Functions of commercial bank - buying government securities, Macroeconomics

Buying government securities: When a commercial bank buys government bonds, the effect is substantially the same as that of lending - new money is created.

To illustrate let us take the same hypothetical example of Bank A, the balance sheet of which stands as under:

Balance Sheet of Bank A

Liabilities                         Rs.                   Assets                           Rs.

Capital

5,00,000

Cash

50,000

Demand deposits

3,00,000

Reserves with RBI

6,45,000

 

 

Required liquid assets

1,05,000

For simplicity, let us assume that the RBI recognizes government bonds as 'acceptable' unencumbered securities which can be held by commercial banks to satisfy the liquid assets requirement. This means that the Bank A can now keep its required liquid assets in government bonds rather than in cash.

Bank A increases its reserves with the RBI to Rs.8,00,000 by depositing the cash with it and holdings of liquid assets. Now suppose that, instead of making a loan, the bank buys Rs.7,55,000 worth of government securities from a bond broker. The bank receives the high interest-bearing bonds which appear on its balance sheet as the assets 'securities' and gives the broker an increase in its demand deposits by the same amount. The balance sheet, then, would appear as follows:

Balance Sheet of Bank A

Liabilities                         Rs.                   Assets                           Rs.

Capital

5,00,000

Cash

-

Demand deposits

10,55,000

Reserves with RBI

8,00,000

 

 

Securities

7,55,000

The important point to note from the above balance sheet is that demand deposits, that is, the supply of money, have been increased by a total of Rs.7,55,000. The bank has accepted government bonds - which are not money - and gives the securities broker an increase in demand deposits - which is money. Thus, by buying government bonds, the bank has created money.

When the securities broker draws and clears the cheque of Rs.7,55,000 against the Bank A, the demand deposits and reserves of Bank A with RBI will reduce by Rs.7,55,000. Its reserves with RBI will be just meeting its 15 percent cash reserve requirement but it will have Rs.7,55,000 worth of government securities, an excess amount to meet its liquid assets requirement. Its balance sheet would show as follows:

Balance Sheet of Bank A

Liabilities                         Rs.                   Assets                           Rs.

Capital

5,00,000

Cash

-

Demand deposits

10,55,000

Reserves with RBI

45,000

 

 

Securities

7,55,000                                              

Posted Date: 9/18/2012 6:22:43 AM | Location : United States







Related Discussions:- Functions of commercial bank - buying government securities, Assignment Help, Ask Question on Functions of commercial bank - buying government securities, Get Answer, Expert's Help, Functions of commercial bank - buying government securities Discussions

Write discussion on Functions of commercial bank - buying government securities
Your posts are moderated
Related Questions
1.  Calculate the duration of a par value bond with a coupon rate of 8% and a remaining time to maturity of 5 years. 2. On September 26, the spot price of gold was $320 per ounc

Why is quantitative easing used during liquidity trap when it lowers interest rates too?

For each of the host countries you have selected for examination (PEST-C analysis), conduct a preliminary assessment of the geographic, economic, social-cultural, and political-leg

What is independent monetary policy Advantages: First, in a freely-floating exchange rate, the exchange rate must move down or up to correct a payments imbalance. Second, monet

(I am providing them below) of Module 5 before beginning this assignment.  You will have the opportunity to work through much of the assignment during the group activity for week 1

Suppose the demand for bread is D(p), where dD/dp Illustrate equilibrium with price on the Y-axis and quantity on the X-axis in which the t > 0. Show the economic incidence

Factors Responsible for changes in Aggregate Supply We know that changes in input costs such as wages, oil and other input prices will cause changes in aggregate supply. Most

Illustrate the UK macroeconomic performance UK macroeconomic performance must be judged on economy's long-term ability to produce growth, create jobs and improve living standa

Are unions “harmful monopolies” or "necessary?" compare and contrast the schools of thought that subscribe and their point of views?

Suppose that Mr. Chauncey Gardener consumes two goods, X 1 and X 2 .His preferences can be described by the following utility function: U = X 1 0.5 X 2 0.5 He