Bank Liquidity, Interbank-Rate Setting and Heterogeneous Lending Responses

Central banks move the interbank borrowing rate through nominal operations that alter the private sector’s portfolio of fiat money and government bonds. This paper elucidates a mechanism by which such operations move the interbank rate, thereby affecting bank lending and thence the wide economy. At the core is a liquidity constraint to which bank lending is subject. By affecting the maximal tightness of banks’ liquidity constraints, the aggregate portfolio of fiat money and bonds determines the interbank rate. Accordingly, an operation that alters the portfolio moves the interbank rate. The tightness of the liquidity constraint depends on a bank attribute related to money circulation and affects banks’ responses to monetary policy. When the central bank (say) decreases the interbank rate, liquidity-unconstrained banks decrease their lending rates, but contrary to received wisdom, maximally constrained banks increase theirs.