Banking ECO-20045

Lecture 13

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 Lecture 13 - Outline (Ch. 15)

Tools of Monetary Policy

•The Market for Reserves and the Overnight Interest Rate

•Open Market Operations

– Advantages

•Lending Facilities
– Advantages & Disadvantages

•Reserve Requirements
– Disadvantages

•Quantitative Easing 1-2

 Use of Tools of Monetary Policy

• Previously we argued that in the 1980s central banks began to

abandon monetary targeting. An alternative is the following:

Operating Intermediate
3 Tools Goals
Instruments Targets
•Open market operations •Short-term • Long-term
•Standing facilities interest rate interest rates
•Reserve requirements

• The overnight interbank rate (i.e. a short-term rate) is now a

very common operating instrument for central banks.
• We want to understand how a central bank can use its 3 tools
to influence the overnight interbank rate. 1-3
 The Market for Reserves
and the Overnight Interbank Rate

• In recent years, central banks have been signalling the

stance of their monetary policy (i.e. how easy/tight) by
targeting the overnight interbank rate.
– (i.e. interest rate on overnight loans of reserves from one
commercial bank to another in the interbank market).

• Rationale:
– Overnight interbank rate  impact on interest rates set by banks
on loans & deposits  impact on level of consumption and
investment in physical capital  impact on aggregate economic
activity (GDP, price level, unemployment,…)

• The overnight interbank rate is called:

• SONIA (sterling overnight index average) in the UK.
• EONIA (euro overnight index average) in the euro area.
• Federal Funds Rate in the US. 1-4
 The Market for Reserves
and the Overnight Interbank Rate

• The interbank rate is determined in the market for

reserves, where commercial banks demand reserves (i.e.
choose the amount of reserves they want to hold) and the
CB supplies reserves:
– Typically, a commercial bank will demand reserves in order to
meet the reserve requirements set by the CB and/or to build a
“cushion” to meet future deposit outflows (excess reserves).

• The CB can set a target for the interbank rate and then
use its 3 tools to manipulate demand and supply of
reserves so that actual rate ≈ target rate.

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 The Market for Reserves: Demand

Overnight
Interbank As such, the demand curve for
Rate, i reserves held at the central bank
is downward sloping.

Rd
Deposit rate, id
Quantity of Reserves, R,
held at the central bank

• The interest rate on reserves that commercial banks hold at the CB is

called deposit rate, id:
• (i - id) represents the opportunity cost for commercial banks of holding
excess reserves in their account at the CB:
– As i ↑ , banks will lend out more excess reserves to other banks  they will
want to hold less reserves at the central bank.
– If i < id  not convenient for banks to lend excess reserves to other banks 
excess reserves will be kept in their accounts at the CB and pile up. 1-6
 The Market for Reserves: Supply
Overnight Interbank
Rate, i

Quantity of Reserves, R,
NBR held at the central bank

• The supply of reserves can be broken up into 2

components:
– 1. The amount of reserves supplied by the CB’s open market
operations, called non-borrowed reserves (NBR), which is insensitive
to the overnight interbank rate, i.

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 The Market for Reserves: Supply
Overnight Interbank
Rate, i

Lending rate, il Rs

Quantity of Reserves, R,
NBR held at the central bank

– 2. The amount of reserves borrowed from the CB, called borrowed

reserves (BR).
• The primary cost of borrowing from the CB is the lending rate, il

– If i > il, then banks would always borrow from the CB rather than in the
interbank market, so the supply curve would become infinitely elastic.
– If i < il, then it is more convenient for banks to borrow in the interbank
market, so borrowed reserves from the CB will be zero. 1-8
 Supply and Demand for Reserves
Overnight
Interbank
Rate, i

il

i2

i*

i1

id

NBR

Market equilibrium: Rd = Rs
Equilibrium occurs at the intersection of the supply curve and the demand curve.
1-9
Monetary Policy and the Overnight Interbank Rate

• The central bank can set a target for the overnight

interbank rate, i , and then use its tools to make sure that:

Actual overnight interbank rate  i  i

*

• The central bank can use the following tools to engineer an

increase or reduction in the overnight interbank rate:
• (A) Open market operations
• (B) Standing facilities
– Lending and deposit facilities

• (C) Reserve requirements

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 (A) Response to Open Market Operations

Typical situation
Overnight Interbank
Rate, i If the central bank
conducts an Open
Market Purchase:
– Nonborrowed
reserves, NBR, 
R1S – This shifts supply
il
curve to right Rs2:
R2S – i *
i*
i**
id Rd

Quantity of Reserves, R
NBR1 NBR2
1-11
 Response to Open Market Operations
However, if i* is already
equal to id, then:
Overnight Interbank
Rate, i Open Market Purchase:
– Nonborrowed
reserves, NBR, 
– This shifts supply
curve to right Rs2:
R1S
il – i stays the same
R2S

i**= i*= id Rd

Quantity of Reserves, R
NBR1 NBR2
1-12
 Open Market Operations

• Effects of open market purchases:

– (A) Expand banks’ reserves and monetary base  money supply
increases (see Ch. 14).
– (B) Reduce overnight interbank interest rate (see previous slides).

