In the previous section,
we concentrated on modeling the demand of
the commercial banking sector for central bank reserves.
We've seen the key concept that explains
the determination of the interbank interest rate as
a liquidity gap between the demand for reserves and the available supply of reserves.
The central bank as the issuer of reserves effectively sets the supply.
In this section, we'll try to answer two questions;
How do central banks set the supply of liquidity
and what is the impact from liquidity supply changes?
Bank reserves are held at the central bank.
The central bank changes the quantity of reserves by buying or selling
market assets from banks using reserve accounts as a vehicle.
The central bank engages in open market operations,
buying or selling government securities,
and crediting and debiting counter-party reserve accounts appropriately.
We'll learn to use T accounts to depict the change in
the banks balance sheets induced by a transaction.
Open market operations are implemented in two basic ways;
outright operations which change reserve liquidity,
and repo operations to stabilize reserves on a temporary basis.
After viewing this segment,
you should be able to; one,
use T accounts describe the impact of a transaction on the bank's balance sheet, two,
identify the types of open market operations,
and three, model the effects of changes in the supply of reserves.
Let's get started.
Consider this weekly data on reserve money issued by the Bank of Thailand.
We see the supply of reserves is growing over
time but also changes sharply from week to week.
This indicates that we cannot think about inter-bank interest rates
without thinking about changes in the supply of reserves.
The primary way that central banks change
the level of reserves is through open market operations.
Open market operations are the purchase or sale of financial assets by the central bank.
We will describe three types of operations;
outright operations, repo operations, and additional operations.
An open market purchase occurs when the central bank
buys financial assets from commercial banks.
The central bank credits the counter-party with
additional funds in the counterparty's reserve accounts.
This expands the monetary base and creates more liquidity.
An open market sale occurs when the central bank sells
their financial assets to commercial banks and
debits the counter-party banks reserve accounts.
Open market sales reduce the monetary base and drain liquidity.
Open market operations can be observed
through their impact on central bank balance sheets.
T accounts are visual aid for understanding the impact of
a transaction on the balance sheet of the entities engaging in the transaction.
Set up the T account by drawing a simple T.
Label the left hand side as assets and put liabilities on the right side.
Now we have a mini balance sheet which can
contain the balance sheet effects of any transaction.
Remember, balance sheets always balance,
so any transaction must have either equal impacts on assets or liabilities,
or zero net effect on either.
Consider how we might depict the impact of an open market operation on
the balance sheets of the central bank and any counter-party to the transaction.
First draw a T account representing the central bank balance sheet.
Then draw a T account for a commercial bank that
will act as a counter-party to the transaction.
Consider a hypothetical example;
A central bank open market purchase of
100 worth of debt securities from a commercial bank.
The central bank adds 100 insecurities to its portfolio.
The counter-party bank was
also credited assets by the same 100 worth of securities that they sell.
The central bank makes payment using its reserve account,
the central bank adds 100 to the reserve accounts of the counter-party bank,
this increases central bank liabilities.
The counter-party bank gets an extra amount of
reserves and loses an equal amount of securities,
so there is zero net effect on its total assets.
However, the composition of its assets has changed.
Now they have actual reserves which might be held or lent to other banks.
The central bank has increased its assets and liabilities
equally so its accounts remain in balances as well.
Notice that at the end of the transaction,
the overall supply of the monetary base of reserves has expanded.
The interbank rate is a market rate agreed upon
by borrowers and lenders in the private sector.
Like any market rate,
it is determined by the forces of supply and demand.
But the central bank determines the overall supply of liquidity
available for lending and thus can dominate market conditions.
If the central bank engages in an open market purchase of securities,
they will pump more money into the system and increase the supply of liquidity.
The excess liquidity surplus available in
the inter-bank market will push down interest rates until they get low enough for
banks to prefer to hold the available liquidity in
their own inventory rather than try to lend it out at the new lower interest rate.
This new interest rate will then become the new market equilibrium.
Likewise, when the central banks sell securities,
they reduce the amount of the monetary base that is available to commercial banks.
Consider an open market sale in which the central bank
sells 100 of debt securities to a counter-party bank.
The central bank finds a private bank that is looking to buy some securities.
If the central banks sell 100 worth of securities,
they can debit the reserve accounts of this counter-party.
The central bank loses some assets,
but also reduces liabilities.
In the end, this shrinks the monetary base of
reserves and all accounts remain in balance.
If the central bank sells assets and debits the counter-party's reserve accounts,
this will drain money from the system.
The supply of reserves will shrink.
This will create a liquidity shortage in the inter-bank market.
The short supply of liquidity in the inter-bank market will
push up interest rates for borrowers.
The decline in reserves creates a shortage of
liquidity that will push up the equilibrium interest rate.
Open market operations set off a chain of events.
An open market purchase will create
a liquidity surplus which will reduce inter-bank rates.
An open market sale will create a liquidity shortage and rising inter-bank rates.
