1 Interest on reserve balances a In October 2008 the Fed introduced a new tool

1 interest on reserve balances a in october 2008 the

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1. Interest on reserve balances: a. In October 2008, the Fed introduced a new tool when it began for the first time to pay interest on banks’ required reserve and excess reserve deposits. 3 This interest rate is called the IOER, which stands for i nterest r ate on e xcess r eserves. Reserve requirements impose an implicit tax on banks because banks could otherwise receive interest on the funds by lending them out or by investing them. The Fed reduces the size of this tax by paying interest on reserve balances. b. The Fed also gains a greater ability to influence banks’ reserve balances. By raising the interest rate it pays, the Fed can increase banks’ holdings of reserves, potentially restraining banks’ ability to extend loans and increase the money supply. By reducing the interest rate, the Fed can have the opposite effect. c. Finally, the interest rate the Fed pays on reserves can help put a floor on short-term interest rates because banks will typically not lend funds elsewhere at an interest rate lower than the rate they can earn on reserves deposited with the Fed. 2. overnight reverse repurchase agreement facility a. the Fed’s traditional means of raising short-term interest rates was to raise its target for the federal funds rate—the rate banks charge each other on overnight loans—by using open market sales to reduce the level of reserves in the banking system b. But with banks still holding trillions of dollars of excess reserves years after the financial crisis, the Fed could not use open market sales to increase its target for the federal funds rate. Instead, in December 2015, when the Fed raised its target for the federal funds rate, it did so by increasing the interest rate it paid banks on reserves and the interest rate it offered on reverse repurchase agreements c. repurchase agreement (or repo ) is a short-term loan backed by collateral. With a repurchase agreement, the Fed buys a security from a financial firm, which promises to buy it back from the Fed the following day. d. With a reverse repurchase agreement (sometimes called a matched sale-purchase agreement or reverse repo ), the Fed does the opposite: It sells a security to a financial firm while at the same time promising to buy the security back the next day e. In effect, the Fed is borrowing funds overnight from the firm that purchases the security. By raising the interest rate it is willing to pay on these loans, the Fed reduces the willingness of the firms it deals with in these transactions—its counterparties —to lend at a lower rate f. The Fed refers to overnight reverse repurchase agreements as ON RRPs and the interest rate on these securities as the ON RRP rate 3. term deposit facility a. In April 2010, the Fed announced that it would offer banks the opportunity to purchase term deposits, which are similar to the certificates of deposit that banks offer to households and firms. The Fed offers term deposits to banks in periodic auctions. The
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