• Operations are conducted in short-term government securities:

– Their market is the most liquid and has the largest trading volume.
– It can absorb the CB’s large volume of transactions without
experiencing excessive price fluctuations.
– Trades typically involve Treasury bills.

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 Open Market Operations

• Advantages of open market operations:

1. The CB has complete control over their volume.

2. They’re flexible and precise; can be used to any extent, no

matter how large/small a change in the monetary base is desired.

3. Are easily reversed in the event of a mistake.

– If e.g. CB realizes the purchase has had too big an impact on the overnight
rate, it can quickly conduct some open market sales to make a correction.

4. Can be implemented quickly. There are no administrative

delays. CB places orders and trades are executed immediately.
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 (B) Standing Facilities

• Most central banks offer two types of standing facilities:

• (1) Lending facilities

– The CB provides overnight reserves at a lending rate to banks that
need liquidity (against eligible collateral)
– Typically, lending rate = CB’s official interest rate + fixed %
– The lending rate sets a ceiling for the overnight interbank rate.

• (2) Deposit facilities

– The CB offers them to absorb overnight reserves of banks wishing
to deposit at the CB. The rate earned on deposit facilities is the
deposit rate.
– Typically, deposit rate = CB’s official interest rate - fixed %
– The deposit rate provides a floor for the overnight interbank rate.
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 Standing Facilities

• Example:

• In the case of the Bank of England:

– The official interest rate is called the “Bank Rate”

– Lending rate = Bank Rate + 1%

– Deposit rate = Bank Rate - 1% (in normal times)

– The standing facility is for overnight repos against eligible collateral

– These 2 rates create a corridor system that limits the

fluctuations in the overnight interbank interest rate in the UK.

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 Response to a Change in the Lending Rate

Typical situation
Overnight Interbank
Rate, i • Initially, borrowed reserves (BR) =0.
• If now the CB lowers the lending
rate il…
• …the equilibrium overnight rate
is unaffected.
R1S
i1 l
i2 l
i**= i* R2S

id Rd

Quantity of Reserves, R
NBR
1-17
 Response to a Change in the Lending Rate
However, if banks were already borrowing
reserves from the central bank, then:
Overnight Interbank
Rate, i • Initially, borrowed reserves (BR) > 0.
• If now the CB lowers the lending
rate…
• Equilibrium overnight rate ↓
• BR ↑ (i.e. banks will borrow more)

i*=i1l R1S
i**=i2l R2S
id
Rd
BR2
Quantity of Reserves, R
NBR
1-18
 Response to a Change in the Deposit Rate

Typical situation
Overnight Interbank
Rate, i • The CB lowers the deposit
rate…
• …the equilibrium overnight rate
is unaffected.

RS
il

i**= i*

i1d R1d
i2d R2d

Quantity of Reserves, R
NBR
1-19
 Response to a Change in the Deposit Rate
However, if i* is already
as low as id, then:
Overnight Interbank
Rate, i • The CB lowers the deposit
rate…
• …the equilibrium overnight
rate ↓

RS
il

i*=i1d R1d
i**= i2d R2d

Quantity of Reserves, R
NBR
1-20
 Standing Facilities Limit Fluctuations in the
Interbank Rate
NB: The central bank exerts good
Overnight Interbank control over the overnight interbank rate,
Rate, i but not full control!
R2d
• If the demand for
reserves held at the
RS central bank
i**= il unexpectedly
increases…

i* • …the equilibrium
interbank rate will
rise.
R1d
• Yet, it won’t rise
id above the lending
rate!

Quantity of Reserves, R
NBR
1-21
 Standing Facilities Limit Fluctuations in the
Interbank Rate
NB: The central bank exerts good
Overnight Interbank control over the overnight interbank rate,
Rate, i but not full control!

• If the demand for

reserves unexpectedly
RS falls…
il
R2d • …the equilibrium
interbank rate will fall.
i*
• Yet, it won’t fall below
R1 d
the deposit rate!
i**= id

Quantity of Reserves, R
NBR
1-22
 Standing Facilities Limit Fluctuations
in the Interbank Rate
• Figure 15.9, page 341:

Main refinancing rate = ECB’s official interest rate 1-23

 Standing Facilities

Advantages:

• (1) The CB can set a floor and a ceiling to effectively

“guide” the overnight interbank interest rate.

• (2) They allow the CB to perform the role of ”lender of last

resort”
– The CB can easily provide reserves to banks when nobody else
would.
– This helps prevent bank runs and financial panics.

