial markets. One key objective of the CB is to control the nations money supply as it is directly related to the total volume of credit in an economy. Credit volume (as well as its cost in terms of interest rates), in turn, determines the nations aggregate output through its effect on the investment volume.In fact, what the CB controls is the monetary base rather than the total money supply. This is because in effect, banks create money through their deposit and loan activities as we will see below. Let us now see how the CB actually controls the monetary base (which is part of the Money Supply, say, M1). Monetary Base: Outstanding Currency (Banks vault cash and currency in circulation outside of banks) + Bank Reserves (Bank reserve deposit accounts at the CB and possible excess reserves willingly held by banks for precaution).There are three major instruments available for the CB to influence the ...
