5.1 The discount market

to expand to accommodate the needs of increasing trade and economic expansion.

If this is all that the expansion does, of course, it will have little effect on money

markets since it will be meeting the banking system’s requirements for additional

reserves with which to carry out its day-to-day banking operations. What we are

concerned with here is uctuations around this trend: short-term changes in the

liquidity of the system which lead to temporary shortages (or surpluses) in bank

reserves. It is these uctuations which have an effect on the ow of ‘call money’ into

and out of the discount market.

The principal source of these uctuations is the net ow of funds between the

government (often called ‘the exchequer’ for this purpose) and the private sector.

The government buys goods and services and hires labour from the private sector,

while the latter pays taxes and other charges to the government. It may well be

that there is a net ow towards the private sector, over the year; but on a short-term

basis these ows could go in either direction. Since the exchequer accounts are held

at the Bank of England, a net ow changes the volume of deposits and the liquidity

of the system.

To understand this fully, we may need again to refer back to the balance sheets

of commercial banks and the central bank in Boxes 3.3 and 3.4 respectively. Any

net payments from the general public to the government cause a reduction in their

deposits at commercial banks (D). At the central bank, government deposits increase

p

by the same amount (D). What is crucial, though, is what happens to commercial

g

bank deposits at the central bank. These are debited by the same amount (D). This

b

is the source of the liquidity shortage. In Chapter 3, we noted that Dis very small

b

relative to D. Therefore, anything which causes an equal absolute reduction in both

p

is going to have a dramatic effect in lowering the D/Dratio. In this example, com-

bp

mercial banks, especially the deposit-taking retail banks, will be looking for ways

to restore D, and the rst course of action will be to recall funds from the discount

b

market. A shortage of this kind will occur whenever there are net payments to the

exchequer from the general public. These transfers may be ‘spontaneous’, the result

of tax payments perhaps, or they could be induced by the sale of government bonds

to the general public. These and other short-term inuences on the state of liquidity

in the discount and other money markets are given in Box 5.2. They are described

in the form in which they give rise to a money market surplus. In terms of demand

curve shifts, therefore, the events as described in Box 5.2 will cause a rightward shift.

But it is a comparatively easy task to reverse the direction of the inuences. When

their effects are reversed, these events will reduce liquidity in the money markets

and the demand curve will shift to the left.

These long-term and short-term inuences on demand are also summarised in

Box 5.3. (Indeed, the contents of Box 5.3 should be interpreted as an expansion of

point ‘D’ in Box 5.2.) In Box 5.3, the events are described in a form which causes

4

the demand curve to shift to the left. It is assumed, for example, that the events of

Box 5.3 have created a shortageof liquidity in the banking system.

Information about selected instruments in the London money markets is published

by the Financial Timeson its ‘Market Data’ page. Box 5.4 contains the relevant

information for 31 May 2006 and illustrates a number of points we have made so far.

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Chapter 5 • The money markets

Box 5.3Flows affecting the liquidity of the banking system

Exchequer transactions

l	Net payments to the exchequer: When the private sector makes net payments to the central government, banks’ balances at the Bank of England are debited while exchequer accounts are credited by the same amount.

l	Net ofcial sales of gilts: The net purchase of government bonds by the private sector is just one way in which net payments may be made to central government with the consequences described above.

l	Net receipts of sterling on the Exchange Equalisation Account (EEA): If the EEA inter- venes to support sterling, it sells foreign currency in exchange for sterling which is drained from the market.

Change in the note issue

When the public makes net drawings of banknotes, retail banks replenish their holdings

from the Bank, which debits banks’ balances.

Bills maturing in ofcial hands/sales of treasury bills

When bills held by the Bank mature, payment ows to the central bank from those who

issued the bills. The purchase of treasury bills at the weekly tender requires a ow from

the market to the Bank.

Unwinding of previous assistance

If the Bank has provided earlier help, perhaps by lending, to the discount market, the

end of that help (the repayment of the loan) requires a ow of funds from the market to

the Bank.

Bankers’ balances below target

If the previous day’s clearing has left banks’ balances at the Bank below their preferred

level (see section 3.4.1), banks will withdraw funds from the discount market. Such a

situation will tend to recur when banks are expanding their lending.

Other ows

The Bank of England has a small number of other accounts (overseas central banks, for

example). Flows into and out of these accounts will sometimes reduce the liquidity of

the UK discount market.

Notice rstly that it gives the rates of return on various money market instruments

with maturities ranging from overnight up to one year. A quick glance at the table

conrms our earlier point about the differences between money market rates being

very small. Not all instruments are available for all maturities, but most are available

for one month and three months. We noted earlier that interest rates can be divided

into parts of 1/100, but the table shows that the London money market still quotes

rates in 1/32 fractions of 1 per cent.

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