The Federal Reserve implements its monetary policy objectives by intervening in the interbank market for overnight loans. In particular, it aims to change the supply of reserves available to commercial banks so that the (average) interest rate in this market equals an announced target rate. A recent change in legislation will give the Federal Reserve greater flexibility in this process by allowing it to pay interest on reserve balances. Together, the change and recent events in financial markets have renewed interest in the process of monetary policy implementation. This article presents a simple analytical framework for understanding this process. We use the framework to illustrate the main factors that influence a central bank’s ability to keep the market interest rate close to a target level. We also discuss how paying interest on reserves can be a useful policy tool in this regard.
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