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7.3. Overnight interest rates

7.3.1. The market for overnight loans

Overnight interest rates are rates for loans over a single night - these are the shortest of all interest rates. During the day, banks normally have access to interest free loans from the central bank. At the end of the day, all such loans must be cleared with the central bank. For this reason, there is a market for loans overnight between banks and the overnight interest rate is determined by supply and demand in this market.

7.3.2. Central bank overnight interest rate

The overnight interest rate is an important interest rate for a central bank and it has methods of influencing this rate. In most countries, the central bank signals what it would like the overnight rate to be. For example, in the United States, this rate is the federal funds rate. If the overnight rate steers away from the federal funds rate, the Federal Reserve will take action to steer it back towards the federal funds rate.

In addition to signaling a desired overnight interest rate, most central banks have "standing facilities" for overnight loans. For example, the ECB has a "deposit facility" and a "marginal lending facility" that member banks can use for deposits and for lending overnight. The overnight interest rate must therefore be in between the deposit rate and the marginal lending rate. Typically, the overnight rate is far from the deposit and lending rates and standing facilities are rarely used.

7.4. Monetary policy

7.4.1. Central bank and monetary policy

By monetary policy we mean the policy directed at controlling the money supply and the interest rates. In most countries, the central bank is responsible for monetary policy. It usually has complete or nearly complete control over:

• Overnight interest rates

• The monetary base

It also has some control over:

• Interest rates with longer maturity. Since loans with longer maturities are substitutes for overnight loans, the central bank also has some control over longer interest rates. The control is larger for shorter rates. This relationship is discussed further in 7.4.4.

• Money supply. The monetary base is only a small part of the total money supply but, through the multiplier effect, the central bank’s control over the money supply is magnified. This is examined in 7.4.2.

• Inflation. For many central banks, this is the variable they are mostly interested in controlling. For all central banks, it is an important variable. Exactly how the central bank affects inflation by controlling the overnight interest rate and monetary base is one of the most important issues in macroeconomic theory and will be discussed throughout the book.

As we shall see in the next section, it is not possible to choose the overnight interest rate and monetary base independently of each other. In most countries, the main focus of the central bank is on controlling the overnight interest rate rather than the monetary base. The next section shows that the central bank must increase the monetary base if it wants to lower the overnight interest rate. When it increases the monetary base, the money supply will increase and we will see a negative correlation between the overnight rate and money supply.

When the overnight interest rate decreases, the money supply increases When the overnight interest rate increases, the money supply decreases

The rest of this section describes:

• How the monetary base affects the money supply through the multiplier effect.

• How changes in the overnight rate cause changes in the money supply.

• How the central bank’s control over the overnight interest rate affects longer interest rates.

• How the central bank can affect inflation by controlling the overnight interest rate.

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