Overnight rates and interest rates with longer maturity, Macroeconomics

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Q. Overnight rates and interest rates with longer maturity?

By controlling overnight interest rates, central bank will affect interest rates with longer maturity. Main reason for this is that interest rates with similar maturity can't be too different. If, for instance, central bank increases the target rate (move intercept on the yield curve upwards) then interest rates with short maturity will very likely increase though longer interest rates may also increase.  

Let's say that central bank increases the target rate. When target rate increases, central bank is required to raise the overnight interest rate that may be accomplished by selling government securities. Central bank will then debit the commercial banks' central bank accounts and banks will debit the accounts of the buyers of securities. The reserves would now be too small and this will create an upward pressure on overnight interest rate. To create a long-term balance, banks would want to increase their deposits and decrease their lending. They can achieve this by raising bank interest rates. 

Another way to explain why banks raise their interest rates is as following. With higher overnight interest rates, it's more expensive for banks to end the day with a deficit. To reduce the risk of having to borrow overnight, they can increase their reserves by increasing deposits and decreasing loans that they again accomplish by raising the interest rates. 

Market interest rates are affected as well. First, when central bank sells government securities, price of these securities will fall and interest rate will increase. Second, government securities are close substitutes for bank deposits and when one of these rates changes, other follows suit.


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