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Firstly, I understand the standard analysis of how a central bank attempts to modulate credit conditions in the economy (and therefore money supply) to dampen demand to prevent excess price level increases.

This standard view is:

  1. Central bank increases base rate - the interest rate they pay on central bank reserves held with them by the commercial banks.
  2. In response, commercial banks needing to borrow reserves to meet their settlement and withdrawal requirements would pay a higher interbank rate (because the lender bank wants to maximise their yields so why lend your reserves at a lower rate than you could get by just keeping them with the central bank).
  3. In response, commercial banks who are paying this increased cost of reserve borrowing will need to increase the rates they charge on customer loans to maintain profitibility. This will tend to decrease customer demand for credit, thereby arriving at one half of the demand suppression desired outcome of the central bank when it raised rates in point 1.
  4. And finally, to attract deposits (and thereby reserves) from customers, this commercial bank would need to offer higher rates on deposits. This would be the 2nd half of the demand suppression desired outcome because customers would be incentivise to withhold spending, thereby also lowering inflationary pressure.

Now, my question.

Why could there not be a scenario (or could there be) where a bank which is a net lender of reserves to other banks (for whatever reason they end up with excess reserves) reduce the loan rates they offer because they are suddenly receiving lots of interest income from both the central bank (because it's just increased base rate) and other commercial banks from reserves it lends to them. It would appear for these banks (with excess reserves), the MP transmission mechanism to loaned credit rates isn't as clear cut.

Indeed, surely in aggregate, the net reserve lending on the interbank market will be zero? Reserve levels do fluctuate from endogenous demand for money but I would think that since every time a bank lends reserves, another bank is borrowing that same amount of reserves. So in this view, why do loan rates go up at all in aggegate?

I'm obviously missing some factors in the analysis but it would be useful to get some perspectives and thoughts.

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Ok so first of all it sounds like you are talking about the pre 2008 world of non-excess reserves. In that system , the central bank controls the total amount of reserves in the system by conducting open market operations.(OMO). Thus there is just the right amount of reserves in the system to maintain equilibrium at their chosen policy rate. A typical OMO would be to inject reserves by conducting a repo transaction with a primary dealer, or withdraw reserves by doing a reverse repo.

In the post 2008 world there are excess reserves in the system , so central bank controls rate by having a deposit facility where the reserves can be parked at the policy rate. So no need for OMO.

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  • $\begingroup$ I feel like you've not addressed my question. If reserves were in excess, why do banks need to borrow them regularly on the interbank market to settle payments each day? The standard MP transmission mechanism relies on banks being charged more by other banks for their reserves, thereby causing that borrower bank to increase their loan rates. Is this not the case? $\endgroup$ Oct 13, 2023 at 11:46
  • $\begingroup$ In excess reserve environment , banks indeed do not need to borrow regularly on the interbank market to settle payments. $\endgroup$
    – dm63
    Oct 13, 2023 at 18:49
  • $\begingroup$ biancoresearch.com/what-will-become-of-the-funds-rate-video $\endgroup$
    – dm63
    Oct 13, 2023 at 18:52
  • $\begingroup$ Don’t understand your ‘MP transmission’ comment. MP transmission doesn’t rely on differences between banks. Fed controls short term rate. All loans by all banks are affected. That’s the mechanism broadly. $\endgroup$
    – dm63
    Oct 13, 2023 at 18:56
  • $\begingroup$ If there were excess reserves such that all commercial banks had more than enough to settle their payments and meet demand for withdrawals then they wouldn't borrow any from any other bank. The short term rate would drop to zero. What would they cause banks to up their loan rates if they just get more interest from central bank on their large stockpile of reserves? $\endgroup$ Oct 14, 2023 at 19:23

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