bain_y_howells__monetary_economics__policy_and_its_theoretical_basis

ly between 1980 and 1985 — it has been the growth rate and not the
absolute size which they have targeted). It is thus a fairly simple task for
the central bank to ensure that the quantity of monetary base (of which
reserves are a part — see equation 3.2) grows slowly enough that at the end
of each day the banks involved in the settlement process are short of funds
(Bank, 1997a). In addition to this, a large fraction of banks’ liquidity consists
of previous short-term borrowing from central banks. When these
loans mature (‘unwinding of official assistance’ in the jargon) they need to
be refinanced. Provided that the shortage is system-wide, interbank lending
and borrowing cannot resolve the shortage and the central bank is then in
the position to exploit its monopoly position in the supply of reserves.
Like any monopolist, the central bank can set either the price or the
quantity of reserves which it supplies. Two contrasting possibilities, and one
intermediate one, are described in Figure 4.1.
Interest
rate
i 2
i 3
i 1 =i*
0
MONEY SUPPLY AND CONTROL IN THE UK 75
Figure 4.1: The supply of bank reserves
R*
S 1
Quantity of reserves
We begin with the situation where the authorities have a fixed target for
reserves, R*. In the event that demand increases from D 1 to D 2 , and there is
a shortage shown by the distance AB, the central bank can hold to its quantity
target, in which case bidding by banks for the available reserves will
push the rate of interest up from i 1 to i 2 . Recall what we said above, namely
that if the shortage is system-wide then interbank bidding cannot change
the quantity which remains at R*. The rise in interest rates must bear all of
the adjustment.
Alternatively, the central bank may choose to target the rate of interest,
i*. In this case, the bank must supply whatever quantity of additional
‘S 3 ’
D 1
‘S 2 ’
D 2