Federal funds rate

The interest rate on overnight loans of reserves from one bank to another

Primary instrument of monetary policy

Federal funds rate is the primary tool of monetary policy

Market for reserves

The market where the federal funds rate is determined

Equilibrium in the market for reserves

The point where quantity of reserves demanded equals quantity of reserves supplied

Quantity of reserves demanded

Required reserves plus quantity of excess reserves demanded

Excess reserves

Insurance against deposit outflows; opportunity cost is interest forgone on lending minus interest earned on reserves

Federal funds rate vs ioer

If federal funds rate > ioer

Demand curve Rd

Downward sloping when federal funds rate is above ioer; flat at ioer if rate falls below it

Non-borrowed reserves (NBR)

Reserves supplied by the Fed through open market operations

Borrowed reserves (BR)

Reserves borrowed from the Fed

Discount rate id

Interest rate charged by the Fed on discount loans; set above federal funds target

Federal funds rate iff

Interest rate on federal funds; if below discount rate id

Vertical section of supply curve

NBR supplied equals total supply; BR = 0

Flat section of supply curve

Supply curve becomes infinitely elastic at discount rate id

Market equilibrium

Rs = Rd with equilibrium federal funds rate i*ff

Open market purchase

Fed buys securities → increases reserves → shifts NBR supply curve right → federal funds rate falls

Open market sale

Fed sells securities → reduces reserves → federal funds rate rises

Discount lending effect

Depends on whether demand intersects vertical or flat section of supply curve; lower discount rate may lower federal funds rate if BR > 0

Reserve requirements increase

Required reserves rise → demand curve shifts right → federal funds rate rises

Reserve requirements decrease

Required reserves fall → demand curve shifts left → federal funds rate falls

Interest on excess reserves

Sets floor for federal funds rate; increasing ioer can raise federal funds rate if it is at flat section

Dynamic open market operations

Intended to change level of reserves and monetary base

Defensive open market operations

Offset movements in reserves due to other factors

Repo transaction

Fed purchases securities with agreement to sell back in short time; defensive OMO

Matched sale-purchase (reserve repo)

Temporary open market sale with agreement to repurchase

Discount window

Facility for banks to borrow reserves from the Fed

Primary credit

Discount lending for healthy banks

Secondary credit

Discount lending for troubled banks at higher penalty rate

Seasonal credit

Discount lending for small banks with seasonal deposit needs

Lender of last resort

Fed provides reserves to banks when no one else will to prevent panics

Required reserve ratio effect on money supply

Rise reduces deposits supported → contracts money supply; fall expands money supply

Effective-lower-bound problem

Central bank cannot lower policy rate much below zero

Nonconventional monetary policy tools

Liquidity provision

Liquidity provision

Fed increases lending facilities to provide liquidity to financial markets

Large-scale asset purchases (LSAPs)

Fed buys securities to lower interest rates and stimulate credit markets

Credit easing

Changing composition of Fed balance sheet to improve credit market functioning

Forward guidance

Commitment to keep rates low to shape expectations of future interest rates

Negative interest rates on bank deposits

Banks pay central bank to hold deposits to stimulate lending

ECB target financing rate

Sets target for overnight cash rate

Overnight cash rate

Interest rate for very short-term interbank loans

ECB main refinancing operations

Weekly reverse transactions

Longer-term refinancing operations

Monthly operations

ECB lending to banks

Conducted via marginal lending facility against eligible collateral

Deposit facility

Standing facility paying interest on excess reserves

ECB reserve requirements

Banks must hold 2% of short-term deposits in reserve accounts