Effect of a reduction in the Bank Rate and increasing bank holdings of UK government bonds on the UK economy

A reduction of the bank rate would cause an overall interest rate reduction in commercial banks. Increasing the bank’s holdings of government bonds increases the level of reserves R issued by the central bank into the economy. This would increase the monetary base M0, which consists of H = C +Rc + Rb, currency and reserves. The overnight interbank rate therefore also decreases.

The Bernarke-Blinder model displays this effect on the money market equilibrium, (1/T)R=m(i_B,y) as the well as the good market equilibrium, y=C((i_B,R). A reduction in the overnight interbank and interest rate would increase the level of the goods market equilibrium, causing a rightward shift of the CC curve through the bank lending channel. Additionally, the increase in reserves would increase the level of the money market equilibrium, resulting in a rightward shift of the LM curve through the Keynesian interest rate channel. This suggests increased bank lending and positive effect on the economy depending on its current state, with increase in consumption, investment and output through the monetary transmission mechanisms. The asset price channel would indicate an increase in equity prices as a result of a reduction in the Bank rate which can have further positive wealth effects and improved financial health, improving economic activity and growth.

Increased reserves would also increase the level of liquidity in the economy, which can reduce short-term interest rates and increase expected inflation π^edue to the Fisher effect. Consequently, there is a positive yield curve as shown by the diagram displaying ytm and term to maturity, increasing the level of bond yields.

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