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Implementation of Monetary Policy: How Do Central Banks Set Interest Rates?

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Central banks no longer set the short-term interest rates that they use for monetary policy purposes by manipulating the supply of banking system reserves, as in conventional economics textbooks; today this process involves little or no variation in the supply of central bank liabilities. In effect, the announcement effect has displaced the liquidity effect as the fulcrum of monetary policy implementation. The chapter begins with an exposition of the traditional view of the implementation of monetary policy, and an assessment of the relationship between the quantity of reserves, appropriately defined, and the level of short-term interest rates. Event studies show no relationship between the two for the United States, the Euro-system, or Japan. Structural estimates of banks' reserve demand, at a frequency corresponding to the required reserve maintenance period, show no interest elasticity for the U.S. or the Euro-system (but some elasticity for Japan). The chapter next develops a model of the overnight interest rate setting process incorporating several key features of current monetary policy practice, including in particular reserve averaging procedures and a commitment, either explicit or implicit, by the central bank to lend or absorb reserves in response to differences between the policy interest rate and the corresponding target. A key implication is that if reserve demand depends on the difference between current and expected future interest rates, but not on the current level per se, then the central bank can alter the market-clearing interest rate with no change in reserve supply. This implication is borne out in structural estimates of daily reserve demand and supply in the U.S.: expected future interest rates shift banks' reserve demand, while changes in the interest rate target are associated with no discernable change in reserve supply. The chapter concludes with a discussion of the implementation of monetary policy during the recent financial crisis, and the conditions under which the interest rate and the size of the central bank's balance sheet could function as two independent policy instruments.

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  • Benjamin Friedman & Kenneth Kuttner, 2010. "Implementation of Monetary Policy: How Do Central Banks Set Interest Rates?," Department of Economics Working Papers 2010-03, Department of Economics, Williams College.
  • Handle: RePEc:wil:wileco:2010-03
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    Cited by:

    1. Reis, Ricardo, 2016. "Funding quantitative easing to target inflation," LSE Research Online Documents on Economics 67883, London School of Economics and Political Science, LSE Library.
    2. Apergis, Nicholas & Christou, Christina, 2015. "The behaviour of the bank lending channel when interest rates approach the zero lower bound: Evidence from quantile regressions," Economic Modelling, Elsevier, vol. 49(C), pages 296-307.
    3. Koray Alper & Mahir Binici & Selva Demiralp & Hakan Kara & Pinar Ozlu, 2014. "Reserve Requirements, Liquidity Risk, and Credit Growth," Koç University-TUSIAD Economic Research Forum Working Papers 1416, Koc University-TUSIAD Economic Research Forum.
    4. Rhee, Hyuk Jae & Turdaliev, Nurlan, 2013. "Central bank transparency: Does it matter?," International Review of Economics & Finance, Elsevier, vol. 27(C), pages 183-197.
    5. Kotaro Ishi & Kenji Fujita & Mark R. Stone, 2011. "Should Unconventional Balance Sheet Policies Be Added to the Central Bank toolkit? a Review of the Experience so Far," IMF Working Papers 11/145, International Monetary Fund.
    6. Warren B. Hrunga & Jason S. Seligman, 2015. "Responses to the Financial Crisis, Treasury Debt, and the Impact on Short-Term Money Markets," International Journal of Central Banking, International Journal of Central Banking, vol. 11(1), pages 151-190, January.
    7. Adigozalov, Shaig & Huseynov, Salman, 2015. "İnflyasiya hədəflənməsinin əməliyyat çərçivəsi: ölkə təcrübələri AMB üçün nə vəd edir?
      [Operational framework of Inflation Targeting: what promises do country experiences make to the CBAR?]
      ," MPRA Paper 76349, University Library of Munich, Germany.
    8. Carla Soares & Paulo M. M. Rodrigues, 2013. "Determinants of the EONIA Spread and the Financial Crisis," Manchester School, University of Manchester, vol. 81, pages 82-110, October.
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    10. Dawid Johannes van Lill, 2017. "Changes in the Liquidity Effect Over Time: Evidence from Four Monetary Policy Regimes," Working Papers 704, Economic Research Southern Africa.
    11. repec:eee:jbfina:v:82:y:2017:i:c:p:1-19 is not listed on IDEAS
    12. Alfonso Palacio-Vera, 2011. "Quantitative Easing, Functional Finance, and the "Neutral" Interest Rate," Economics Working Paper Archive wp_685, Levy Economics Institute.
    13. Carla Soares & Paulo M.M. Rodrigues, 2010. "Determinants of the EONIA spread and the financial turmoil of 2007-2009," Economic Bulletin and Financial Stability Report Articles, Banco de Portugal, Economics and Research Department.
    14. Koray Alper & Mahir Binici & Selva Demiralp & Hakan Kara & Pınar Ozlu, 2016. "Reserve Requirements, Liquidity Risk, and Bank Lending Behavior," Koç University-TUSIAD Economic Research Forum Working Papers 1612, Koc University-TUSIAD Economic Research Forum.
    15. Carrera, César, 2012. "Políticas de Encajes y Modelos Económicos," Working Papers 2012-006, Banco Central de Reserva del Perú.
    16. Annette Vissing-Jorgensen & Adair Morse & Anna Cieslak, 2015. "Stock returns over the FOMC cycle," 2015 Meeting Papers 1197, Society for Economic Dynamics.

    More about this item

    Keywords

    Reserve supply; reserve demand; liquidity effect; announcement effect;

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects

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