This blog follows directly from “Deficit Spending 101 – Part 3”.
The central bank operations aim to manage the liquidity in the banking system such that short-term interest rates match the official targets which define the current monetary policy stance. In achieving this aim the central bank may:
(a) Intervene into the interbank money market (e.g. the Federal funds market in the US) to manage the daily supply of and demand for funds; (b) buy certain financial assets at discounted rates from commercial banks; and (c) impose penal lending rates on banks who require urgent funds, In practice, most of the liquidity management is achieved through (a). That being said, central bank operations function to offset operating factors in the system by altering the composition of reserves, cash, and securities, and do not alter net financial assets of the non- government sectors.
Money markets are where commercial banks (and other intermediaries) trade short-term financial instruments between themselves in order to meet reserve requirements or otherwise gain funds for commercial purposes. In terms of the diagram [as seen in the previous blog] all these transactions are horizontal and net to zero.
Commercial banks maintain accounts with the central bank which permit reserves to be managed and also the clearing system to operate smoothly. In addition to setting a lending rate (discount rate), the central bank also sets a support rate which is paid on commercial bank reserves held by the central bank. Many countries (such as Australia, Canada and zones such as the European Monetary Union) maintain a default return on surplus reserve accounts (for example, the Reserve Bank of Australia pays a default return equal to 25 basis points less than the overnight rate on surplus Exchange Settlement accounts). Other countries like Japan do not offer a return on reserves which means persistent excess liquidity will drive the short-term interest rate to zero (as in Japan until mid 2006) unless the government sells bonds (or raises taxes). This support rate becomes the interest-rate floor for the economy.
The short-run or operational target interest rate, which represents the current monetary policy stance, is set by the central bank between the discount and support rate. This effectively creates a corridor or a spread within which the short-term interest rates can fluctuate with liquidity variability. It is this spread that the central bank manages in its daily operations.
In most nations, commercial banks by law have to maintain positive reserve balances at the central bank, accumulated over some specified period. At the end of each day commercial banks have to appraise the status of their reserve accounts. Those that are in deficit can borrow the required funds from the central bank at the discount rate. Alternatively banks with excess reserves are faced with earning the support rate which is below the current market rate of interest on overnight funds if they do nothing. Clearly it is profitable for banks with excess funds to lend to banks with deficits at market rates. Competition between banks with excess reserves for custom puts downward pressure on the short-term interest rate (overnight funds rate) and depending on the state of overall liquidity may drive the interbank rate down below the operational target interest rate. When the system is in surplus overall this competition would drive the rate down to the support rate.
The demand for short-term funds in the money market is a negative function of the interbank interest rate since at a higher rate less banks are willing to borrow some of their expected shortages from other banks, compared to risk that at the end of the day they will have to borrow money from the central bank to cover any mistaken expectations of their reserve position.
The main instrument of this liquidity management is through open market operations, that is, buying and selling government debt. When the competitive pressures in the overnight funds market drives the interbank rate below the desired target rate, the central bank drains liquidity by selling government debt. This open market intervention therefore will result in a higher value for the overnight rate. Importantly, we characterise the debt-issuance as a monetary policy operation designed to provide interest-rate maintenance. This is in stark contrast to orthodox theory which asserts that debt-issuance is an aspect of fiscal policy and is required to finance deficit spending.
The significant point for this discussion which we build on next is to expose the myth of crowding out is that net government spending (deficits) which is not taken into account by the central bank in its liquidity decision, will manifest as excess reserves (cash supplies) in the clearing balances (bank reserves) of the commercial banks at the central bank. We call this a system-wide surplus. In these circumstances, the commercial banks will be faced with earning the lower support rate return on surplus reserve funds if they do not seek profitable trades with other banks, who may be deficient of reserve funds. The ensuing competition to offload the excess reserves puts downward pressure on the overnight rate. However, because these are horizontal transactions and necessarily net to zero, the interbank trading cannot clear the system-wide surplus. Accordingly, if the central bank desires to maintain the current target overnight rate, then it must drain this surplus liquidity by selling government debt, a vertical transaction.
