7.6 The monetary authorities and the rate of interest

In theory, it should be more difcult for banks to resist attempts by the central

bank to push up interest rates, as long as the central bank has the power to induce

a genuine shortage of liquidity in the economy. If banks hold their assets in a more

liquid form than is needed, all they are doing is forgoing potential prots. If they hold

their assets in a less liquid form than is needed, they ultimately face the possibility

of a loss of condence by the depositors and hence of collapse. Even here, however,

there are limits to the power of the central bank. In developed and sophisticated

nancial markets, banks have considerable ability to overcome shortages of liquidity

without resorting to borrowing from the central bank. In any case, it would be a very

risky policy for central banks to squeeze liquidity to such an extent that the banks

genuinely feared collapse. Indeed, for such a policy to be effective, the authorities

would have to accept reasonably frequent bank collapses. This, in turn, would reduce

the condence of depositors in the banking system – a result that modern govern-

ments do not desire.

There is a second quite different difculty with our analysis. When we described

the process above by which banks became more or less willing to make loans, we

implied two things: (a) that the demand curve for loans did not shift; and (b) that

the market for loans was genuinely competitive – that is, that banks are prepared

to lend to anyone prepared to pay the market rate of interest. Let us look at each

of these.

We suggested above that the willingness of investors and consumers to borrow

depended a good deal on condence. That is, if rms believe that the economy is

heading into a recession, they will not wish to borrow in order to invest because

they are worried about their ability to sell their products. Decisions by potential

house buyers and purchasers of consumer durables depend a good deal on their

current estimates of their net wealth. A major part of the net wealth of many house-

holds is the current value of the house in which they live. Any fall in house prices

is thus likely to affect consumers’ condence. In addition, estimates of household

wealth are now strongly linked to the prices of nancial assets. Any sharp fall in the

prices of equities or other nancial assets or any expectation that such a fall might

occur can have a powerful impact on household estimates of wealth and a strong

impact on their willingness to go further into debt. It follows that any exogenous

inuences on the condence of rms or households might shift the demand curve

for new loans.

In Figure 7.3, then, we assume a sharp fall in the demand for new loans. For the

moment, we shall assume no change in the willingness of banks to lend. The demand

curve shifts down, and in a competitive marketthe interest rate on longer-term loans

would fall. As loan rates fall, the cost to banks of holding liquid assets falls and banks

hold a higher proportion of their assets in liquid form. The demand for short-term

assets rises and short-term interest rates fall. The monetary authorities are not deter-

mining interest rates here. This allows us to consider the circumstances in which the

authorities might have an inuence.

Suppose that the market is not fully competitive and that interest rates do not

fall as quickly as they would do in a competitive market. In Figure 7.3, we show the

possibility that interest rates do not move at all. We move from point A to point C

217

....

FINM_C07.qxd 1/18/07 11:33 AM Page 218

Chapter 7 • Interest rates

Figure 7.3

rather than to point B. Therefore, the value of loans falls from OLto OL. Under

13

these circumstances, the central bank could act at the short end of the market to

exert pressure on banks to reduce interest rates in the direction in which they would

fall in a competitive system. However, there are clear limits to the inuence of the

central bank. It could succeed only in pushing interest rates down in the direction

dictated by market forces. In general, we can say that in a system that does not have

a strong tendency towards equilibrium, the central bank is able to push the rate

of interest towards the equilibrium rate. As we shall see later, the job of the central

bank is much more difcult than this implies. The point we are making here is that

the central bank is not free to push the rate of interest in either direction or by any

amount that it chooses.

Let us next return to the question of whether banks are prepared to lend to

anyone at the existing rate of interest. This is certainly not so. There is no doubt that

there is at least some degree of rationing in the market for bank loans. That is, at

least some would-be borrowers are unable to obtain loans even if they are willing

to pay the market rate of interest. Some market agents are unable to obtain loans at

all; others will be able to obtain loans only at higher rates of interest. One possible

explanation for this depends on the presence of asymmetric information (dened

in section 4.1). We noted in section 3.1.4 that banks have better knowledge about

the risk to which they are going to put funds than do the savers who lend them but

we might also argue that banks are less able to know the likely prospects of success

of investment projects than are investors. In the case of consumers, banks know

less than the would-be borrower about the likelihood that the loan will be repaid.

They may respond by imposing additional conditions on borrowers (for example,

a stipulation of a certain amount of collateral for the loan) or by including an addi-

tional risk premium in the interest rate to take into account their assessment of the

risk associated with the loan. Poor people often have no access at all to bank nance

and are forced to borrow from pawnbrokers and other informal nancial institutions,

which charge much higher rates of interest than banks.

218

....

FINM_C07.qxd 1/18/07 11:33 AM Page 219