|Book Edition||7th Edition|
How does the Federal Reserve impact short-run nominal interest rates?
The Federal Reserve can boost interest rates by raising the rate it pays on needed and excess reserves. 9 Banks will not lend money to one another at a lower interest rate than they get for their reserves. The fed funds rate now has a floor. 10 The Fed was permitted to pay interest on reserves under the Emergency Economic Stabilization Act of 2008.
Banks are required by law to determine their own effective fed funds rate. The Fed uses open market operations, the reserve requirement, and the discount rate to substantially affect this rate. To fine-tune interest rates, the Fed can pay interest on bank reserves and acquire repos or reverse repos.
Reverse repurchase agreements, commonly known as reverse repos, can also be raised by the Fed. Overnight, the Fed "borrows" money from its member banks, using Treasurys on hand as collateral. There is no currency or Treasurys exchanged, therefore it isn't a true loan.
The interest is deposited into the banks' accounts the next day by the Fed. Because banks won't lend to each other at a lower rate than what they're getting on reverse repos, the fed funds rate is kept in check.