Module 4, Section 7: Central Bank Operations in "Normal" Times

Overview of Module 4, Section 7: Central Bank Operations in "Normal" Times, which discusses mechanisms through which Central Banks manage the overnight bank-to-bank lending rate during “normal” economic periods. i.e. in periods prior to significant events like the 2008 Financial Crisis.

Main Themes

1. The Overnight Bank-to-Bank Lending Rate as a Key Monetary Policy Tool

• The overnight bank-to-bank lending rate (in the US, the federal funds rate), the interest rate at which banks lend reserves to each other overnight, is the central lever for monetary policy. Central banks aim to influence this rate to achieve broader economic objectives.

2. Supply and Demand of Reserves

• The federal funds rate is determined by the equilibrium between the supply and demand for bank reserves.
• Demand for Reserves: Banks demand reserves for various reasons, including meeting reserve requirements, hedging against liquidity risk, and potential speculative opportunities. The demand curve for reserves is downward sloping because as the federal funds rate decreases, banks have less incentive to lend out excess reserves and are more willing to hold onto them. Expectations of future interest rate increases can also shift the demand curve outward.
• Supply of Reserves: The Central Bank is the sole entity capable of creating reserves. The supply of Reserves is a policy decision and is represented by a vertical line at the quantity set by the central bank.

3. Central Bank Tools to Influence the Federal Funds Rate

• Open Market Operations: Buying and selling government securities (primarily Treasuries) is the primary tool to shift the supply of Reserves. Purchasing securities injects reserves into the banking system (shifting the supply curve outward and typically lowering the federal funds rate), while selling securities withdraws Reserves (shifting the supply curve inward and typically raising the federal funds rate).
• Discount Rate: This is the interest rate at which commercial banks can borrow money directly from the Central Bank. The discount rate acts as a ceiling for the federal funds rate because banks would be unlikely to borrow from other banks at a rate higher than what they could obtain from the Central Bank.
• Required Reserve Ratio: This is the fraction of a bank's deposits that they are legally required to hold in reserve at the Central Bank. Increasing the Reserve Ratio forces banks to hold more Reserves, shifting the demand curve for Reserves outward and typically increasing interest rates. Decreasing the ratio has the opposite effect.
• Interest on Reserve Balances (IORB): This is the interest rate that the central bank pays to commercial banks on the Reserves they hold at the central bank. The IORB acts as a floor for the federal funds rate because banks would be unwilling to lend Reserves to other banks at a rate lower than what they can earn by simply holding those reserves at the Central Bank. Prior to the financial crisis in the US, this rate was generally 0%.