<p>Ok so first of all it sounds like you are talking about the pre 2008 world of non-excess reserves.  In that system , the central bank controls the total amount of reserves in the system by conducting open market operations.(OMO).   Thus there is just the right amount of reserves in the system to maintain equilibrium at their chosen policy rate.  A typical OMO would be to inject reserves by conducting a repo transaction with a primary dealer, or withdraw reserves by doing a reverse repo.</p>
<p>In the post 2008 world there are excess reserves in the system , so central bank controls rate by having a deposit facility where the reserves can be parked at the policy rate.  So no need for OMO.</p>

CC BY-SA 4.0
2023-10-13T11:46:36.927Z
I feel like you've not addressed my question.  If reserves were in excess, why do banks need to borrow them regularly on the interbank market to settle payments each day? The standard MP transmission mechanism relies on banks being charged more by other banks for their reserves, thereby causing that borrower bank to increase their loan rates.  Is this not the case?
Jamie Smith
CC BY-SA 4.0
2023-10-13T18:49:33.150Z
In excess reserve environment , banks indeed do not need to borrow regularly on the interbank market to settle payments.
dm63
CC BY-SA 4.0
2023-10-13T18:52:03.860Z
https://www.biancoresearch.com/what-will-become-of-the-funds-rate-video/
dm63
CC BY-SA 4.0
2023-10-13T18:56:32.870Z
Don’t understand your ‘MP transmission’ comment.  MP transmission doesn’t rely on differences between banks.  Fed controls short term rate.  All loans by all banks are affected.  That’s the mechanism broadly.
dm63
CC BY-SA 4.0
2023-10-14T19:23:09.093Z
If there were excess reserves such that all commercial banks had more than enough to settle their payments and meet demand for withdrawals then they wouldn't borrow any from any other bank.  The short term rate would drop to zero.  What would they cause banks to up their loan rates if they just get more interest from central bank on their large stockpile of reserves?
Jamie Smith
CC BY-SA 4.0
2023-10-14T22:20:42.087Z
"The short term rate would drop to zero" is incorrect because they have access to the Fed IORB.  In fact that is why it is there- to prevent rates going to zero.
dm63
CC BY-SA 4.0
2023-10-14T22:23:21.813Z
"What would they cause banks to up their loan rates if they just get more interest from central bank on their large stockpile of reserves" there are some typos in your question but i think you are asking why they bother to make loans when they can just deposit at Fed? - answer: to earn the credit spread.
dm63
CC BY-SA 4.0
2023-10-15T07:55:26.950Z
No, I mean the standard MP transmission seems to break if excess reserves drive interbank rate to the central bank rate (or maybe zero? Since no bank would bother borrowing reserves since they all have plenty). No bank would INCREASE loan rates if they actually get MORE interest on their large reserve stockpile. There would be no reason to.
Jamie Smith
CC BY-SA 4.0
2023-10-15T09:07:36.747Z
I think you have misunderstood MP transmission.   When base rates go up, all banks charge more for loans , regardless of their current reserve position, because all banks face a higher cost of funding whether it be interbank borrowing , deposits or bond issuance.  Maybe the source you were reading from has confused the issue by mentioning reserve flows.
dm63
CC BY-SA 4.0
2023-10-15T19:23:58.320Z
But isn't that the whole point of the discussion we're having?   If reserves are in complete excess, there will be NO interbank borrowing. So why would base rate increasing cost banks such that they need to raise loan rates? Maybe I'm missing another bank cost which goes up as a result of base rate (interest paid out by central bank to commercial banks on reserves).
Jamie Smith
CC BY-SA 4.0
2023-10-16T05:10:00.087Z
Last comment:  bank cost of funds go up when Fed raises rates.  Deposit rates go up.  Yield on bonds that are issued go up.  So even if there is no interbank borrowing , cost of funds go up.
dm63
CC BY-SA 4.0
2023-10-16T08:45:25.900Z
smh..  but WHY do bank cost of funds go up???  In excess reserve scenario, they're NOT paying higher funds to borrow reserves.  Instead, they are getting MORE money from central bank as interest on the excess reserves they already hold. Why would giving banks MORE money mean they have to raise loan rates? You seem to be skipping over precise cause and effect chains that are a vital part of any MP tranmission mechanism analysis.  Unless I am missing something, in which I would welcome explanation but you've not done that thus far.
Jamie Smith
CC BY-SA 4.0
2023-10-16T09:34:20.590Z
Deposit rates go up because of competition.  If bank does not raise deposit rates ,it risks losing deposits to other banks.  Bond yields go up because bonds are priced versus prevailing interest rates.  And finally, this is kind of moot because most bank loans are floating rate loans (base rate +x) so they automatically reprice upwards when base rate goes up.
dm63
CC BY-SA 4.0
2023-10-16T09:54:58.150Z
@dm663  I appreciate you responding.  I think we're talking past each other though.  My scenario: complete excess of reserves (say 1000 times what's required by each bank).  So NO bank is borrowing anything from any other bank (or the central bank) as they already have plenty. This means increasing base rate would NOT increase cost to banks because they aren't borrowing. It would actually increase their reserves. Also, no bank needs deposits (or more precisely the reserves than accompany them) in this scenario so there wld be weakened incentive to increase deposit rates. What am I missing?
Jamie Smith
CC BY-SA 4.0
2023-10-16T09:56:11.970Z
Your statement that "they automatically reprice upwards when base rate goes up" doesn't make sense in a zero fund cost scenario of excess reserves. Loan rates ONLY go up because banks put them up to maintain profitibility if their cost of borrowing reserves go up.
Jamie Smith
CC BY-SA 4.0
2023-10-13T11:24:54.520Z
2023-10-13T11:24:54.520Z
dm63
<p>Firstly, I understand the standard analysis of how a central bank attempts to modulate credit conditions in the economy (and therefore money supply) to dampen demand to prevent excess price level increases.</p>
<p>This standard view is:</p>
<ol>
<li>Central bank increases base rate - the interest rate they pay on central bank reserves held with them by the commercial banks.</li>
<li>In response, commercial banks needing to borrow reserves to meet their settlement and withdrawal requirements would pay a higher interbank rate (because the lender bank wants to maximise their yields so why lend your reserves at a lower rate than you could get by just keeping them with the central bank).</li>
<li>In response, commercial banks who are paying this increased cost of reserve borrowing will need to increase the rates they charge on customer loans to maintain profitibility. This will tend to decrease customer demand for credit, thereby arriving at one half of the demand suppression desired outcome of the central bank when it raised rates in point 1.</li>
<li>And finally, to attract deposits (and thereby reserves) from customers, this commercial bank would need to offer higher rates on deposits.  This would be the 2nd half of the demand suppression desired outcome because customers would be incentivise to withhold spending, thereby also lowering inflationary pressure.</li>
</ol>
<p>Now, my question.</p>
<p>Why could there not be a scenario (or could there be) where a bank which is a net lender of reserves to other banks (for whatever reason they end up with excess reserves) reduce the loan rates they offer because they are suddenly receiving lots of interest income from both the central bank (because it's just increased base rate) and other commercial banks from reserves it lends to them.  It would appear for these banks (with excess reserves), the MP transmission mechanism to loaned credit rates isn't as clear cut.</p>
<p>Indeed, surely in aggregate, the net reserve lending on the interbank market will be zero? Reserve levels do fluctuate from endogenous demand for money but I would think that since every time a bank lends reserves, another bank is borrowing that same amount of reserves. So in this view, why do loan rates go up at all in aggegate?</p>
<p>I'm obviously missing some factors in the analysis but it would be useful to get some perspectives and thoughts.</p>

