Comparative Monetary Tools: Open Market Operations and Interest on Reserves

In 2008, the Federal Reserve implemented several new monetary policy tools. One of these tools included that it began to pay interest on a commercial bank's reserves, which created a channel system. A channel system describes a scenario where the central bank can establish an upper and a lower bound around an announced benchmark interest rate such as the federal funds rate. The penalty rate establishes the upper bound since a bank will not borrow from another commercial commercial bank above this rate. A benefit of paying interest on reserves is that IORs place a lower bound on the federal funds rate. In order to analyze this new policy, this paper utilizes a DSGE model with a banking sector. The banking sector includes excess reserves in its balance sheet that receive interest that can be adjusted by the monetary authority. Exogenous shocks are applied to a deterministic model, where agents anticipate future shocks, and a stochastic model, where agents react to an unexpected shock, in order to analyze the impact on macroeconomic variables. I find that an expansionary IOR policy results in a lower price level compared to applying an expansionary OMO policy.