3.4 Constraints on bank lending

do generally make reserves available, as and when they are required. The quantityof

reserves is not usually a constraint on bank lending. But in making additional reserves

available, the central bank can set the price. After all, in the event of a general shortage,

the central bank is the monopoly supplier of reserves. (Bank A may bid customer

deposits from bank B and the movement of Dwill be matched by movements of D.

pb

But what bank A gains, bank B loses. This is no solution to a generalshortage.) For

this reason, the central bank is sometimes said to be acting in this role as ‘lender of

last resort’ (see section 3.1).

The ‘price’ in such cases is the rate of interest at which reserves are made available.

We have just seen in the case of repos that the difference between the prices of sale

and repurchase is the cost of the loan. In all the other cases too, the central bank

can set the rate of interest at which funds are made available to the banking system.

When it buys government debt, for example, the price which it pays for the bonds

sets a rate of return in the bond market. (The relationship between bond prices and

rates of return is discussed in Chapter 6.) When it lends to government, again, it sets

a rate of interest. Whatever the mechanism it chooses, the central bank is setting

the price at which reserves are available. Since reserves are an essential input into

banking operations, the cost of those reserves represents a benchmark rate, to which

banks relate all other rates. The price of reserves is given different names in different

systems. Sometimes it is known as ‘base rate’, or ‘minimum lending rate’, or some-

times as ‘repo rate’ and sometimes as the ‘rediscount rate’. Whatever the name,

banks set their lending rates by adding appropriate mark-ups to this key rate while

paying rates on deposits which are below this rate. Notice that if these mark-ups are

generally maintained, a rise in the repo rate will cause all rates to rise, while a cut

in the rate will cause all rates to fall. The central bank has considerable power over

interest rates.

3.4Constraints on bank lending

We have just seen that banks have the power to create money through lending and

that they will frequently have a commercial interest in so doing. Why then does the

money supply not grow very much faster than in fact it does? There are three sources

of constraint: the rst two we might call ‘demand’ constraints and the third we can

think of as a ‘supply’ constraint. Both types of constraint can form the basis for

monetary control techniques.

3.4.1The demand for bank lending

The rst limitation on banks’ ability to lend is the demand for bank lending. As we just

remarked, banks charge interest on bank loans. Conventionally, we would expect

people to borrow up to the point where the utility gained from the last pound

borrowed is just equal to the cost of borrowing it. The utility of a bank loan lies not

in the money itself, of course, but in the goods that can be purchased with it. Since

the marginal utility of most goods is assumed to decrease with increasing quantities

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Chapter 3 • Deposit-taking institutions

of the good, it follows that the utility associated with each addition to one’s bor-

rowing also diminishes. In short, we should expect the demand for bank lending to

vary inversely with the rate of interest charged. In these circumstances, we can see

the importance of the central bank’s lender of last resort role.

Imagine, for example, that the authorities were pursuing a policy of targeting the

growth of money and/or credit, and that the current rate of expansion threatened

to exceed the target. The rapid expansion would mean that the banking system

would frequently need additional reserves. As we have said, these will always be

forthcoming, but in the present circumstances the appropriate response from the

central bank would be to raise the rate of interest at which they are supplied.

Banks would then know that their protability would diminish if they continued

to lend at current rates of interest while having to pay a higher price for reserves.

In practice, banks will raise all their interest rates once the central bank raises its

dealing rate. If there is some price elasticity in the demand for loans, the demand

for new loans will diminish. New loans (and deposits) will still be created, but their

rate of growthwill be less than before. This explains why we frequently see interest

rates going up in times of rapid credit expansion while cuts in interest rates occur

when money and credit growth is slow, especially if this looks likely to be an early

warning of recession.

This is not to say that demand is necessarily elastic with respect to the rate of

interest. Recent experience suggests it is not. Nor does it mean that demand is stable.

Many things, for example changes in income and wealth, and expectations about

future interest rates, may cause the demand curve for bank lending to move. What

we do wish to note is that, other things being equal, the demand for bank lending

will vary inversely with interest rates and that banks cannot lend unless people wish

to borrow.