A simple theory of banking and the relationship between commercial banks and the central bank

Abstract

This note provides an explanation of the relationship between the nominal and real lending rates of the commercial banks and central bank policy rates. It suggests that "a real interest rate rule" on the part of the central bank would influence the real lending rate perceived by commercial banks and their borrowers, and could affect the real economy via this route. There is a negative theoretical relationship between the inflation adjusted "real" lending rate and the rate of inflation itself.

Keywords:

• banking
• central banking
• deposit rates
• interest rate policy
• lending rates
• monetary policy rules
• profit maximization
• risk