Topic 1: Money and Central Banks Flashcards

Question

What do we asssume about interest rates among banks and money markets and reserves How does this determine reserve supplies

Answer 1

Assume a single interest rate i for all banks and all money markets Reserves cannot leave banking system, only transfer among banks; only left through cash conversion or paid into gov. account at CB **total reserve supply determined by CB** --> **Inelastic reserve supply curve** shifted by OMO or other factors adding or draining reserves

Answer 2

If banks reserves low ---> brrow more If reserves too high --> then lend to others Borrow if overnight IR < CB reserve rate Do not borrow if overnight rate > CB loan rate Only lend reserves if overnight rate > CB reserve rate

Answer 3

Borrow if overnight rate< CB reserve rate --> createss unlimited demandd and asymptore Do no borrow if overnight rate > CB loan rate --> asymptote above i b Only lend reserves if overnight rate > CB reserve rate Above 𝑖𝑟 , the higher the market rate of interest, the greater the incentive to minimize cash balances at the central bank, so the quantity of reserves demanded goes down as interest rates go up—hence a downward‐sloping demand curve.

Answer 4

Equilibrium inter bank market interest rate i * is at intersection of reserve demand Rd and reserve supply curves Rs

Answer 5

'Traditional' system - based on OMO operations 'Corridor' system - based on standing facilities 'Floor' system - where money markets are saturated with liquidity

Answer 6

No interest paid on reserves i(r) = 0 - assump Changes to market interest rate i * through OMO that shift Rs Shape and position of Rd not known exactly so less price control of i *

Answer 7

Raise IR by: Selling assets --> draining reserves --> shifts R Supply in --> I * increases

Answer 8

System based on standing facilties: reserve demand depends on i relative to ir (CB reserve rate) and ib (CB loan rate)

Answer 9

Changes to market interest rate i * acheived using equal change in adminstered standing facility interest rates ir (CB reserve rate) and ib (CB loan rate) causes paralell vertical shift of reserve demand curve as Rd bounded by i(b) and i(r) Changes i * **precisely** without an OMO; i can't go outside corridor

Answer 10

Money markets are saturated with liqudity by reserves from the central bank to shift the Rs close to i(r)

Answer 11

Money market saturated with reserves by central bank R Supply shifted so much to the right it intersects R Demand close to or at i(r) Change to i * can be implemented by adjusting i(r)

Answer 12

Corridor: i * between i(r) and i(b); parallel shift of i(r) and i(b) moves i * by same amount Floor system ensures i * = i (r) as reserves abundant Traditional system has large spread between i(r)=0 and i(b), and requires knowledge of R Demand to calibrate size of OMO Thus floor is best!

Answer 13

In a floor system, the central bank sets the interest on reserves at (or very near) the policy target. As a result, banks are not willing to lend reserves in the interbank market for less than what they can earn from the central bank. That creates a floor under market interest rates. Hence, the central bank’s balance sheet size doesn’t itself force rates off target, so long as reserves remain in ample supply. The rate the central bank pays on reserves is doing the “hard work” of pinning the market rate.

Answer 14

CB money as a liquid asset has a social value But no cost of production, so should have no opp cost Thus floor system achieves this with i * = i(r) CB reserve rate Traditional and corridor systems have artificial scarcity of reserves

Answer 15

CB profits distributed to Treasury/finance ministry

Answer 16

* CB profits from holding interest-bearing assets * Paying interest on reserves reduces CB profitability * Combined with QE purchases of long-term bonds, CB can make losses if IR rise