When a central bank lends money – what is interest rate? What is a central bank?

A central bank is a public institution that manages the currency of a country or group of countries and controls the money supply – literally the amount of money in circulation. The primary goal of many central banks is price stability. In some countries, central banks are also required by law to act to support full employment.

One of the most important tools of any central bank

is the setting of interest rates – the „cost of money” – as part of monetary policy. The Central Bank is not a commercial bank. A private person cannot open an account with the central bank or apply for a loan from it, and as a public institution it is not based on profit.

It works as a bank for commercial banks and thus influences

the flow of money and credit in the economy to achieve stable prices. Commercial banks can turn to the central bank to borrow money, usually for very short-term needs. To borrow from the central bank, they must provide collateral – an asset, such as a government bond or corporate loan, that has value and acts as a guarantee that they will repay the money.

Because commercial banks can make long-term loans against short-term deposits,

they can face „liquidity problems” – a situation where they have money to pay the debt, but no way to quickly turn it into cash. This is where the central bank can intervene „as a last resort”. This helps keep the financial system stable. Central banks can have many different tasks besides monetary policy. They typically issue banknotes and coins, often ensure the smooth operation of payment systems for banks and tradable financial instruments, manage foreign exchange reserves and inform the public about the economy. Many central banks also contribute to the stability of the financial system by supervising commercial banks to ensure that lenders do not take on too much risk.

Central banks can provide credit to achieve a variety of policy goals,

two of which are discussed in this Economic Bulletin. First, lending can be used to control interest rates. Second, the loan can be used to ensure liquidity. A narrow view of central bank lending emphasizes the first objective, where interest-bearing loans to target market parties are not considered necessary. A broader view sees targeted lending as sometimes necessary. Which perspective is preferred depends largely, though not entirely, on assessments of the market’s ability to distribute liquidity-suppressing frictions.

The preamble to the Federal Reserve Act states that the Fed was created

to „provide a flexible currency.” In the early years of the Federal Reserve, this goal was achieved primarily through loans given by the central bank to commercial banks. In particular, regional central banks offered loans through their „discount windows”. Although the Federal Reserve currently uses open market operations—the purchase and sale of government securities—to expand or contract the amount of money in the banking system, it continues to lend directly to market participants.

This economic review discusses two alternative viewpoints

the role of central bank loans in the implementation of monetary policy. First, the role of central bank lending as a means of achieving interest rate parity is limited. In particular, a standing arrangement is often seen as useful for limiting the frequent fluctuations in interest rates resulting from trade between market participants. Second, in a broader perspective, the central bank’s activities go beyond controlling the interest rate and extend to providing liquidity insurance to eligible institutions. Direct loans are the main means of this insurance.

These two different points of view are based on different understandings. When a central bank lends money?

of how well the interbank market can distribute liquidity between firms. In the narrow view, central bank lending is a way of changing the overall financial supply of the economy. This frictionless view suggests that the implementation of monetary policy can be accomplished entirely through open market operations that affect the total money supply of the central bank, without paying much attention to the distribution of that supply among financial institutions – which is left to market forces. If a central bank has the flexibility to act whenever it detects a significant change in the demand for central bank money – for example, due to unusually large interbank payment flows – it can meet that demand without resorting to direct lending.

The broader view is based on the idea that significant frictions impede the market’s ability to allocate liquidity between institutions. Next, we discuss some of the pitfalls proposed in the literature to justify direct and targeted central bank lending.

If the central bank grants credit to individual institutions as a type of liquidation insurance,

a problem of moral hazard may arise. Moral hazard is a potential problem for all types of insurance because insurance can reduce incentives to avoid risk. Thus, banks that have received loans from a central bank may have a greater risk of illiquidity – for example, the mismatch between the maturity of their assets and liabilities increases. If, moreover, the central bank is not able to perfectly distinguish between liquidity stress and solvency problems, the problems related to moral hazard will become even worse.

If lending creates the possibility of subsidized credit for insolvent institutions,

banks’ risk incentives are weakened so that they involve not only liquidity management decisions, but also broader portfolio decisions that affect banks’ default risk. When a central bank lends money? An important additional consideration is that extensive central bank lending can change the distribution of credit across markets or institutions, similar to fiscal policy, which is a function of Congress, not the central bank.

Weighing the costs and benefits of providing liquidity is difficult

Although the theoretical literature has presented stylized friction models that can motivate such central bank interventions, they are generally not suitable for quantitative cost-benefit assessment. For example, in such a model, both costs and benefits typically depend on the severity of information or other problems that are inherently difficult to measure.

Narrow view

A narrow view of the role of central bank loans in the implementation of monetary policy is based on the assumption that there is little friction in the redistribution of reserves in the banking system. According to this hypothesis, the central bank can achieve effective control of short-term interest rates by controlling the money supply (mainly bank reserves) through open market operations and setting interest rates on deposits or loans from the central bank.

From a narrow point of view, one of the most common articulations of interest policy is the reserve management model developed by William Poole. In this context, the demand for reserves is driven by the uncertainty of interbank payment flows caused by the activities of banks. brokerage services. customers and banks with costs resulting from running out of reserves late at night. The nature of the charges depends on how the central bank treats the bank’s reserves – often it is some combination of the reserve requirement and the central bank’s overnight lending penalty. Regarding frictions, an important assumption in this model is that interbank trading is more difficult and/or more expensive later than before, when most of the trading takes place.

In this context,

the terms on which banks can borrow from the central bank affect the expected cost of not having the desired reserve balance late in the day, and thus the demand for reserves. The possibility to borrow from the central bank also reduces the volatility of market interest rates by setting a ceiling on interbank lending. An important assumption in the intermediate framework is that it is difficult or expensive for the central bank to adjust the supply of reserves through an open market operation several times a day.

