25 August 2012

Day 78: Monetary Policy - Part 1

Now that we know what is involved with the supply for money and the demand for money - let's have a look at one of the policies used to influence the money supply in a certain economy.

Note that there are several policies, but we limit the discussion here to the accommodation policy.

Accommodation policy

In The Demand for Money - Part 1 it was mentioned how the interest rate will influence the demand for money. If the interest rate goes up - and thus, loans become more expensive - the demand for money will go down and, in turn, the supply of money will go down as well. Why do I say that the supply of money will go down if the demand for money goes down? Because money is mostly created through loans and loans are only created when there is a demand for it. We therefore speak of a 'demand-determined money supply'.

If the interest rate of individual banks has such an influence on the money supply - then what influences the interest rate? What influences the interest rate is the repo-rate.

The repo-rate

What is the repo-rate?

When banks are having liquidity problems - meaning: they don't have enough cash - they will usually borrow funds from other banks on 'the interbank market'. However, if all the banks are simultaneously experiencing liquidity problems, they turn to the central bank. We say that the central bank acts as 'lender of last resort'. Borrowing from the central bank is done by means of repurchase agreements. A repurchase agreement is the sale of securities together with an agreement that the seller will buy the securities back after a specified period of time - for instance, 7 days. So, in terms of banks requiring liquidity: they will sell securities to the central bank - with the money obtained from the sale, the individual banks relieve their liquidity shortage. However, the indivudal banks must agree to repurchase those same securities from the central bank after, for instance, 7 days. You can see that repurchase agreements are in essence the same thing as a loan - where money is given to the individual banks (in exchange for securities) and the individual banks have to pay this money back after a specific amount of time (after which they also get back their securities).

Now - in the same way as individual banks charge a 'fee' for their lending services by charging interest, so does the central bank make use of the repo-rate. The repo-rate is basically the interest rate that the central bank uses. It means that the amount at which the individual banks repurchase the securities from the central bank, will be higher than the initial amount. And this higher amount is determined by the repo-rate.

So - what does the repo-rate have to do with the money supply?

Well - we're dealing with a domino-effect. If the repo-rate is high, it means that it costs a lot for individual banks to get funds.
If banks are faced with higher costs, they will 'pass the cost down' to their clients, by making their interest rates higher as well. And if the interest rate is higher, the demand for money will go down, as it becomes less interesting for individuals to get a loan at a bank, knowing it will cost more to pay the loan back.

On the other hand - if the repo-rate goes down, individual banks can afford to lower their interest rate as well and will do so to become more competitive. With lower interest rates, the demand for money will go up, and thus also the supply for money, because it is more interesting to take out a loan at a low cost (low interest rate) than at a high cost (high interest rate).

So - the accommodation policy refers to the decision of the central bank to make the repo-rate higher or lower. Because - if the repo-rate changes, other interest rates will follow and if the interest rate changes, the amount of money in circulation changes.

For instance, if the central bank wishes to avoid inflation - it can raise its repo-rate, which in turn raises interest rates, which will refrain people from taking out loans and increasing the money supply to a point where all prices increase and keep on increasing.


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