Money creation and the central bank-to-bank interbank market

The b2cb IBM represents the banks' RR (= a ratio of BD required by statute) on which interest is not paid. Thus as the BD increases, the amount of additional RR required is:

In the aforementioned example this was ignored for the sake of simplicity. As we now know, when BD increases the reserves required to be held increases by ABD x rr, thus by LCC 10 million. This brings us to the cb2b IBM: in order to comply with the increased reserve requirement (+10) the banks have no option but to borrow the funds from the central bank at the KIR. The liquidity shortage (assuming there is one) increases by LCC 10 million (BR = +LCC 10 million). This is indicated in Balance Sheets 16-17 (we assume Bank B wrestled the lost deposit back).

BALANCE SHEET 16: CENTRAL BANK (LCC MILLIONS)

Loans to banks (BR)

+10

Reserve accounts (TR) RR +10

+10

Total

0

Total

So, now we know that when BD increases, the RR increases by ABD x rr. It is also important to know that whenever a central bank does a deal itself (OMO) it brings about a change in its balance sheet. This is a critical element in monetary policy, because it means that the central bank can influence its balance sheet at will, and specifically the amount that it lends to banks at its KIR. In other words, the central bank, depending on the deal, will be a part of the interbank clearing (apart from assisting banks to settle amongst themselves). Allow us present an OMO example:

• The central bank sells LCC 100 billion treasury bills (TBs) on tender.

• Bank A buys the TBs.

The balance sheets of the central bank (CB) and Bank A change as indicated in Balance Sheets 18-19.

BALANCE SHEET 18: CENTRAL BANK (LCC BILLIONS)

Assets

TBs

-100

Reserve accounts: Bank A

-100

Total

BALANCE SHEET 19: BANK A (LCC BILLIONS)

Assets

TBs

Reserve account at CB (TR)

+ 100 -100

Bank A is now short of RR to the extent of LCC 100 billion. This is the only deal done in Local Country on the day, so there are no funds available in the b2b IBM. And here comes a critical point: Bank A cannot create central bank money; only the central bank itself can do so. Thus, critically, this deal ends up with the central bank making a loan to Bank A (BR) so that it again complies with the reserve requirement. Their balance sheets end up as indicated in Balance Sheets 20-21.

BALANCE SHEET 20: CENTRAL BANK (LCC BILLIONS)

TBs

Loan to Bank A @ KIR

-100 + 100

Total

0

BALANCE SHEET 21: BANK A (LCC BILLIONS)

Assets

TBs

+ 100

Loan from CB @ KIR (BR)

+ 100

Total

The liquidity of the banking sector [as measured by excess reserves (ER) less central bank loans to the banks (BR) = NER (net excess reserves)] has deteriorated by LCC 100 billion. This fairly intricate concept will be elucidated in some detail later.

What was the reason for the central bank doing this deal? It was to increase the bank's indebtedness to the central bank (i.e. reduce bank liquidity), in order to indicate a tougher stance on monetary policy. The banks are in a worse liquidity situation in that they are paying the KIR on a larger borrowing from the central bank. This interbank "market" is where monetary policy has its genesis.

The bottom end of the yield curve (specifically the one-day rate) can be said to be heavily influenced (almost "set" as we shall see later) by the central bank through "manipulating" the liquidity condition of the banks. Through open market operations the central bank ensures (in most countries) that the banks at all times are in liquidity shortage (LS) condition (also called the money market shortage - MMS - in some countries). This means that they are kept (by the central bank) perennially short of liquidity and the central bank supplies the required liquidity (BR) at the KIR, thus making the KIR effective.

As said before, the purpose is to influence the cost of bank liabilities, specifically bank deposits, and through the bank margin, the banks' lending rates. The level of bank lending rates affects the demand for loans, which creates BD (money). Before turning to the detail of this mechanism, and the application of this model in different countries, we need to introduce you to the measures of money, the causes of money creation, and the fallacies that exist.

 
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