15.1 Tools of Monetary Policy

What are open‑market operations?

The Fed’s buying and selling of U.S. government bonds or federal agency bonds to manage money supply and interest rates.

Why are they called “open‑market” operations?

Because the transactions occur in public bond markets that are open to all participants.

What happens when the Fed buys bonds?

• Money supply increases (Fed creates new money to pay sellers).

• Bond demand rises, prices go up.

• Interest rates on those bonds fall.

What happens when the Fed sells bonds?

• Money supply decreases (cash is removed from circulation).

• Bond supply rises, prices go down.

• Interest rates on those bonds rise.

What is the inverse relationship between bond prices and interest rates?

When bond prices rise, interest rates fall; when bond prices fall, interest rates rise.

What are administered rates?

Interest rates directly set by the Fed (not market‑determined) to influence lending and borrowing decisions.

Why are administered rates powerful?

Because they are independent of market forces and can decisively influence equilibrium interest rates.

Which two administered rates affect the money market?

• Interest rate on reserve balances (IORB).

• Overnight reverse repo rate (ON RRP).

What is the money market?

A collection of short‑term lending markets (loans from overnight to 1 year) including Treasury bills, CDs, commercial paper, interbank loans, money market mutual funds, and repos.

Why is the money market important?

It provides safe, liquid, short‑term lending opportunities and accounts for about one‑third of all lending and credit in the U.S. economy.

What is the Interest Rate on Reserve Balances (IORB)?

The rate the Fed pays banks on money they keep overnight in reserve accounts at the Fed.

How does the IORB influence money market rates?

Banks won’t lend at rates below IORB, so it sets a floor under money market interest rates.

What happens when the Fed raises the IORB rate?

Banks park more money at the Fed → money supply decreases → overall interest rates rise.

What happens when the Fed lowers the IORB rate?

Banks lend more into the economy → money supply increases → overall interest rates fall.

What is the Overnight Reverse Repo Rate (ON RRP)?

The rate the Fed pays nonbank financial firms (like money market funds) for overnight loans to the Fed via reverse repo transactions.

Why does the Fed use ON RRP separately from IORB?

Because only banks can earn IORB, ON RRP lets the Fed influence nonbanks in the money market.

How do IORB and ON RRP together affect money market rates?

They create a “floor” — banks won’t lend below IORB, nonbanks won’t lend below ON RRP.

Why is ON RRP usually set slightly below IORB?

To manage banks and nonbanks independently, giving each group different incentives.

What happens when the Fed raises the ON RRP rate?

Nonbanks lend more to the Fed → money supply decreases → interest rates rise.

What is the Discount Rate?

The interest rate at which banks can borrow directly from the Fed, using collateral like Treasury bonds.

Why is the discount rate important?

It provides emergency liquidity during bank runs or financial crises when the money market freezes.

Why is the discount rate always set higher than IORB?

To prevent arbitrage (banks borrowing cheaply from the Fed and immediately lending back at a higher IORB rate).

When do banks typically use the discount rate?

Only in emergencies, since it’s more expensive and carries stigma compared to market borrowing.

Why does the Fed have 100% credibility in enforcing administered rates?

Because it can create unlimited new money at any time to pay interest or provide loans.

How does the Fed enforce IORB and ON RRP rates?

By paying interest on overnight loans from banks (IORB) and nonbanks (ON RRP), ensuring they prefer lending to the Fed at those rates rather than at lower market rates.

How does the Fed enforce the discount rate?

By lending unlimited funds to banks during panics or crises, backed by collateral, calming financial markets

What is forward guidance?

The Fed’s communication of its economic outlook and future policy actions to shape public expectations and decisions.

Why is forward guidance powerful?

It can influence spending and investment decisions, altering the economy’s trajectory even before rates change.

How does positive forward guidance affect the money supply?

Encourages more loans → increases checkable deposits → expands money supply.

How does negative forward guidance affect the money supply?

