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 in public markets to influence interest rates and the money supply

What happens when the Fed buys bonds?

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

• Bond demand rises → bond prices rise.

• Interest rates fall (inverse relationship between price and yield).

What happens when the Fed sells bonds?

• Money supply decreases (Fed removes money from circulation).

• Bond supply rises → bond prices fall.

• Interest rates rise.

What are administered rates?

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

Why are administered rates important?

They act as outside anchors on market interest rates, giving the Fed strong control over short-term lending costs.

What is the IORB?

The interest rate the Fed pays banks on reserves they keep overnight at the Fed. It’s like banks lending money to the Fed.

How does the IORB influence money market rates?

• If IORB = 2%, banks won’t lend in the money market below 2%.

• Other borrowers must offer ≥ 2% to compete.

• Sets a “floor” under short-term interest rates

How does changing the IORB affect the money supply?

• Raising IORB → banks park more money at Fed → money supply shrinks → interest rates rise.

• Lowering IORB → banks lend more → money supply grows → interest rates fall.

What is the ON RRP?

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

Why does the Fed use ON RRP?

To influence nonbank lenders in the money market, complementing IORB for banks.

How does ON RRP set a floor under rates?

Nonbanks won’t lend below the ON RRP rate, so nearly all money market rates stay at or above that level.

How does changing ON RRP affect the money supply?

• Raising ON RRP → nonbanks lend more to Fed → money supply shrinks → interest rates rise.

• Lowering ON RRP → nonbanks lend less → money supply grows → interest rates fall

What is the discount rate?

The interest rate banks pay when borrowing directly from the Fed, with collateral.

What is its purpose?

Provides emergency liquidity during bank runs or financial crises when banks can’t borrow elsewhere.

Why is the discount rate set higher than IORB?

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

What is the federal funds rate?

The Fed’s policy rate — the interest rate on overnight loans of reserves between large financial institutions

How does the Fed control it?

By adjusting IORB and ON RRP so the effective federal funds rate stays within the Fed’s target range (usually 0.25% wide).

Why is it important?

It’s the headline rate the public sees, signaling whether policy is expansionary (lower rates) or restrictive (higher rates).

What is forward guidance?

The Fed’s communication about its future policy intentions, shaping expectations of businesses and households.

How does it affect the money supply?

• Positive guidance → more loans issued → checkable deposits rise → money supply grows.

• Negative guidance → fewer loans issued → deposits shrink → money supply contracts.

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

Because the Fed can create unlimited money at any time. This guarantees it can always pay interest on IORB/ON RRP or lend at the discount rate, so markets fully trust its ability to anchor short‑term interest rates.

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