5.1 The discount market

in the incentive to borrow via bills, especially if it is alternative short-term funds

which become costlier.

Although bills are a source of short-term nance, the behaviour of interest rates

on long-term instruments could also be relevant. Suppose that longer-term rates are

expected to fall. In these circumstances, rms which require medium and long-term

nance, which they might get by issuing bonds, might decide to defer committing

themselves now to current longer-term rates. Although there may be disadvantages

to using short-term nance for longer-term projects, these might be outweighed by

borrowing short just now, so as to be in a position in the near future to issue longer-

term debt when long-term rates have fallen.

Finally, we need to understand that the issue of treasury bills by government is

a form of residual nance. That is, bills are issued from week to week to cover any

shortfall that may occur between expenditure and revenue from taxation, charges

and longer-term borrowing. In the very short term (meaning week to week) there-

fore, there may be sharp uctuations in treasury bill sales resulting from the uneven

timing of government receipts and payments.

All of these inuences on supply are summarised in Box 5.2, together with inu-

ences on demand. Note two things. Firstly, the inuences are all described as though

they are shifting the supply curve to the right. It is easy to see how they could cause

leftward shifts. Secondly, these are described as inuences on the bills’ market, but

we noted that all the markets for money are closely related. These inuences might

be felt rst in the bills market, but they will affect the parallel markets too.

Box 5.2Supply and demand inuences in the bills’ market

Supply

Demand

Long term	S	Economic growth	D	Economic growth
	1		1
	S	Ination	D	Ination
	2		2

Short term	S	Expected fall in interest rates	D	Increase in liquidity preference
	3		3
	S	Rise in interest rates on	D	Excess liquidity in banking system
	4		4
		alternative sources of funds

S	Residual nancing of PSNCR	D	Fall in yields on alternative assets
5		5

In Figure 5.1 we also have a demand curve for bills, D. This expresses the willing-

0

ness of buyers of bills to hold the existing stock. It is negatively sloped with respect

to price because of the inverse relationship between bill prices and rates of discount.

At low prices, i.e. at large rates of discount, ceteris paribus, holders will be willing to

hold more bills than they would at low rates of discount, i.e. at high prices.

What might cause the demand curve to shift? Again, we can expect long-term

inuences such as increasing income, prices and wealth to cause a rightward shift of

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Chapter 5 • The money markets

the demand curve. In addition, there may be short-term causes of increased preference

for bills. We emphasised earlier that bills are a very liquid form of asset. They carry

negligible risk, a known rate of return if held to their redemption which occurs always

in the near future, and there is a ready market for them. It is a reasonable supposition,

therefore, that anything that increases the community’s demand for liquid assets

relative to other forms of wealth will cause a rise in the demand for bills. Uncertainty

about the future value of other nancial assets, or about the timing of important

receipts and payments, are examples.

One of the most important short-term inuences on the demand for money

market instruments of all kinds is referred to in Box 5.2 as excess liquidity in the

banking system. Since banking system liquidity changes from day to day, with major

implications for the money markets, we need to look at how the two are connected.

We shall stay with the discount market as our example of the market which most

directly feels the impact of these banking system uctuations, but all money markets

will be affected to some degree.

Bills are held mainly by nancial institutions which see them as highly liquid,

interest-bearing assets, and especially by discount houses for which holding bills

is a specialist and major activity. Most important of all, therefore, will be changes

in the factors determining discount houses’ willingness and ability to buy bills and

this, in turn, depends upon the ability of other monetary nancial institutions to

lend ‘surplus’ funds to the discount houses in order to nance the purchase. The

demand for bills, in other words, depends upon the liquidity of the rest of the bank-

ing system.

When we talk of the ‘liquidity of the banking system’ we refer to the supply of

bank reserves relative to their liabilities or relative to their other assets. Essentially,

this means relative to deposits or to loans. As we saw in Chapter 3, it is normally

expressed as a ratio of reserves to deposits, R/D. If reserves are plentiful, some can

p

be lent to the money markets (and discount houses will then have funds to buy

bills); if reserves are scarce, existing loans to the discount market (money lent ‘at

call’) will be recalled and discount houses will have to sell bills. The ows of funds

which cause changes in banks’ liquidity positions are many and varied. Notice,

though, that since we are talking about reserves, R(= C+ D), we are talking about

bb

changes in the monetary base, B(= C+ D+ C). Box 3.4 showed us that the

bbp

components of the monetary base are all liabilities of the central bank. They will

change, therefore, whenever there is a change in central bank assets. A look back

at Box 3.4 shows that one component of central bank assets is loans to the govern-

ment. This lending will increase if the central bank either buys bonds directly from

the government at the time of issue or buys them from other holders subsequently.

In either event, the payment for the bonds is deposited in a bank which then has

larger customer deposits (D), but, more importantly, it has an equal increase in

p

reserves (D).

b

Since most governments run annual decits, central banks can always add to

the monetary base by their acquisition of government debt. This they do on a con-

tinuous but limited basis. This steady source of new monetary base clearly adds to

the liquidity of the banking system over time. But this does no more than allow it

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