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Markets - Money markets

Theory 2 - The 'shortage' - who is short of what?

As part of their operations to maintain market interest rates at the official rate set by the MPC, the Bank of England creates a shortage of liquidity every day. This literally means that the banks and other financial institutions will not have enough cash to maintain their day-to-day operations. They will therefore have to borrow from the Bank of England at the rate the Bank of England wants! This borrowing is done through 'repo' operations (see Theory 3 - repo operations). So how does the Bank of England create the shortage each day?

Each morning they will calculate the expected shortage. The exact breakdown of the shortage will vary each day, but there will nearly always be one. This comes about partly because of the Bank's role as banker to the government. Every day there are flows of money to and from the government. These arise because of government spending and tax commitments. However, it will generally be that more flows to the government than from it. This happens as tax bills are paid. When an individual or firm pays tax, they will write a cheque to the Inland Revenue. That will mean that their bank will have to transfer that money from their account to the Inland Revenue account. This is a flow to the government, and will help to generate the shortage.

Another contribution to the shortage will be the gilt-edged security and Treasury Bill issues. When anyone in the private sector buys a gilt or Treasury Bill, they will transfer money to the Bank of England. In exchange they get a certificate. Again, this has acted as a transfer of money from the private sector to the Bank of England, contributing further to the shortage.

Another factor is the number of notes in circulation. As the number of notes increases, the banks have to pay the Bank of England for the notes. This is yet another transfer from the private sector to the Bank.

All of these and other factors help to generate a shortage of liquidity each day. The Bank of England can then lend each day to alleviate the shortage, at the interest rate they have set.