Firm borrowed reserves model

At the other extreme is the firm-BR model. In this model the CB ensures that the banks are indebted to it (the CB) at all times, and whether the banks have a reserve requirement or not (which is the case in a few countries) is immaterial. The CB relies entirely on interest rates to allocate funds (new money in fact), and the CB has absolute control over interest rates. Therefore, in this system monetary policy is virtually all about the item in the central bank's books: "loans to banks" (BR) and the KIR that is applied to these loans. The existence of loans to banks, the outstanding amount of which is also called the liquidity shortage (LS), is what makes the KIR effective and influences the banks' interest rates on both sides of their balance sheets, and through their lending rate (PR) the demand for loans (and other economic variables / prices such as the exchange rate).

The CB makes daily and longer forecasts of the items that influence bank liquidity, which impact on the net reserve balance of the banking system that will reflect on the reserve accounts at the end of the business days, and then undertakes OMO to ensure that the banks are borrowing from the CB (or does nothing if the net amount remains negative). The KIR is applied to the CB loans to the banks.

There are a number of central banks that engage this model. The South African Reserve Bank follows this model; the banks are permanently indebted to the CB and it has been able to "control" the banks' lending rates in an almost exacting fashion, as indicated in Figure 4.

KIR & PR (month-ends over 50 years)

Figure 4: KIR & PR (month-ends over 50 years)

The Bank of England162 also follows this model, as indicated in the following:

"In practice the pattern of Government and Bank operations usually results in a shortage of cash in the market each day. The Bank supplies the cash which the banking system as a whole needs to achieve balance by the end of each settlement day. Because the Bank is the final provider of cash to the system it can choose the interest rate at which it will provide these funds each day. The interest rate at which the Bank supplies these funds is quickly passed throughout the financial system, influencing interest rates for the whole economy. When the Bank changes its...rate, the commercial banks change their own base rates from which deposit and lending rates are calculated"

We hasten to add that there are extraordinary times when drastic measures are taken - away from CB lending to the banks and toward creating a money market surplus (a +ER condition):

"In March 2009, the Monetary Policy Committee announced that, in addition to setting Bank Rate at 0.5%, it would start to inject money directly into the economy in order to meet the inflation target.163 The instrument of monetary policy shifted towards the quantity of money provided rather than its price (Bank Rate). But the objective of policy is unchanged - to meet the inflation target of 2 per cent on the CPI measure of consumer prices. Influencing the quantity of money directly is essentially a different means of reaching the same end.

"Significant reductions in Bank Rate have provided a large stimulus to the economy but as Bank Rate approaches zero, further reductions are likely to be less effective in terms of the impact on market interest rates, demand and inflation. And interest rates cannot be less than zero. The MPC therefore needs to provide further stimulus to support demand in the wider economy. If spending on goods and services is too low, inflation will fall below its target.

"The MPC boosts the supply of money by purchasing assets like Government and corporate bonds -a policy often known as 'Quantitative Easing'. Instead of lowering Bank Rate to increase the amount of money in the economy, the Bank supplies extra money164 directly. This does not involve printing more banknotes. Instead the Bank pays for these assets by creating money electronically and loaning the accounts of the companies it bought the assets from. This extra money supports more spending in the economy to bring future inflation back to the target."

Let us analyse this statement: the Bank of England buys securities (assume government bonds) from retirement funds to the extent of GBP 200 billion. The banking system was indebted to the Bank by GBP 100 million. [Note that we have ignored the reserve requirement here for the sake of simplicity.] The transaction has increased the money stock by GBP 200 billion and created GBP 100 in ER (the other GBP 100 was used to repay the banks' BR to the Bank of England). The banks' ER reinforces the lower Bank rate (i.e. KIR) and puts pressure on them to make loans to the NBPS at lower rates.

The reference to bringing inflation bank to the target (of 2%) is an allusion to the dangers of deflation (when prices decline) - which makes assets (like homes) worth less, while keeping debts (like mortgage debt) unchanged. Deflation has a major negative impact on C + I = GDE, because investors in assets are worse off.

BALANCE SHEET 10: RETIREMENT FUNDS (NBPS) (GBP BILLIONS)

Liabilities

Government bonds Deposits at banks

-200 +200

BALANCE SHEET 11: BANKS (GBP BILLIONS)

Liabilities

Bank reserves (TR) (ER = +100)

+ 100

Deposits of NBPS Loans from CB (BR)

+200 -100

Total

Liabilities

Government bonds Loans to banks (BR)

+200 -100

Bank reserves (TR) (ER = +100)

+ 100

Total

+100

Total

+100

The Reserve Bank of Australia165 has a similar monetary policy execution style (note that "overnight loans" is loans from the CB to the banks, and the interbank rate is termed "cash rate"):

"Monetary policy decisions involve setting the interest rate on overnight loans in the money market. Other interest rates in the economy are influenced by this interest rate to varying degrees, so that the behaviour of borrowers and lenders in the financial markets is affected by monetary policy (though not only by monetary policy). Through these channels, monetary policy affects the economy in pursuit of the goals...

"From day to day, the Bank...has the task of maintaining conditions in the money market so as to keep the cash rate at or near an operating target decided by the Board. The cash rate is the rate charged on overnight loans between financial intermediaries. It has a powerful influence on other interest rates and forms the base on which the structure of interest rates in the economy is built.... Changes in monetary policy mean a change in the operating target for the cash rate, and hence a shift in the interest rate structure prevailing in the financial system."

 
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