Part 3/3:

So the open market sale of government bonds raises yields, hence interest rates, the price of money, and discourages borrowing from commercial banks.

Conversely, the purchase of government bonds lowers yields, thereby decreasing competition for bank credit from government bonds.

However, lower interest rates may not induce demand from borrowers for loans. When bond yields are near the "zero bound", open market purchases may have a limited effect in stimulating borrowing.

The secondary use of open market operations, as previously described, is to liquefy commercial bank balance sheets and create bank reserves. This is called "quantitative easing".

There is yet another way in which central banks influence the supply of money. This is through rates of interest in the "interbank market". For example, central banks may alter either the rate of "interest on excess reserves" or the "discount rate".

The difference between a commercial bank's reserves, and the amount of reserves required, according to the reserve ratio, to be held on deposit with the central bank in order to support its loan book, is called its "excess reserves".

Commercial banks lend to each other in the "interbank lending market". A bank may borrow from another bank in order to increase its reserves. Thus it may borrow reserves, in order to increase its capacity for credit creation.

The central bank also may pay interest on a bank's excess reserves, known as "interest on excess reserves" ("IOER").

If the central bank increases the rate of interest on excess reserves, the commercial bank may be incentivised to hold the excess reserves, rather than lend them.

The higher the rate, the more incentive for the bank to maintain larger deposits at the central bank, rather than lend in the interbank market.

Hence, a lower (higher) IOER, stimulates more (less) interbank lending of reserves, resulting in higher (lower) aggregate capacity of credit creation.

In order to influence bank reserves, the central bank may also make use of the "discount window". It may loan reserves to commercial banks at the "discount rate".

A lower (higher) discount rate may result in more (less) borrowed reserves, and consequently higher (lower) capacity for credit creation.

In the foregoing, we have seen how, through a variety of policy tools, central banks influence aggregate commercial bank lending, and, thereby, the money supply.

In summary, the policy tools discussed were:

1. Reserve ratios
2. Interest rate policy
3. Quantitative easing
4. Interest on excess reserves
5. The discount window

The money supply, or aggregate of deposit liabilities of the banking system, is a key determinant in the value of money. The more money on issue, the less valuable each unit of currency; the more scarce, the more valuable.

As money becomes more valuable, prices fall, resulting in consumer price deflation. As money becomes less valuable, prices rise, resulting in consumer price inflation.

Thus central banks, through open market operations, influence commercial banks' lending capacity, who, in turn, through expanding and contracting their loan books, determine the supply of money.

This supply of money is a key determinant of the rate of inflation or deflation of prices observed by consumers and businesses in the real economy for goods and services.

THE END