11. How the Fed set Interest Rates Flashcards
Why do banks wish to hold reserves with the central bank?
Regulatory: in addition to reserves requirements relating to deposits, the Basel process has imposed various liquidity-related regulations that affect the demand for reserves
Payments: Banks need to keep enough reserves with the central bank to be able to honour payment requests that come through central bank payment systems such as TARGET2.
In the U.S. what is the interest rate for borrowing reserves between banks called?
Federal Funds Rate
In the Eurozone, what is the interest rate for borrowing reserves between banks called?
EONIA rate (Euro Overnight Index Average), or the ECB’s refinancing rate
Why do banks borrow off each other?
When a bank has a reserve shortfall, it may borrow reserves from another bank that has excess reserves, and the borrowing bank pays interest on this loan.
Where is the Federal Funds rate set?
In the Federal Funds market - in this case the money the interest rate that banks charge reserves depends on both supply and demand. - The Fed is uniquely positioned to control this price (i.e. the interest rate)because it can control both supply and demand in the market
How does the Fed control supply and demand which controls the money supply?
- Demand: The Fed sets reserve requirements so they can increase or reduce demand for reserves via adjusting this requirement. I t can make the demand curve for reserves shift left or right.
- Supply: The Fed can determine the total supply of reserves to the system via open market operations
When does a low federal funds rate occur?
this occurs when the Fed creates lots of reserves, demand for reserves is low relative to supply and they are cheap to borrow
When does a high federal funds rate occur?
This occurs when the Fed keeps the supply of reserves low, demand for reserves is high relative to supply and they are expensive to borrow
What does a downward-sloping curve mean in how the Fed control the Federal Funds Rate?
it means demand for reserves goes up as the Federal Funds declines - because the “opportunity cost” of holding reserves is lower with a low Fed Funds rate
What are the factors that determine the demand for reserves by banks
Why have interbank “money markets” existed?
Why central banks are able to influence money market interest rates?
How the Fed traditionally conducted monetary policy?
Why a large supply of reserves meant the Fed had to change its approach to monetary policy
The new tools introduced by the Fed to control interest rates
