Federal Funds Market

  • Banks hold reserves in cash and at the Fed
  • Reserves held at the Fed are known as “federal funds” and are like electronic cash
    • Federal funds are very liquid and can be used as payments, to satisfy reserve requirements, etc.
  • Over $2 trillion of interbank payments are made every day
  • Banks can borrow federal funds from other banks or from the Fed in order to make payments/satisfy reserve requirements
    • These federal funds loans are typically made for one day at a time
  • The central bank is a “banker’s bank”; banks can deposit reserves at and borrow from the central bank
  • There are three “federal funds” interest rates
    • Interest rate banks receive on reserves (IOR rate)
    • Interest rate banks pay for loans
    • Interest rate banks receive pay each other for federal funds loans

Interest on Reserves (IOR)

  • The IOR/IORB rate (Interest on Reserves (Balances)) is the rate that banks receive from the Fed on federal funds
  • The IOR rate improves the Fed’s ability to control the R/D ratio, or rr
    • This allows the Fed to better control the money multiplier and total amount of money

Discount Rate (Primary Credit Rate)

  • The federal funds that the Fed loans out to banks are collateralized so the risk to the Fed is low
  • These loans are known as “discount window” loans and the interest rate is known as the discount rate or primary credit rate
  • The discount window is rarely used because it is a sign of weakness to take a loan from the Fed

Federal Funds Rate

  • Banks can borrow and lend federal funds to each other via the federal funds market
    • The interest rate on one-day loans between banks for federal loans is known as the federal funds rate
  • The federal funds rate is the one that the Fed targets every day
  • In theory, the federal funds rate should be between the IOR and primary credit rate, or else banks would have no incentive to give and receive loans from each other

Federal Funds Market

  • If the Fed wants to add reserves to the federal funds market, the Fed buys government bonds from banks
    • Banks trade bonds for cash reserves, or federal funds, increasing the federal funds in circulation
  • If the Fed wants to sell reserves to the federal funds market, the Fed sells government bonds to banks
    • Banks buy bonds for cash reserves, reducing the amount of federal funds in circulation
  • Both processes are accomplished through auction to banks

How the Fed Controls Interest Rates

  • There are many other short-term interest rates, such as the treasury bill rate, commercial paper rate, bank deposit rate, etc.
  • Arbitrage is the act of buying an asset in one market and selling it in another market at a higher price to make a profit
    • If there is a significant profit to be made via arbitrage, then arbitrageurs would being abusing that fact which would drive the prices closer together
  • Arbitrage applies to short-term interest rate markets as well
    • If other short-term interest rates were different, then financial traders at banks would begin arbitraging away the difference
    • For example: if the federal funds rate was 5.4% and the 1-month Treasury bill interest rate was 5.9%, then banks would borrow federal funds and buy Treasury bills to make a profit
  • Due to arbitrage, all US short-term interest rates move along with the federal funds rate
  • Arbitrage is harder to do between two different assets, so long-term interest rates can differ from short-term interest rates
    • This means that the 1-month Treasury rate is very close to the federal funds rate, but the 10-year Treasury rate is less linked to the federal funds rate

Real vs. Nominal Interest Rates

  • The IS-MP curve is in terms of real interest rates, but the cental bank can only control the nominal short-term interest rate
    • In the short-run, we think of inflation as fixed, so the central bank controls the real interest rate by controlling the nominal interest rate

Targeting Interest Rates vs. Targeting Money

  • The quantity theory of money says the central bank should target the quantity and growth rate of money
    • MV = PY
  • The IS-MP model indicates that the central bank targets the interest rate directly
  • Because the demand for cash and reserves varies (sometimes by a lot), the velocity of money is not constant, and the money multiplier can shift substantially, it’s difficult to target a monetary base
    • This leads to the Fed targetting a federal funds rate instead due to its stability
    • Makes it easier to formulate monetary policy, decide on a interest rate level, and communicate monetary policy
    • All of the world’s major central banks use a short-term interest rate target than a monetary base target