<macroeconomics><monetary-policy><central-banking>
Monetary policy: could there by alternative outcomes?
Jamie Smith
# Monetary policy: could there by alternative outcomes?

(Asked by: username_0 on 2023-10-13)

Firstly, I understand the standard analysis of how a central bank attempts to modulate credit conditions in the economy (and therefore money supply) to dampen demand to prevent excess price level increases.

This standard view is:

1. Central bank increases base rate - the interest rate they pay on central bank reserves held with them by the commercial banks.
2. In response, commercial banks needing to borrow reserves to meet their settlement and withdrawal requirements would pay a higher interbank rate (because the lender bank wants to maximise their yields so why lend your reserves at a lower rate than you could get by just keeping them with the central bank).
3. In response, commercial banks who are paying this increased cost of reserve borrowing will need to increase the rates they charge on customer loans to maintain profitibility. This will tend to decrease customer demand for credit, thereby arriving at one half of the demand suppression desired outcome of the central bank when it raised rates in point 1.
4. And finally, to attract deposits (and thereby reserves) from customers, this commercial bank would need to offer higher rates on deposits. This would be the 2nd half of the demand suppression desired outcome because customers would be incentivise to withhold spending, thereby also lowering inflationary pressure.

Now, my question.

Why could there not be a scenario (or could there be) where a bank which is a net lender of reserves to other banks (for whatever reason they end up with excess reserves) reduce the loan rates they offer because they are suddenly receiving lots of interest income from both the central bank (because it's just increased base rate) and other commercial banks from reserves it lends to them. It would appear for these banks (with excess reserves), the MP transmission mechanism to loaned credit rates isn't as clear cut.

Indeed, surely in aggregate, the net reserve lending on the interbank market will be zero? Reserve levels do fluctuate from endogenous demand for money but I would think that since every time a bank lends reserves, another bank is borrowing that same amount of reserves. So in this view, why do loan rates go up at all in aggegate?

