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Part 4 Central Banking and the Conduct of Monetary Policy
I N S I D E T H E F E D
Why Does the Fed Need to Pay Interest on Reserves?
For years, the Federal Reserve asked Congress to
pass legislation allowing the Fed to pay interest on
reserves. In 2006 legislation was passed allowing the
Fed to pay interest on reserves to go into effect in
2011, but the starting date was moved up to October
2008 during the financial crisis of 2007–2009. Why
is paying interest on reserves so important to the Fed?
One argument for paying interest on reserves is
that it reduces the effective tax on deposits, thereby
increasing economic efficiency. The opportunity cost
for a bank of holding reserves is the interest the bank
could earn by lending out the reserves minus the
interest payment that it receives from the Fed. When
there was no interest paid on reserves, this opportu-
nity cost of holding them was quite high, and banks
went to extraordinary measures to reduce them (for
example, sweeping out deposits every night into
repurchase agreements in order to reduce their
required reserve balances). With the interest rate on
reserves set close to the federal funds rate target, this
opportunity cost is lowered dramatically, sharply
reducing the need for banks to engage in unneces-
sary transactions to avoid this opportunity cost.
The second argument for paying interest on
reserves is that, as our supply-and-demand analysis
of the market for reserves shows, it puts a floor under
the federal funds rate, and so limits fluctuations of the
federal funds rate around its target level.
The third argument for paying interest on reserves
became especially relevant during the financial crisis
of 2007–2009. As discussed next, during that period
the Fed needed to provide liquidity to particular parts
of the financial system using its lending facilities in
order to limit the damage from the financial crisis. As
the discussion of the Fed’s balance sheet earlier in the
chapter shows, when the Fed provides liquidity
through its lending facilities, the monetary base and
the amount of reserves expands, which raises the
money supply and also causes the federal funds rate
to decline, as the supply-and-demand analysis of the
market for reserves in this chapter shows. To prevent
this, the Fed can conduct off-setting, open market
sales of its securities to “sterilize” the
liquidity created by its lending and so keep the
money supply and the federal funds rate at their prior
levels. But doing so leads to a reduction of the hold-
ings of these securities on the Fed’s balance sheet. If
the Fed were to run out of these securities, it would no
longer be able to sterilize the liquidity created by its
lending: In other words, it would have used up its
balance sheet capacity to channel liquidity to specific
sectors of the financial system that needed it, without
altering monetary policy. This problem became partic-
ularly acute during the 2007–2009 financial crisis
when the huge lending operations of the Fed caused
a precipitous drop in the Fed’s holdings of securities,
raising fears that the Fed would not be able to
engage in further lending operations.
Having the ability to pay interest on reserves helps
solve this balance-sheet-capacity problem. With inter-
est paid on reserves, the Fed can expand its lending
facilities as much as it wants, and yet as our supply-
and-demand analysis of the market for reserves
demonstrates, the federal funds rate will not fall below
the interest rate paid on reserves. If the interest rate
paid on reserves is set close to the federal funds rate
target, the expansion of the Fed’s lending will then not
drive down the federal funds rate much below its
intended target. The Fed can then do all the lending it
wants without having much of an effect on its mone-
tary policy instrument, the federal funds rate.
Given the huge expansion in the Fed’s lending
facilities during the 2007–2009 financial crisis, it is
no surprise that Chairman Bernanke requested that
Congress move up the date when the Fed could pay
interest on reserves. This request was granted in the
Emergency Economic Stabilization Act passed in
October 2008.
Open Market Operations
The effect of an open market operation depends on
whether the supply curve initially intersects the demand curve in its downward-
sloped section versus its flat section. Panel (a) of Figure 10.2 shows what hap-
pens if the intersection initially occurs on the downward-sloped section of the
demand curve. We have already seen that an open market purchase leads to a
Chapter 10 Conduct of Monetary Policy: Tools, Goals, Strategy, and Tactics
221
greater quantity of reserves supplied; this is true at any given federal funds rate
because of the higher amount of nonborrowed reserves, which rises from NBR
1
to NBR
2
. An open market purchase therefore shifts the supply curve to the right
from
to
and moves the equilibrium from point 1 to point 2, lowering the fed-
eral funds rate from
to
.
1
The same reasoning implies that an open market
sale decreases the quantity of nonborrowed reserves supplied, shifts the supply
curve to the left, and causes the federal funds rate to rise. Because this is the typ-
ical situation—since the Fed usually keeps the federal funds rate target above the
interest rate paid on reserves—the conclusion is that an open market purchase
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