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 bonds price goes up?

Interest rates go down

What happens when the bond price goes down?

Interest rates go up

The Fed uses that inverse relationship with bonds to decide…..

Whether to purchase or sell a particular type of bond.

That purchase of bonds by the Fed will also automatically increase the money supply…

Because the Fed will pay for those bonds by creating new money, which it hands over to the sellers of the bonds to pay them for the bonds that they just sold to the Fed.

How does the purchase of bonds by the Fed increase the money supply?

• Banks now hold extra reserves.

• With more reserves, banks can lend more money to households and businesses.

• Lending multiplies through the banking system (via the money multiplier effect), so the total money supply expands far beyond the initial purchase.

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.

Selling bonds

1. The Fed sells bonds from its inventory into the open market.

2. This increases the supply of 20-year Treasury bonds available for investors.

3. More supply → lower equilibrium price for those bonds.

4. Lower price → higher interest rate (yield).

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.

Why are interest rate on reserve balances and the overnight reverse repo rates important?

They are set, or administered, by the Fed to influence market equilibrium interest rates in the so-called money market.

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.

Money Market

An umbrella term that refers to a wide variety of short-term lending markets that involve commercial and financial loans that range in duration from overnight to 1 year.

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

Federal Funds Rate

• It’s the policy rate the Fed uses to signal its stance (expansionary, restrictive, neutral).

• In the U.S., it’s the overnight interest rate that large financial institutions charge each other to borrow reserves (money held at the Fed).

• Participants include banks, savings & loans, foreign bank branches, government-sponsored enterprises (like Fannie Mae), and securities firms

The Fed doesn’t directly set the federal funds rate….

it guides it using its administered rates:

• IORB (Interest on Reserve Balances): Paid to banks.

• ON RRP (Overnight Reverse Repo): Paid to nonbanks.

By raising or lowering IORB and ON RRP, the Fed influences where the federal funds rate settles:

• Raise IORB/ON RRP → effective federal funds rate rises.

• Lower IORB/ON RRP → effective federal funds rate falls.

Changing IORB and ON RRP doesn’t just move interest rates — it also changes the money supply:

• Higher IORB/ON RRP: Banks and nonbanks lend more money to the Fed → less money circulating in the economy → tighter money supply → higher interest rates overall.

• Lower IORB/ON RRP: Banks and nonbanks lend less to the Fed → more money circulating → looser money supply → lower interest rates overall.

Federal Funds rate

Fed’s main policy signal

IORB + ON RRP

The tools the Fed uses to keep the federal funds rate inside its target range.

Changing the target range

Changes money supply → shifts interest rates economy-wide.

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 interest rate of bonds.

• They influence the equilibrium price of bonds.

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

Select all the choices that accurately describe administered rates.

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

• Administered rates are directly controlled by the Fed.

• The Fed uses three administered rates.

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.

How does the Fed complete open-market operations?

By buying and selling bonds in public markets

Which of the following statements accurately describe the IORB?

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

• 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.

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.

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

Administered rate

What are the two administered rates used to influence market equilibrium interest rates in the money market?

• Interest rate on reserve balances

• Overnight reverse repo 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

What happens when the Fed raises the IORB rate?

It reduces the money supply and puts upward pressure on all interest rates.

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.

Which administered rate involves select nondepository financial firms as its eligible entities?

Overnight reverse repo rate

Which of the following statements accurately describes policy rates?

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

• They are easy to understand.

• They are used to communicate with the public.

• They are part of forward guidance programs

What is monetary policy stance?

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

The federal funds rate is the interest rate that

banks charge each other for lending reserves on an overnight basis

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

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

Monetary policy stance

The ________ rate is the interest rate banks charge on overnight loans to each other. (Enter one word in each blank.)

Federal Funds

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.

The federal funds rate is the interest rate that

banks charge each other for lending reserves on an overnight basis

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