1-24
 Standing Facilities

Disadvantages:
• (1) The amount of borrowed reserves is not fully controlled by
the CB.
– The CB can only encourage or discourage banks to borrow reserves by
altering the lending rate… then banks choose how much to borrow.

• (2) Unexpected fluctuations in banks’ demand for reserves can

cause unintended fluctuations in the overnight interbank
rate.

• (3) The CB’s lender-of-last-resort role creates a moral hazard

problem.
– If banks expect that the CB will provide them with reserves when
they get into trouble, they will be willing to take on more risk knowing
that the CB will come to the rescue. 1-25
 (C) Response to a Change in the Required
Reserve Ratio
Typical situation
Overnight Interbank
Rate, i • CB lowers required reserve ratio…
• …quantity of reserves demanded
falls for any given interest rate
• Demand curve shifts to the left
• Equilibrium overnight rate ↓
RS
il

i*

i** R1d
id
R2d

Quantity of Reserves, R
NBR
1-26
 Reserve Requirements
• A decrease in reserve requirements increases the money supply
through an increased money multiplier (see lecture #12).
• As just seen, a decrease in reserve requirements also reduces the
overnight interbank rate.

• Disadvantages:
1. Raising required reserve ratio can cause immediate liquidity
problems for commercial banks.

2. Frequent changes cause uncertainty for commercial banks.

3. Reserves act as a tax on commercial banks (pay very little or no

interest)  may reduce bank competitiveness.

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 Use of Tools of Monetary Policy

• If the central bank wants to stimulate the economy  it lowers

the overnight interbank rate by:
– Conducting open market purchases and/or…
– Lowering the lending and deposit rates and/or…
– Lowering the required reserve ratio.
• All other rates will go down with it, lowering the cost of
borrowing  this promotes consumption and investment.

• If the central bank wants to slow the economy down it raises

the overnight interbank rate by:
– Conducting open market sales and/or…
– Raising the lending and deposit rates and/or…
– Raising the required reserve ratio.
• All other rates will go up with it, raising the cost of borrowing
 this curbs consumption and investment.
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 Quantitative Easing

• In normal times, CBs use the 3 tools described so far.

• Sometimes, however, CBs respond with unconventional

measures.
– The 2007/09 global financial crisis caused a major storm in financial
markets and a severe economic recession.

• The Bank of England and the Fed responded using a measure

called ”Quantitative Easing”:
– Large-scale asset purchases
– MPC started buying:
• Medium- and long-term UK government securities
• High-quality commercial paper and corporate bonds
• Unprecedented amounts (£375 billion between 2009 and 2012, i.e. 1/5 of UK’s GDP)

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 Quantitative Easing

• What is quantitative easing?

• The Bank of England defines QE as follows:

– “In March 2009, the Monetary Policy Committee (MPC) announced that it
would reduce Bank Rate to 0.5%. The Committee also judged that Bank
Rate could not practically be reduced below that level, and in order to give a
further monetary stimulus to the economy, it decided to undertake a series of
asset purchases.”
– “This policy of asset purchases is often known as 'Quantitative Easing'. It
does not involve printing more banknotes. […] [T]he policy is designed to
circumvent the banking system. The Bank of England electronically
creates new money and uses it to purchase gilts from private investors
such as pension funds and insurance companies. These investors
typically do not want to hold on to this money, because it yields a low return.
So they tend to use it to purchase other assets, such as corporate bonds
and shares. That lowers longer-term borrowing costs and encourages the
issuance of new equities and bonds to stimulate spending and keep inflation
on track to meet the government’s target.”

Source: http://www.bankofengland.co.uk/monetarypolicy/pages/qe/default.aspx 1-30

 Quantitative Easing

• What are central banks trying to achieve with QE?

• The goal is to reduce interest rates on medium- and long-term

government and corporate bonds & signal that policy rates will
remain low in the future

• This will reduce the cost of borrowing to businesses and

households  more consumption and investment!

• Stimulate aggregate economic activity

– (Y = Consumption + Investment + Gov. Spending + Net exports)

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 Quantitative Easing
Initially, central banks What else can you do when
responded by lowering their overnight rate is already
The global financial
targets for the overnight rate close to 0%? crisis starts

% 7 7 %

6 6

5 5

4 4

3 3

2 2

1 1

Fed Funds Rate ECB Refi Rate UK Base Rate

0 0
Apr-00

Oct-01

Jul-02

Apr-03

Oct-04

Jul-05

Apr-06

Oct-07

Jul-08

Apr-09
Jan-01

Jan-04

Jan-07

Source: Bloomberg 1-32

 Quantitative Easing

Figure 15.6,
page 335:

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Note:
•The following sections will not be covered in the module and
are not required for the exams:

–“Inside the European Central Bank” (pp. 337-338)

–“Inside the Federal Reserve” (pp. 342-344)

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