Understanding Federal Funds Rate and Reservation Rate part 3

Key Concepts:

  • Banks and Interest Earnings

    • Banks can earn interest on deposits at their Federal Reserve Bank or through lending to other banks in the federal funds market.

    • When funds are held in reserve balance accounts, banks earn the interest on reserve balances rate.

    • When banks lend to other banks from their reserve balance, they earn the federal funds rate.

  • Choosing Investment Options

    • Banks evaluate where to invest excess funds based on interest rates available.

Reservation Rate:

  • Definition

    • The reservation rate is the minimum return a bank will accept for lending funds.

    • If the interest on reserve balances exceeds the rate available from lending, banks prefer depositing it at the Fed.

  • Example

    • Option 1: Deposit funds at the Fed with an interest rate of 2.5 ext{%}.

    • Option 2: Lend funds in the federal funds market at an interest rate of 2 ext{%}.

    • The bank will prefer Option 1 since it offers a higher return (2.5 ext{%} > 2 ext{%}).

Role of Arbitrage:

  • Definition

    • Arbitrage is the practice of simultaneously buying and selling assets to profit from interest rate differences.

  • How Arbitrage Affects Rates

    • In the example with a 2.5 ext{%} interest on reserve balances and a 2 ext{%} federal funds rate:

    • Banks may borrow at 2 ext{%} and deposit at 2.5 ext{%}, making a profit of 0.5 ext{%} (50 basis points).

    • Increased borrowing in the federal funds market by banks results in higher rates due to increased demand.

  • Impact on Federal Funds Rate

    • Arbitrage pushes the federal funds rate up to align closely with the interest on reserve balances rate, preventing significant divergence between the two rates.

The Federal Reserve's Strategy:

  • Interest on Reserve Balances Impact

    • The Federal Reserve influences the federal funds rate via the interest on reserve balances rate.

    • When the FOMC raises the target range, the Fed increases the interest on reserve balances rate, prompting the federal funds rate to rise.

    • Conversely, a decrease in the interest on reserve balances rate leads to a lower federal funds rate within the new target range.

Conclusion:

  • Understanding these economic concepts is crucial for comprehending how the Fed utilizes interest on reserve balances to guide the federal funds rate towards its target range, which supports its dual mandate of maximum employment and price stability.

  • More insights will be shared in the next installment about how the Fed sets policy rates accordingly.