If the central bank could intervene after bank late payment shocks,

it could largely eliminate the risk of banks running out of late reserves, reducing the need for banks to hold „cautionary” reserves. Even if the central bank could not conduct open market operations several times a day, there is still an arrangement to control the interest rate with little use of central bank credit. A prime example is a system in which the central bank pays interest on reserves and provides ample reserves.

This is called a „floor” system because the supply

of reserves becomes so large that interbank lending of reserves does not occur at a rate higher than the rate paid by the central bank. This is essentially the system the Federal Reserve used as reserve balances rose dramatically during the financial crisis. The experience of the first interest rate hike in December 2015 suggests that with large reserves, the interest rate can be kept under control mainly by interest paid on reserves, without the practical need for routine central bank lending.

Borderline case of a central bank. lending

If the interbank market, or more generally the wholesale financial market, effectively distributes liquid assets among market participants, open market operations should in principle be the most appropriate means of managing conventional monetary policy, which is understood as the interest rate. purpose and control. . For example, Marvin Goodfriend and Robert King arrived at this conclusion in their classic article on the subject.6 They argue that open market operations are sufficient to achieve the monetary goals of interest rate policy. In this paradigm, one way of thinking is credit management (such as the discount window) as a mechanism to automatically smooth interest rates due to demand for central bank money, for example, or credit growth more generally. liquidity By itself, the lending facility is not absolutely necessary to carry out an appropriate monetary policy, but it can be a convenient (semi-automatic) option to deal with the possibility that an unexpectedly large demand for reserves will push interbank rates higher than target levels. politicians .

Such use of central bank loans as an automatic adjustment

of supply leads to administrative costs of a loan facility, such as a discount window. Goodfriend and King argue that these costs are related to monitoring banks and their assets to constantly assess the creditworthiness of the banks and the adequacy of the collateral they promise. In their view, reducing such costs is one of the advantages of implementing interest rate policy in a way that does not require central bank borrowing. The idea behind Goodfriend and King’s arguments is that the central bank only lends against collateral that is also used in open market operations – typically government securities. With such a narrow loan arrangement, it is also possible to achieve the goal of minimizing the costs of Goodfriend and King.

The broader view

Insofar as the purpose of the central bank lending facility is to go beyond managing risk-free interest rates and specifically target solvent but illiquid institutions seeking emergency credit, the instrument is less about the implementation of monetary policy (strictly speaking). ) and more. what Goodfriend and King call banking policy—and related regulatory measures.

Frictions in financial markets can create

a useful role in the liquidity insurance provided by the central bank lending facility. In order to act appropriately, the central bank has the problem of distinguishing between insolvent and insolvent institutions and the extent to which liquidity constraints are due to firm-specific problems and market conditions.

If a country’s economy were a human body,

its heart would be the central bank. And just as the heart pumps life-giving blood throughout the body, the central bank pumps money into the economy to keep it healthy and growing. Sometimes economies need less money and sometimes more. The methods by which central banks control the money supply vary depending on the financial situation and power of the central bank. In the United States, the central bank is the Federal Reserve, often called the Fed. Other important central banks are the European Central Bank, the Swiss National Bank, the Bank of England, the Bank of China and the Bank of Japan.

Let’s look at some of the more common ways central banks control the money supply – the money in circulation around the country.

Why is the amount of money important

The amount of money circulating in the economy affects both micro- and macro-economic trends. At the micro level, a large supply of free and easy money means that people and businesses will spend more. It is easier for individuals to obtain personal loans, car loans or mortgages; it’s also easier for companies to get financing.

At the macroeconomic level, the amount of money circulating in the economy affects, among other things, the gross national product, general growth, interest rates and the unemployment rate. Central banks tend to control the amount of money in circulation to achieve economic goals and influence monetary policy.

At one time, countries tied their currency to the gold standard, which limited their production capacity. But that ended in the mid-20th century, so now central banks can increase the amount of money in circulation simply by printing it. They can print as much money as they want, although there are consequences. Simply adding money has no effect on economic income or production levels, so money itself becomes less valuable. Because it can lead to inflation, simply adding money is not the first choice for central banks.

Establishing a reserve requirement

One of the main methods used by all central banks to control the amount of money in the economy is the reserve requirement. In general, central banks authorize depository institutions (ie commercial banks) to keep a certain amount of funds in reserve (in warehouses or at the central bank) against the amount of deposits in customer accounts.

So a certain amount of money is always hidden and never circulates. Suppose the central bank set the reserve requirement at 9 percent. If a commercial bank has a total of $100 million in deposits, it must then set aside $9 million to meet the reserve requirement. It could put the remaining $91 million into circulation.

If the central bank wants more money to circulate

in the economy, it can lower the reserve requirement. This means that the bank can lend more money. If he wants to reduce the amount of money in the economy, he can raise the reserve requirement. This means that banks have less money to lend and are therefore more selective when it comes to lending.
Central banks periodically review the reserve percentage assigned to banks. In the United States (effective January 1, 2022), smaller account managers with net trading accounts of $32.
million or less are exempt from holding the reserve. Medium-sized institutions with accounts between$32.
million and $640.6 million must set aside 3 percent of liabilities as reserves. Institutions over $6
0.6 million have a reserve requirement of 10 percent.

Affects interest rates

In most cases the central bank cannot directly set interest rates for loans such as mortgages, car loans or personal loans. However, the central bank has some tools to raise interest rates to the desired level. For example, the central bank has the key to the policy interest rate – the interest rate at which commercial banks can borrow from the central bank (in the US, this is called the federal discount rate).

If banks get cheaper loans from the central bank,

they pass this saving on by reducing the cost of borrowing to their customers. Lower interest rates increase lending, which means the amount of money in circulation increases.

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