Fewer loans demanded/granted → checkable deposits shrink → money supply decreases.

What is the federal funds rate?

The Fed’s policy rate: the overnight lending rate financial firms and government agencies charge each other for funds held at the Fed.

How does the Fed manage the federal funds rate?

By setting a target range (usually 0.25% wide) and adjusting IORB and ON RRP so the effective rate stays within that range

Why does the Fed announce the federal funds target range publicly?

For simplicity — it signals the stance of monetary policy in a way the public can easily understand.

How do changes in IORB and ON RRP affect the money supply?

• Higher rates: More money lent to Fed → money supply decreases → interest rates rise.

• Lower rates: Less money lent to Fed → money supply increases → interest rates fall.

Select all the choices that accurately describe administered rates.

• Administered rates are directly controlled by the Fed.

• Administered rates serve as an outside influence on many equilibrium interest rates.

• The Fed uses three administered rates.

What is the interest rate Federal Reserve banks charge on loans they make to commercial banks and thrifts?

Discount rate

What is the term for the financial market in which short-term, low-risk debt securities are traded, including U.S. Treasury bills, overnight loans of bank reserves, and commercial paper?

Money market

Which of the following statements accurately describes policy rates?

• They are easy to understand.

• They are part of forward guidance programs.

• They are used to communicate with the public.

• They explain whether or not the central bank feels expansionary, restrictive, or neutral.

Which of the following statements accurately describes the federal funds rate?

• The effective federal funds rate is always within the federal funds target range.

• The Fed can lower the effective federal funds rate by lowering the IORB and ON RRP rates.

Which of the following statements accurately describes the three administered rates?

• The discount rate is paid to the Fed; the other rates are paid by the Fed.

• Each of the three rates was lowered between 2020 and 2022 because of the pandemic.

What is a short-term interest rate that a central bank manages to help communicate the stance of monetary policy as well as to achieve its monetary policy goals?

Policy rate

What is the 0.25 percent wide range used by the Fed to guide its policy rate and to facilitate forward guidance communications?

Federal funds target range

Which of the following three choices accurately describes the main effects of the Fed's purchases and sales of bonds in open-market operations?

• They influence the supply of money available to the public.

• They influence the interest rate of bonds.

• They influence the equilibrium price of bonds.

What is the term for a central bank's disposition regarding how it sees the current and future state of the economy?

Monetary policy stance

What is the term for an interest rate set by a central bank to help it manage market-determined interest rates?

Administered Rate

Which of the following statements accurately describe the IORB?

• The IORB is one of the three administered rates.

• The IORB helps the Fed control the rate at which banks are willing to lend into the money market.

• Deposits paid at the IORB are functionally equivalent to loans.

What are ways in which the Fed uses the overnight reverse repo rate?

• It raises the rate to decrease the money supply and increase interest rates.

• It has traditionally set the ON RRP rate about 0.10 percentage point below the IORB rate.

What is monetary policy stance?

Whether the central bank sees the the outlook for monetary policy as expansionary, restrictive, or neutral

What are the consequences of a negative interest rate?

• People do not want to leave their money in their checking accounts.

• The reserves in the banking system are reduced.

What is the effect of the Fed's purchases and sales of bonds?

The Fed buys and sells large quantities of bonds to influence the equilibrium price and interest rates on bonds.

Which of the following choices accurately describe the money market?

• It is made up of lending markets that involve commercial and financial loans.

• It involves loans lasting from overnight to one year.

Which of the following statements accurately describe the discount rate?

• It is set by the Fed to be higher than the IORB rate.

• It is useful during bank runs and major crises.

What is the term for the purchases and sales of U.S. government securities that the Federal Reserve System undertakes in order to influence interest rates and the money supply?

Open-market operations

Which of the following choices accurately describe the overnight reverse repo rate?

• It lets the Fed provide nonbanks with an option besides money market investments.

• It is administered separately from the interest rate on reserve balances.

• It uses bonds as collateral in case of default.