The Banking Sectors

Country One’s private financial sector purchases and holds bonds issued in all three countries. The bonds it holds at the beginning of the current period generate income during the current period. The bonds it buys during the current period do not generate interest income until next period. To finance their purchases of interest-earning assets, Country One’s private financial sector issues noninterest-earning checkable deposits denominated in its country’s unit of account to its household customers. The sector incurs labor costs associated with servicing both its bond holdings and its checking account liabilities. Furthermore, because the checkable deposits are transferable into Country One’s coin and currency on demand, the private banks in Country One hold excess reserves in the form of vault cash and/or deposits held at their central bank to reduce the transactions costs associated with servicing these accounts. The private financial sector is required to hold reserves equal to the required reserve ratio (set by its central bank) times the volume of its demand-deposit liabilities. For simplicity, the private financial sector’s ability to borrow from the central bank is ignored here.