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The mechanics of a graceful exit: Interest on reserves and segmentation in the federal funds market

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  • Bech, Morten L.
  • Klee, Elizabeth

Abstract

To combat the financial crisis that intensified in the fall of 2008, the Federal Reserve injected a substantial amount of liquidity into the banking system. The resulting increase in reserve balances exerted downward price pressure in the federal funds market, and the effective federal funds rate began to deviate from the target rate set by the Federal Open Market Committee. In response, the Federal Reserve revised its operational framework for implementing monetary policy and began to pay interest on reserve balances in an attempt to provide a floor for the federal funds rate. Nevertheless, following the policy change, the effective federal funds rate remained below not only the target but also the rate paid on reserve balances. We develop a model to explain this phenomenon and use data from the federal funds market to evaluate it empirically. In turn, we show how successful the Federal Reserve may be in raising the federal funds rate even in an environment with substantial reserve balances.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Monetary Economics.

Volume (Year): 58 (2011)
Issue (Month): 5 ()
Pages: 415-431

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Handle: RePEc:eee:moneco:v:58:y:2011:i:5:p:415-431

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Web page: http://www.elsevier.com/locate/inca/505566

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  1. Berentsen, Aleksander & Monnet, Cyril, 2008. "Monetary policy in a channel system," Journal of Monetary Economics, Elsevier, vol. 55(6), pages 1067-1080, September.
  2. Leonardo Bartolini & Spence Hilton & Alessandro Prati, 2008. "Money Market Integration," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(1), pages 193-213, 02.
  3. Bindseil, Ulrich & Camba-Mendez, Gonzalo & Hirsch, Astrid & Weller, Benedict, 2006. "Excess reserves and the implementation of monetary policy of the ECB," Journal of Policy Modeling, Elsevier, vol. 28(5), pages 491-510, July.
  4. Ho, Thomas S Y & Saunders, Anthony, 1985. " A Micro Model of the Federal Funds Market," Journal of Finance, American Finance Association, vol. 40(3), pages 977-88, July.
  5. Todd Keister & Antoine Martin & James McAndrews, 2008. "Divorcing money from monetary policy," Economic Policy Review, Federal Reserve Bank of New York, issue Sep, pages 41-56.
  6. Hamilton, James D, 1996. "The Daily Market for Federal Funds," Journal of Political Economy, University of Chicago Press, vol. 104(1), pages 26-56, February.
  7. Joshua N. Feinman, 1993. "Reserve requirements: history, current practice, and potential reform," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), issue Jun, pages 569-589.
  8. Leslie E. Papke & Jeffrey M. Wooldridge, 1993. "Econometric Methods for Fractional Response Variables with an Application to 401(k) Plan Participation Rates," NBER Technical Working Papers 0147, National Bureau of Economic Research, Inc.
  9. Marvin Goodfriend, 2002. "Interest on reserves and monetary policy," Economic Policy Review, Federal Reserve Bank of New York, issue May, pages 77-84.
  10. Huberto M. Ennis & Todd Keister, 2008. "Understanding monetary policy implementation," Economic Quarterly, Federal Reserve Bank of Richmond, issue Sum, pages 235-263.
  11. repec:fip:fedgsq:y:2009:x:34 is not listed on IDEAS
  12. Furfine, Craig H, 2001. "Banks as Monitors of Other Banks: Evidence from the Overnight Federal Funds Market," The Journal of Business, University of Chicago Press, vol. 74(1), pages 33-57, January.
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