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Divorcing money from monetary policy

  • Todd Keister
  • Antoine Martin
  • James McAndrews

Many central banks implement monetary policy in a way that maintains a tight link between the stock of money and the short-term interest rate. In particular, their implementation procedures require that the supply of reserve balances be set precisely in order to implement the target interest rate. Because bank reserves play other key roles in the economy, this link can create tensions with other important objectives, especially in times of acute market stress. This article considers an alternative approach to monetary policy implementation -- known as a "floor system" -- that can reduce or even eliminate these tensions. The authors explain how this approach, in which the central bank pays interest on reserves at the target interest rate, "divorces" the supply of money from the conduct of monetary policy. The quantity of bank reserves can then be set according to the payment or liquidity needs of financial markets. By removing the opportunity cost of holding reserves, the floor system also encourages the efficient allocation of resources in the economy.

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Article provided by Federal Reserve Bank of New York in its journal Economic Policy Review.

Volume (Year): (2008)
Issue (Month): Sep ()
Pages: 41-56

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Handle: RePEc:fip:fednep:y:2008:i:sep:p:41-56:n:v.14no.2
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  1. Clouse, James A. & Dow, James Jr., 2002. "A computational model of banks' optimal reserve management policy," Journal of Economic Dynamics and Control, Elsevier, vol. 26(11), pages 1787-1814, September.
  2. Alessandro Prati & Giuseppe Bertola & Leonardo Bartolini, 2000. "Day-To-Day Monetary Policy and the Volatility of the Federal Funds Interest Rate," IMF Working Papers 00/206, International Monetary Fund.
  3. Carpenter, Seth & Demiralp, Selva, 2006. "The Liquidity Effect in the Federal Funds Market: Evidence from Daily Open Market Operations," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(4), pages 901-920, June.
  4. James D. Hamilton, 1996. "Measuring the liquidity effect," Working Papers in Applied Economic Theory 96-06, Federal Reserve Bank of San Francisco.
  5. Guthrie, Graeme & Wright, Julian, 2000. "Open mouth operations," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 489-516, October.
  6. James J. McAndrews, 2006. "Alternative arrangements for the distribution of intraday liquidity," Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 12(Apr).
  7. Marvin Goodfriend, 2002. "Interest on reserves and monetary policy," Economic Policy Review, Federal Reserve Bank of New York, issue May, pages 77-84.
  8. Huberto M. Ennis & John A. Weinberg, 2007. "Interest on reserves and daylight credit," Economic Quarterly, Federal Reserve Bank of Richmond, issue Spr, pages 111-142.
  9. Robert E. Lucas, Jr., 2000. "Inflation and Welfare," Econometrica, Econometric Society, vol. 68(2), pages 247-274, March.
  10. James J. McAndrews & Simon M. Potter, 2002. "Liquidity effects of the events of September 11, 2001," Economic Policy Review, Federal Reserve Bank of New York, issue Nov, pages 59-79.
  11. Morten L. Bech & Bart Hobijn, 2007. "Technology Diffusion within Central Banking: The Case of Real-Time Gross Settlement," International Journal of Central Banking, International Journal of Central Banking, vol. 3(3), pages 147-181, September.
  12. Antoine Martin, 2008. "Reconciling Bagehot with the Fed's response to September 11," Staff Reports 217, Federal Reserve Bank of New York.
  13. Furfine, Craig H., 2000. "Interbank payments and the daily federal funds rate," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 535-553, October.
  14. Daniel L. Thornton, 2006. "The daily liquidity effect," Working Papers 2006-020, Federal Reserve Bank of St. Louis.
  15. Huberto M. Ennis & Todd Keister, 2008. "Understanding monetary policy implementation," Economic Quarterly, Federal Reserve Bank of Richmond, issue Sum, pages 235-263.
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