Thursday, January 7, 2010

Chinese Conduct Open Market Operations---Read further to find out which one and its effect...:)

The Chinese Central Bank, Peoples Bank of China (PBOC) recently conducted monetary policy to INCREASE their equilivent of our Federal Funds Rate (the inter-bank lending rate).
In its weekly open-market operation, the central bank sold 60 billion yuan (US$8.8 billion) worth of three-month bills at 1.3684% Thursday, after keeping the yield unchanged at 1.3280% since Aug. 13.
Notice this was the SELLING of SECURITIES (3 Month Bills). This will DECREASE the reserves in the financial system or, more simply, decrease the money supply.  This sends a signal to the banking system that there is less money in circulation and banks should adjust their interest rates accordingly.  In this case, it should lead to increases in interest rates that people/businesses pay/receive for money.

The Money Market Graph we are familiar with from class illustrates the result of this policy on the Nominal Interest Rate(s) in China. (althought this graph is for dollars, ANY currency can be substituted and the result will be the same).

Why would the Chinese RAISE interest rates just as their economy is recovering from "The Great Recession"?
The tightening move, in the form of a higher yield in its weekly bill sale, came less than a day after the People's Bank of China hinted its priorities had shifted toward managing inflation expectations and away from single-mindedly supporting economic growth.

Higher interest rates serve as an incentive for people to borrow less money to buy houses, cars, other consumer goods, and for businesses to borrow less money to buy new capital equipment, replace capital equipment, expand factory production or build new factories.  The goal is to reduce demand for goods and services in order to take pressure off of rising prices (Inflation). 

It is only a matter of time before the US Federal Reserve has to cross this road.  When/if all the money pumped into the economy during the last year or so starts to promote recovery, the Fed will have to absorb some of that currency in order to get ahead of inflation.  If they delay too long then inflation MAY be a problem down the road...Stay tuned for that story to be written.

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