Controlling reserve amounts
When the amount of money spent rises faster than the quantity of goods and services produced in the economy, the result is likely to be raised inflation. To understand how a central bank controls money supply and interest rates you need to focus on the fact that it acts as banker to the banks (including other depository institutions, e.g.
building societies), holding commercial bank reserves in its accounts, which banks are either formally obliged to hold or feel informally obliged to hold because of the need to settle accounts between depository institutions when cheques and electronic payments are cleared at the central bank and for liquidity-safety reasons. A central bank might insist that, say, 2% or 10% of the amount deposited by customers be held as the required reserve ratio.[36]Thus, one way to control money supply and interest rates is to use its special powers to insist that each bank leaves a certain proportion of the amount it has received as deposits from its customers (households, small businesses, etc.) at the central bank. If a bank's reserves at the central bank fall below the minimum required then it has to top this up.
Many central banks, e.g. the Bank of England, some time ago moved from a fixed daily level of reserves to target balances of reserves held at the central bank on average over ‘maintenance periods'. In the case of the BoE the maintenance period ran from one meeting of the committee that sets interest rates (the Monetary Policy Committee) to the next, usually one month. Smaller banks may be exempt from the system.
A couple of years before the financial crisis the BoE removed its formal insistence for banks to achieve targeted levels of reserves to be held with it. It had a ‘voluntary' system. However, when motivated by self-imposed prudential liquidity levels and the need to settle payments with other commercial banks, bankers want to hold reserves at the BoE.
Currently, even this voluntary reserves averaging system in the UK is described as ‘suspended' (since March 2009). Because there may be a return to this system, and because it is used elsewhere in the world, we need to understand the system first. While there are no formal reserve requirements in the UK, Australia, New Zealand and Canada, elsewhere, such as the eurozone, Switzerland, the US and China have reserve requirements in proportion to the bank's holdings of deposits. After describing monetary policy under a reserves targeting system we'll look at how monetary policy changed over the last few years of crisis.
Banks and other depository institutions (henceforth ‘banks') like to maintain an additional buffer beyond the required reserves at the central bank, excess reserves, to feel comfortable about the prospect of a sudden outflow of cash. The target amount of the excess reserves may, in fact, be largely dictated by the banking regulator (which is usually the central bank) and may be strongly influenced by international agreements on the appropriate amounts.