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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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References

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  1. 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.
  2. 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.
  3. Marvin Goodfriend, 2002. "Interest on reserves and monetary policy," Economic Policy Review, Federal Reserve Bank of New York, issue May, pages 77-84.
  4. Leonardo Bartolini & Spence Hilton & Alessandro Prati, 2005. "Money market integration," Staff Reports 227, Federal Reserve Bank of New York.
  5. 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.
  6. 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.
  7. Aleksander Berentsen & Cyril Monnet, 2007. "Monetary Policy in a Channel System," CESifo Working Paper Series 1929, CESifo Group Munich.
  8. 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.
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Citations

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Cited by:
  1. Morten L. Bech & Todd Keister, 2013. "Liquidity regulation and the implementation of monetary policy," BIS Working Papers 432, Bank for International Settlements.
  2. Lawrence L Kreicher & Robert N McCauley & Patrick McGuire, 2013. "The 2011 FDIC assessment on banks managed liabilities: interest rate and balance-sheet responses," BIS Working Papers 413, Bank for International Settlements.
  3. Afonso, Gara M. & Lagos, Ricardo, 2014. "The over-the-counter theory of the fed funds market: a primer," Staff Reports 660, Federal Reserve Bank of New York.
  4. Morten L. Bech & Antoine Martin & James McAndrews, 2012. "Settlement liquidity and monetary policy implementation—lessons from the financial crisis," Economic Policy Review, Federal Reserve Bank of New York, issue Mar, pages 3-20.
  5. Su-Hsin Chang & Silvio Contessi & Johanna L. Francis, 2013. "Understanding the accumulation of bank and thrift reserves during the U.S. financial crisis," Working Papers 2013-029, Federal Reserve Bank of St. Louis.
  6. Elizabeth Klee, 2011. "The first line of defense: the discount window during the early stages of the financial crisis," Finance and Economics Discussion Series 2011-23, Board of Governors of the Federal Reserve System (U.S.).
  7. Huberto Ennis & John Weinberg, 2013. "Over-the-counter loans, adverse selection, and stigma in the interbank market," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 16(4), pages 601-616, October.
  8. George A. Kahn, 2010. "Monetary policy under a corridor operating framework," Economic Review, Federal Reserve Bank of Kansas City, issue Q IV, pages 5-34.
  9. Jaime Marquez & Ari Morse & Bernd Schlusche, 2012. "The Federal Reserve's balance sheet and overnight interest rates," Finance and Economics Discussion Series 2012-66, Board of Governors of the Federal Reserve System (U.S.).
  10. Ansgar Belke, 2014. "Exit Strategies and Their Impact on the Euro Area - A Model Based View," Ruhr Economic Papers 0467, Rheinisch-Westfälisches Institut für Wirtschaftsforschung, Ruhr-Universität Bochum, Universität Dortmund, Universität Duisburg-Essen.
  11. Ricardo Lagos & Gara Afonson, 2011. "Trade Dynamics in the Market for Federal Funds," 2011 Meeting Papers 314, Society for Economic Dynamics.
  12. Edward Nelson, 2011. "Friedman's monetary economics in practice," Finance and Economics Discussion Series 2011-26, Board of Governors of the Federal Reserve System (U.S.).
  13. Jochen Güntner, 2013. "The federal funds market, excess reserves, and unconventional monetary policy," Economics working papers 2013-12, Department of Economics, Johannes Kepler University Linz, Austria.
  14. Marquez, Jaime & Morse, Ari & Schlusche, Bernd, 2013. "The Federal Reserve’s balance sheet and overnight interest rates: Empirical modeling of exit strategies," Journal of Banking & Finance, Elsevier, vol. 37(12), pages 5300-5315.
  15. Goodfriend, Marvin, 2011. "Central banking in the credit turmoil: An assessment of Federal Reserve practice," Journal of Monetary Economics, Elsevier, vol. 58(1), pages 1-12, January.
  16. Goodfriend, Marvin, 2011. "Monetary policy after the crisis - commentary," Proceedings, Federal Reserve Bank of San Francisco, issue Nov, pages 51-56.
  17. Gara Afonso & Ricardo Lagos, 2012. "An empirical study of trade dynamics in the fed funds market," Staff Reports 550, Federal Reserve Bank of New York.
  18. Dennis Kuo & David Skeie & James Vickery & Thomas Youle, 2013. "Identifying term interbank loans from Fedwire payments data," Staff Reports 603, Federal Reserve Bank of New York.

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