Central Bank Actions Impact on Intra-Bank Loan Demand and Interest Rates

Effect of Central Bank's Actions on Intra-Bank Loan Demand

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Question

First National Bank currently does not have the legally required cash reserves on hand. The bank expects this situation will only last a day or two. In order to rectify the reserve problem, the bank treasurer borrows cash on the intra-bank loan market. The loan was actually granted by the Central Bank. This is the only action by the Central Bank that day. How has the Central Bank's actions impacted the demand curve for the purchase of intra-bank loans and the interest rate paid on those loans?

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Explanations

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Explanation

When a bank lacks reserves it has essentially loaned too much money, i.e. it has put too much money into circulation. If the Central Bank lends money to the bank to cover the shortfall, then the cash from the excess loans can stay in circulation.

If the reserve loan had come from another bank, then this would have simply transferred excess reserves from one bank to another. Since the Central Bank stepped in, banks with excess reserves will now choose to make more traditional loans and further expand the money supply.

Remember that the borrower has sold a loan and the lender has bought a loan. Therefore, the Central Bank's actions have increased demand for intra-bank loans.

This would cause the interest rate paid to fall.

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