SEMINAR 4 - QUESIONS

1. Read the article “Monetary Policy in a World with Interest on Reserves” by Charles T.
Carlstrom and Timothy Fuerst and answer the following questions about the innovative
monetary policy tool: interest paid on reserves (IOR).
a. In Figure 2 the banks’ demand for reserves is downward-sloping but turns flat
when the federal funds rate equals IOR. Could you explain the rationale behind
this shape?

We have: the quantity of reserves demanded = required reserves + excess

reserves. When funds rate is high, demand for reserves is low (downward sloping
that becomes flat), meaning that when the federal funds rate equals the interest
rate paid on excess reserves the demand curve for reserves is horizontal.

b. In Figure 1 the federal funds rate appears to be below IOR most of the time. Does
this contradict with the theoretical prediction of the model of demand and supply
of reserves? If so, how do you explain this fact?

The Federal Funds Rate typically hovers close to the IOR rate, but it can fluctuate
both above and below the IOR rate. This can occur due to the complexities of the
financial system and the various factors influencing short-term interest rates.
These deviations are not necessarily a contradiction but rather reflect the dynamic
and multifaceted nature of the financial markets.

c. If the federal funds rate target equals IOR, would a surge in demand for reserves
lead to an increase in federal funds rate?

If the federal funds rate target equals the Interest on Reserves (IOR), a surge in
demand for reserves would generally not lead to an increase in the federal funds
rate. This is because the Federal Reserve, by setting the IOR rate equal to the
federal funds rate target, is signalling its intention for the federal funds rate to
closely align with the IOR rate. Since the IOR rate is the rate paid by the Federal
Reserve on reserves held by banks, it serves as a floor for the federal funds rate.

d. If the federal funds rate target is slightly above IOR, like in Figure 2, how would
a flight for liquidity affect the federal funds rate?

A flight for liquidity could lead to upward pressure on the federal funds rate when
the target is slightly above the IOR rate. Because when there is a sudden increase
in the demand for liquidity, possibly due to uncertainty or concerns about
financial stability, banks may become more reluctant to lend in the federal funds
market. The reduced willingness of banks to lend and increased demand for
liquidity can put upward pressure on the federal funds rate. Banks that are
approached for loans may demand higher interest rates to compensate for the
 perceived increase in risk or to reflect the opportunity cost of forgoing the IOR
rate.

e. If the federal funds rate target is way above IOR, how would a surge in demand
for reserves affect the federal funds rate?

If the federal funds rate target is significantly above the Interest on Reserves
(IOR) rate, a surge in demand for reserves could potentially lead to an increase in
the federal funds rate, because of the following reasons:
- The IOR rate acts as a floor for the federal funds rate.

- A surge in demand for reserves and banks need additional reserves to meet their
requirements, they may be more willing to pay higher interest rates.
- In market dynamics perspective, the increased demand could put upward
pressure on the federal funds rate.
- Banks may find it more attractive to borrow reserves from other banks in the
federal funds market as banks seek higher returns.

f. The federal funds rate is currently virtually zero and the excess reserves held by
banks are on the order of $1.1 trillion. If conventional monetary policy tools were
used to raise the federal funds rate target to 1%, what exactly would the Fed have
to do? What problem might be created by such a policy?

Things that Fed might do:

- Sell government securities in the open market.
- By that, the Fed reduces the amount of reserves in the banking system, reducing
the overall level of reserves available and banks might compete more for the
remaining reserves, pushing up the federal funds rate.
- The Fed aims to reduce the supply of reserves in the banking system to a level
where the federal funds rate reaches the desired target of 1%.

Problems might be created:

- Bond prices to fall and interest rates on other securities to rise due to the
financial market disruptions.
- Significant market volatility.

g. If the Fed decides to raise IOR to 1% today, what would happen to excess
reserves, federal funds rate and the MBS and long-term Treasury securities it
purchased during LSAPs?

- Excess Reserves:

+ Making holding reserves more attractive for banks. As a result, banks may be
less inclined to lend excess reserves in the federal funds market.
+ Excess reserves in the banking system may increase as banks choose to hold
more reserves, attracted by the higher IOR rate.

- Federal Funds Rate:

+ Exert upward pressure on the federal funds rate, pushing it closer to the new
IOR rate.

- MBS and Long-Term Treasury Securities Purchased During LSAPs:

+ The Fed's decision to raise the IOR rate doesn't directly impact the Mortgage-
Backed Securities (MBS) and long-term Treasury securities it purchased during
LSAPs.
+ The impact on longer-term securities is more indirect. An increase in the IOR
rate might affect overall interest rate dynamics in financial markets, potentially
influencing yields on longer-term securities.