2 - Microeconomics of the reserve industry

Summary

Overview

The traditional monetary theory of central banking has been one with little institutional detail. Operating in a closed economy, a monopoly central bank prints an initial allocation of infinitely lived, non-interest-bearing currency at a cost of zero. The central bank uses the currency to buy assets from private individuals. In subsequent periods the central bank has the option of printing new money and acquiring new assets or perhaps selling some of its previously acquired assets for old money. One of the side effects of money creation is that it provides a source of revenue equal to the nominal interest rate times the real quantity of central bank assets. This revenue is often referred to as seigniorage.

Modern central banks bear little resemblance to this theoretical construct. In addition to printing money, central banks typically provide payments services (for example, check-clearing services) and lender of last resort services. They also tend to regulate the banking system, most notably, by imposing reserve requirements.

Why do modern central banks engage in such a wide range of activities? One possible explanation is that the central bank is little more than a voluntary association among private banks; that is, a banking club. According to this view, the activities of a central bank correspond to what private banks would ask from a banking club. To understand the operation of a banking club, therefore, is to understand the operation of a central bank (see Gorton and Mullineaux, 1987).

Another explanation is based on the notion that central banks do more than banking clubs. Left to themselves, banking clubs would fail to undertake certain activities that are crucial to the safety of the banking system.