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

The federal funds market also functions as the core of a more extensive overnight market for credit free of reserve requirements and interest rate controls. Nonbank depositors supply funds to the overnight market through repurchase agreements (RPs) with their banks. Under an overnight repurchase agreement, a depositor lends funds to a bank by purchasing a security, which the bank repurchases the next day at a price agreed to in advance. In 1991, overnight RPs accounted for about 25 percent of overnight borrowings by large commercial banks. Banks use RPs to acquire funds free of reserve requirements and interest controls from. | Implementation of Monetary Policy How Do Central Banks Set Interest Rates Benjamin M. Friedman and Kenneth N. Kuttner1 June 21 2010 1Economics Department Harvard University Cambridge MA 02138 bfriedman@harvard.edu Friedman and Economics Department Williams College Williamstown MA 01267 ken-neth.n.kuttner@williams.edu Kuttner . Prepared for the Handbook of Monetary Economics vol. 3 Elsevier forthcoming . We are grateful to Huw Pill for thoroughgoing and very helpful comments on an earlier draft to Spence Hilton Warren Hrung Darren Rose and Shigenori Shiratsuka for their help in obtaining the data used in the original empirical work developed here to Toshiki Jinushi and Yosuke Takeda for their insights on the Japanese experience and to numerous colleagues for helpful discussions of these issues. Abstract 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 .