{"id":12233,"date":"2010-11-07T04:00:54","date_gmt":"2010-11-06T17:00:54","guid":{"rendered":"https:\/\/billmitchell.org\/blog\/?p=12233"},"modified":"2010-11-07T04:00:54","modified_gmt":"2010-11-06T17:00:54","slug":"saturday-quiz-november-6-2010-answers-and-discussion","status":"publish","type":"post","link":"https:\/\/billmitchell.org\/blog\/?p=12233","title":{"rendered":"Saturday Quiz – November 6, 2010 – answers and discussion"},"content":{"rendered":"

\t\t\t\tHere are the answers with discussion for yesterday’s quiz. The information provided should help you work out why you missed a question or three! If you haven’t already done the Quiz from yesterday then have a go at it before you read the answers. I hope this helps you develop an understanding of modern monetary theory (MMT) and its application to macroeconomic thinking. Comments as usual welcome, especially if I have made an error.
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\nQuestion 1:<\/strong><\/p>\n

\nThe price at which the central bank provides reserves to the commercial banks is restricted by its target monetary policy rate.\n<\/p><\/blockquote>\n

The answer is True<\/strong>.<\/p>\n

The facts are as follows. First, central banks will always provided enough reserve balances to the commercial banks at a price it sets using a combination of overdraft\/discounting facilities and open market operations.<\/p>\n

Second, if the central bank didn’t provide the reserves necessary to match the growth in deposits in the commercial banking system then the payments system would grind to a halt and there would be significant hikes in the interbank rate of interest and a wedge between it and the policy (target) rate – meaning the central bank’s policy stance becomes compromised.<\/p>\n

Third, any reserve requirements within this context while legally enforceable (via fines etc) do not constrain the commercial bank credit creation capacity. Central bank reserves (the accounts the commercial banks keep with the central bank) are not used to make loans. They only function to facilitate the payments system (apart from satisfying any reserve requirements).<\/p>\n

Fourth, banks make loans to credit-worthy borrowers and these loans create deposits. If the commercial bank in question is unable to get the reserves necessary to meet the requirements from other sources (other banks) then the central bank has to provide them. But the process of gaining the necessary reserves is a separate and subsequent bank operation to the deposit creation (via the loan).<\/p>\n

Fifth, if there were too many reserves in the system (relative to the banks’ desired levels to facilitate the payments system and the required reserves then competition in the interbank (overnight) market would drive the interest rate down. This competition would be driven by banks holding surplus reserves (to their requirements) trying to lend them overnight. The opposite would happen if there were too few reserves supplied by the central bank. Then the chase for overnight funds would drive rates up.<\/p>\n

In both cases the central bank would lose control of its current policy rate as the divergence between it and the interbank rate widened. This divergence can snake between the rate that the central bank pays on excess reserves (this rate varies between countries and overtime but before the crisis was zero in Japan and the US) and the penalty rate that the central bank seeks for providing the commercial banks access to the overdraft\/discount facility.<\/p>\n

So the aim of the central bank is to issue just as many reserves that are required for the law and the banks’ own desires.<\/p>\n

Now the question seeks to link the penalty rate that the central bank charges for providing reserves to the banks and the central bank’s target rate. The wider the spread between these rates the more difficult does it become for the central bank to ensure the quantity of reserves is appropriate for maintaining its target (policy) rate.<\/p>\n

Where this spread is narrow, central banks “hit” their target rate each day more precisely than when the spread is wider.<\/p>\n

So if the central bank really wanted to put the screws on commercial bank lending via increasing the penalty rate, it would have to be prepared to lift its target rate in close correspondence. In other words, its monetary policy stance becomes beholden to the discount window settings.<\/p>\n

The best answer was True<\/strong> because the central bank cannot operate with wide divergences between the penalty rate and the target rate and it is likely that the former would have to rise significantly to choke private bank credit creation. <\/p>\n

You might like to read this blog for further information:<\/p>\n