Question

By 2040, the economy of Malta will be reaching full employment and rising inflation. At that time, the banking system has a lot of excess reserves and hires a new advisor. What policies should the new advisor recommend to prevent the banking system from lending excess reserves to the public. State a few policy recommendations and explain.

Answer 1

Ans.

In Malta with excess reserve there will is full employment and increasing inflation. So to guard against inflationary pressure banking system can pay interest on reserves. Such that link between level of reserves paid and willingness of commercial banks to lend is broken. So new advisor will increase interest rates being paid on reseves without changing quantity of reserves. Which will reduce lending to public. So the higher interest rate on reserves makes banks hold reserves rather than lending.

Other than this policy central bank can use reverse repos. Where central bank can sell security to financial institution and repurchase at future date. These reverse repurchase agreements liability would prevent from lending excess reserves and reverse rate policy takes care of inflation as well.. Moreover banking system can offer interest bearing term deposit to institutios that depository institutions would have available for short term lending. Such that it will prevent banking system from lending excess reserves to public.