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7.4.2. Monetary base and the supply of money

It is not possible for the central bank to print and distribute money - that would increase their debt without increasing their assets. Instead, they change the monetary base by buying and selling financial assets (usually government bonds) in so-called open market operations.

Let us say that the central bank buys government securities for 100 million. They can pay for these bonds simply by printing new bills to the amount of 100 million. At first this may seem suspicious and "too simple". But remember that outstanding notes count as a liability for the central bank. When it buys the government securities, its assets will increase by exactly the same amount as its liabilities.

Typically, the central bank will not pay cash when it buys government securities. Instead, it will ask the seller’s bank to credit the individual’s account and will then credit the bank’s central bank account. This procedure is equivalent to paying in cash - the monetary base will increase by the same amount in both cases (remember that the banks’ assets in the central bank are included in the monetary base).

Since this will lead to an increase in deposits in the banks, the money supply will increase. By the multiplier effect, the increases in the money supply will be more than 100 million. This way, the central bank can influence the money supply several-fold by changing the monetary base.

7.4.3. Overnight interest rates targets and money supply

There are many ways to explain the important connection between the overnight interest rate target and the money supply. We will use an example to demonstrate why a decrease in the overnight rate target increases the money supply.

Imagine that the central bank changes the target from 6% to 4%. Before lowering their target, overnight interest rates were at around 6%, say between 5.6% and 6.4%. When the central bank cuts the target to 4%, it signals that it wants to see an overnight rate around 4%.

Remember that central banks normally have standing facilities allowing banks to borrow from the central bank at a rate slightly above the target rate (and to lend at a rate slightly below). If the central bank does nothing except to change the target rate, the banks would immediately use the standing facilities and borrow from the central bank. They were used to borrowing at rates around 6% overnight but can now borrow from the central bank at slightly above 4%. But the central bank does not want the standing facilities to be used - it wants the overnight rate to be close to the target such that the banks lend and borrow from each other in the market. The question then is, how can they influence the overnight market so that banks will want to borrow / lend at around 4%? The answer is by increasing the monetary base and thus the money supply.

When the central bank buys government securities, it purchases from many individuals, companies and institutions. Deposits and reserves in most banks will increase as described in the previous section. Therefore, most banks will want to lend overnight and this will drive down the overnight interest rate.

To summarize: When the Central Bank cuts the target rate, they must simultaneously increase the monetary base by buying government securities. The growth of the monetary base creates a surplus in the banks, the supply of funds overnight increases, the demand falls and the overnight rate falls. Although the monetary base represents a small portion of the money supply, a change in the monetary base is magnified by the multiplier effect.

7.4.4. Overnight rates and interest rates with longer maturity

By controlling overnight interest rates, the central bank will affect the interest rates with longer maturity. The reason for this is that interest rates with similar maturity cannot be too different. If, for example, the central bank increases the target rate (move intercept on the yield curve upwards), then interest rates with short maturity will very likely increase but longer interest rates may also increase.

Let’s say that the central bank increases the target rate. When the target rate increases, the central bank needs to raise the overnight interest rate which may be accomplished by selling government securities. The central bank will then debit the commercial banks’ central bank accounts and the banks will debit the accounts of the buyers of the securities. The reserves will now be too small, and this will create an upward pressure on the overnight interest rate. To create a long-term balance, banks will want to increase their deposits and reduce their lending. They can achieve this by raising bank interest rates.

Another way to explain why banks raise their interest rates is as follows. With higher overnight interest rates, it is more expensive for banks to end the day with a deficit. To reduce the risk of having to borrow overnight, they can increase their reserves by increasing deposits and reducing loans, which they again accomplish by raising the interest rates.

Market interest rates are affected as well. First, when the central bank sells government securities, the price of these securities will fall and the interest rate will increase. Second, government securities are close substitutes for bank deposits, and when one of these rates changes, the other follows suit.

7.4.5. Overnight target rates and inflation

One of the main targets of every central bank is a low and stable inflation. It’s main control variable is the overnight interest rate target, and the mechanism that allows the target to affect inflation is called the transmission mechanism. A brief description of the transmission mechanism looks like this:

1. When the central bank target rate increases, other interest rates in the economy will increase (and the money supply will decrease, but that is not important here).

2. With higher interest rates, it is more expensive to borrow and more advantageous to save. Therefore, consumption and investment will decrease (we say that the central bank "cools off" the economy).

3. As consumption and investment fall, GDP is reduced and unemployment will rise. This will cause inflation and the growth rate in wages to fall. The exact details in this mechanism will be discussed in the following chapters.

7.5. The real interest rate

7.5.1. Interest rates and inflation

Suppose you have 1 million on 1st January 2008. A basket of goods and services similar to the CPI basket costs 100,000. You can then buy exactly 10 such baskets on 1st January 2008.

Say that you can invest your million at a 10% interest rate. On 1st January 2009 you will then have 1.1 million. 1.1 million may not be enough for 11 baskets as prices may have changed. Say that inflation was 4% in 2008. The price of a basket has then increased to 100,000 * 1.04 = 104,000 and you can buy 1,100/104 = 10.58 baskets, which is 5.8% more than last year. Even though your wealth has increased by 10% (in whatever currency you use), your real wealth (in baskets) has only increased by 5.8% and we say that the real interest rate is 5.8%.

7.5.2. Nominal and real interest rates

To distinguish the real interest rate from the "normal" interest rate, the latter is called the nominal interest rate. The nominal interest rate shows the growth of your money while the real rate shows the growth of what your money can buy.

7.5.3. Expected inflation

Note that it is changes in prices during 2008 which matter for the high real interest rate (the time period when your deposit is earning interest). This means that you can never know how high the real rate is actually going to be when you start to save on 1st January 2008, even if you know the nominal interest rate exactly. Crucial to the determination of the real rate is the expected inflation - the inflation expected in the year you save.

7.5.4. Relation between nominal interest rate, real interest rate and inflation

If we denote the nominal interest rate by R, the real rate by r and the expected inflation by ne then the real interest rate is defined by:

Many textbooks use actual inflation (as measured during the previous period) instead of expected inflation in the definition of the real interest rate. Such a definition is not entirely incorrect (although the correct definition uses expected inflation), as expected inflation is often close to the current observed inflation.

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