Money, Banking, and Financial Markets : Econ. 212. Stephen G. Cecchetti Monetary Policy: Using Interest Rates to Stabilize the Domestic Economy. The Federal Reserve’s Monetary Policy Toolbox The central bank can control the quantity of reserves that commercial banks hold.
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Stephen G. Cecchetti Monetary Policy:
Using Interest Rates to Stabilize the Domestic Economy
i. Open market operations are used to control the federal funds rate.
ii. The Fed forecasts the demand for reserves each day and then supplies the amount needed to meet the demand at the target rate.
i. The Fed sets the primary lending rate 100 basis points above the target federal funds rate.
ii. In setting the primary lending rate above the target federal funds rate, the Fed is attempting to stabilize the interest rate on overnight interbank lending.
iii. The Fed also makes loans to banks in distress, through the secondary lending facility, and to banks in need of seasonal liquidity.
Reserve requirements are used to stabilize the demand for reserves.
i. Banks are required to hold reserves against certain deposits.
ii. Banks can hold either deposits at Federal Reserve Banks or vault cash, neither of which earns interest.
iii. Reserves are accounted for in such a way that everyone knows the level of reserves that is required several weeks before banks must hold them.