Monetary Policy, Part 3: Reservation Rate and Arbitrage

 In part 3 we learned how the interest on reserve balances rate acts as a reservation rate for banks and how arbitrage steers the federal funds rate into the FOMC's target range.  


Now let's turn to how the FOMC decides on the appropriate level for the target range.  It might be easiest to think about a situation where the economy seems to be weakening.  Suppose the FOMC is meeting and looking at the economic data after a thorough review the FOMC determines that employment or inflation is too low and economic data suggests the economy may weaken further. In this case the FOMC might decide to use expansionary or accommodative monetary policy to provide stimulus for the economy.  That is the FOMC could lower its target range for the federal funds rate and the fed would decrease the interest on reserve balances rate. 


For example, if the FOMC lowers the target range by 25 basis points which is one-fourth percent then the fed is likely to also lower the interest on reserve balances rate by 25 basis points. Because of the economic concepts of reservation rate and arbitrage the lowering of the interest on reserve balance rate pulls the interest rate that banks charge each other in the federal funds market down. When the federal funds rate declines it starts a chain reaction. Other interest rates tend to follow which then affects overall financial conditions.  When interest rates decline the cost of borrowing money declines which encourages households to increase spending and businesses to increase investment.  


As spending increases so will production and businesses are likely to hire additional employees and spend more on other resources. As these increases in spending ripple through the economy unemployment decreases moving the unemployment rate down towards its full employment level and inflation possibly moves up. So when the economy is stalling the fed's monetary policy actions both lowering the target range for the federal funds rate and reducing the interest on reserve balances rate can be effective for moving the economy back towards maximum employment and price stability. To make sure we got this let's walk through when the FOMC thinks the economy is overheating or growing too fast. In this case the fed may decide to use contractionary or tighter monetary policy. That is the FOMC would raise its target range for the federal funds rate and the fed would simultaneously increase the interest on reserve balances rate. Now as the federal funds rate increases other interest rates rise and overall financial conditions tighten. 


Higher interest rates increase the cost of borrowing which discourages consumers from spending on some goods and services and reduces businesses investment in new equipment.  This increases both their savings rates. As spending decreases demand for resources including workers would lessen and inflationary pressures would diminish.  So by increasing the target range for the federal funds rate and increasing the interest on reserve balances rate the fed can move the economy back toward maximum employment and price stability.


To conclude our discussion about monetary policy let's sum up with a few key points. The federal reserve has a dual mandate from congress to promote maximum employment and price stability.  The fed moves the economy toward these goals by setting a target range for the federal funds rate. The fed uses inter-sun reserve balances as its primary policy tool to steer the federal funds rate into the target range. The setting of monetary policy affects other interest rates which ultimately influence broader financial conditions.  These factors affect consumer and producer decisions and ultimately the level of employment and inflation which promote a strong us economy.  


So now you know what it means when you hear news reports that the fed raised or lowered interest rates. It is really that the FOMC adjusted its target range and because of economic concepts like reservation rate and arbitrage, market interest rates moved appropriately and this affected consumer and businesses decisions. This is all done to move the economy forward in a healthy manner towards maximum employment and keeping prices stable.