Limited Commitment and the Implementation of Monetary Policy

Trade volumes in the federal funds market have remained low since the recent financial crisis. While some argue that this derives from a flood of money in the system, we propose an alternate explanation based on the distinguishing characteristic of the fed funds market: unlike other markets, whose volumes have recovered, fed funds loans are unsecured. In a model of a money market with unsecured loans subject to endogenous borrowing constraints where the central bank pays interest on reserves (IOR), we show that high levels of IOR reduce trade by tightening credit limits. Friedman's dictum that the central bank should pay a market rate fails to deliver efficiency because IOR decreases the opportunity cost of money holdings relative to credit, so decreases both the profits from lending and the value of borrowing. This results in a tightening of the endogenous borrowing constraint. When IOR exceeds the growth rate of money, credit limits plummet to zero, and no borrowing occurs despite an extant need for funds. Alternate rate schedules besides constant IOR, such as the limited deposit regime employed by Norges Bank in response to dissatisfaction with the functioning of their floor system provide additional incentives to trade which relax credit constraints and improve welfare.