To briefly recapitulate the Simplified Framework, it is a system in which bank reserves do not exist. Since bank reserves have not yet been abolished in the United States, and most economic textbook writers are American, too much emphasis is placed upon the role of bank reserves in most descriptions of the financial system. Moreover, the "monetary base" consists of the sum of currency outstanding and bank reserves, which leads some analysts to treat bank reserves as somehow being interchangeable with currency. The beauty of eliminating bank reserves from the analytical framework is that such confusion is essentially impossible.Bond Economics
The key assumption of the Simplified Framework is that in the absence of bank reserves, all net transactions at the end of the day between the government and the banking sector have to be settled with a transfer of government bills and bonds (since those are the only instruments that appear on the central bank's balance sheet at the end of the day). This assumption colours our analysis of the role of currency within the system.
During the day, banks could have non-zero settlement balances, but those balances have to be netted out to zero by the close. Yes, the situation is slightly more complicated in the actual Canadian banking system, and those complications are addressed later in Understanding Government Finance. However, it is best to understand a simpler framework before attempting to deal with every possible complication that has been embedded within financial systems.…
The Limited Role Of Currency In Government Finance
Brian Romanchuk
3 comments:
The key assumption of the Simplified Framework is that in the absence of bank reserves, all net transactions at the end of the day between the government and the banking sector have to be settled with a transfer of government bills and bonds (since those are the only instruments that appear on the central bank's balance sheet at the end of the day). This assumption colours our analysis of the role of currency within the system.
Brian what about the capital account? Iow if a bank needs more regulatory capital due to some asset being priced lower, would they not have to re designate some reserves as capital? And possibly have to go out and obtain those reserves by selling a bond or exchanging foreign currency reserves for domestic reserves or something?
Rsp
Bank capital is a balance sheet regulatory concept. Either the bank has profits (which raises equity) or it has to issue "equity-like" instruments. The regulators allow preferred shares and some types of subordinated debt to be treated as capital.
Bank reserves - settlement balances at the central bank - are assets and cannot be reclassified. Since they are guaranteed by the government, they have the advantage of holding their par value.
There are other usages of the word reserves, which I note in the book.
Banks "hold reserves" against loan losses, like other businesses. Since Canada has not abolished the credit cycle, that type of reserves still exists.
Foreign currency reserves are liquid assets held by a central bank (or similar entity) as a means of allowing it to defend the value of the currency. Although it has implications for the domestic economy, private banks are not directly involved (unless the foreign central bank is lending to the banks).
Bank reserves are just loans. But they are loans to the central bank rather than to other entities.
It always amuses me that we don't talk about these 'loans to government' but spend all the time talking about the other ones.
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