I'm obviously missing some factors in the analysis but it would be useful to get some perspectives and thoughts.

**Tags:** macroeconomics, monetary-policy, central-banking


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## 1 answers

### Answer by username_1 on 2023-10-13. Score: 0

Ok so first of all it sounds like you are talking about the pre 2008 world of non-excess reserves. In that system , the central bank controls the total amount of reserves in the system by conducting open market operations.(OMO). Thus there is just the right amount of reserves in the system to maintain equilibrium at their chosen policy rate. A typical OMO would be to inject reserves by conducting a repo transaction with a primary dealer, or withdraw reserves by doing a reverse repo.

In the post 2008 world there are excess reserves in the system , so central bank controls rate by having a deposit facility where the reserves can be parked at the policy rate. So no need for OMO.

> **Comments:**
> **username_0**: I feel like you've not addressed my question.  If reserves were in excess, why do banks need to borrow them regularly on the interbank market to settle payments each day? The standard MP transmission mechanism relies on banks being charged more by other banks for their reserves, thereby causing that borrower bank to increase their loan rates.  Is this not the case?  
> **username_1**: In excess reserve environment , banks indeed do not need to borrow regularly on the interbank market to settle payments.  
> **username_1**: https://www.biancoresearch.com/what-will-become-of-the-funds-rate-video/  
> **username_1**: Don’t understand your ‘MP transmission’ comment.  MP transmission doesn’t rely on differences between banks.  Fed controls short term rate.  All loans by all banks are affected.  That’s the mechanism broadly.  
> **username_0**: If there were excess reserves such that all commercial banks had more than enough to settle their payments and meet demand for withdrawals then they wouldn't borrow any from any other bank.  The short term rate would drop to zero.  What would they cause banks to up their loan rates if they just get more interest from central bank on their large stockpile of reserves?  
> **username_1**: "The short term rate would drop to zero" is incorrect because they have access to the Fed IORB.  In fact that is why it is there- to prevent rates going to zero.  
> **username_1**: "What would they cause banks to up their loan rates if they just get more interest from central bank on their large stockpile of reserves" there are some typos in your question but i think you are asking why they bother to make loans when they can just deposit at Fed? - answer: to earn the credit spread.  
> **username_0**: No, I mean the standard MP transmission seems to break if excess reserves drive interbank rate to the central bank rate (or maybe zero? Since no bank would bother borrowing reserves since they all have plenty). No bank would INCREASE loan rates if they actually get MORE interest on their large reserve stockpile. There would be no reason to.  
> **username_1**: I think you have misunderstood MP transmission.   When base rates go up, all banks charge more for loans , regardless of their current reserve position, because all banks face a higher cost of funding whether it be interbank borrowing , deposits or bond issuance.  Maybe the source you were reading from has confused the issue by mentioning reserve flows.  
> **username_0**: But isn't that the whole point of the discussion we're having?   If reserves are in complete excess, there will be NO interbank borrowing. So why would base rate increasing cost banks such that they need to raise loan rates? Maybe I'm missing another bank cost which goes up as a result of base rate (interest paid out by central bank to commercial banks on reserves).  
> **username_1**: Last comment:  bank cost of funds go up when Fed raises rates.  Deposit rates go up.  Yield on bonds that are issued go up.  So even if there is no interbank borrowing , cost of funds go up.  
> **username_0**: smh..  but WHY do bank cost of funds go up???  In excess reserve scenario, they're NOT paying higher funds to borrow reserves.  Instead, they are getting MORE money from central bank as interest on the excess reserves they already hold. Why would giving banks MORE money mean they have to raise loan rates? You seem to be skipping over precise cause and effect chains that are a vital part of any MP tranmission mechanism analysis.  Unless I am missing something, in which I would welcome explanation but you've not done that thus far.  
> **username_1**: Deposit rates go up because of competition.  If bank does not raise deposit rates ,it risks losing deposits to other banks.  Bond yields go up because bonds are priced versus prevailing interest rates.  And finally, this is kind of moot because most bank loans are floating rate loans (base rate +x) so they automatically reprice upwards when base rate goes up.  
> **username_0**: @dm663  I appreciate you responding.  I think we're talking past each other though.  My scenario: complete excess of reserves (say 1000 times what's required by each bank).  So NO bank is borrowing anything from any other bank (or the central bank) as they already have plenty. This means increasing base rate would NOT increase cost to banks because they aren't borrowing. It would actually increase their reserves. Also, no bank needs deposits (or more precisely the reserves than accompany them) in this scenario so there wld be weakened incentive to increase deposit rates. What am I missing?  
> **username_0**: Your statement that "they automatically reprice upwards when base rate goes up" doesn't make sense in a zero fund cost scenario of excess reserves. Loan rates ONLY go up because banks put them up to maintain profitibility if their cost of borrowing reserves go up.  

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