Chapter 15

The Banking System

This chapter analyzes the monetary system, which is intimately connected to the capital markets. Both constitute the financial system. The capital market rests on money. The financial system is a pillar for the capital market. Saving in the form of money is mobilized and invested through the capital market as well as the banking system. Perturbation in capital markets translates into perturbation in the banking system, and vice versa. Moreover, monetary policy has a direct bearing on the capital market. Inversely, the capital market may influence money policy. In some countries, money policy is geared to provide liquidity to the capital market and prop up stock prices. Interest rates may be forced to near-zero level in support of the capital market. The government may announce, for instance, that interest rates will be maintained at near-zero level for three years in order to support rising trend in stock prices. Inflation of asset prices and goods prices can be due only to the money supply. The only way to arrest inflation is to keep the money supply fixed.

This chapter addresses the definition of money, fractional banking and the money multiplier, the central bank, the reserves market (i.e., demand and supply of reserves), the regulatory and supervisory role of the central bank, the debate over the role of the central bank, the theory of two interest rates, central banking and financial markets, and the central bank in Islamic finance.

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