In the US, the Fed alters the monetary policies majorly by using the federal funds rates. The federal fund market is a platform for overnight lending. On this platform, the banks that require funds can borrow from the banks that have excess money. In some scenarios such as during the financial crisis, the banks may borrow money from the Fed. However, “the discount rate of borrowing money from the Fed is higher than the federal fund rate” (Wright and Quadrini 1). This difference is intentional because it is meant to discourage borrowing from the Fed. Besides, continuous borrowing from the Fed is likely to attract investigation by the regulator. Therefore, it is not advisable for banks to use this option. The federal fund rate is a key pointer of the position of monetary policy of the state (Wright and Quadrini 1).
The diagram presented below shows the demand and supply curve in the federal fund market.
The quantity of reserve supplied is the summation of both the lent and non-borrowed funds. The price of supply is the federal funds rate. Thus, the supply curve depicts the relationship between the quantity of reserve supplies and the federal funds rate. The supply curve of Fed fund takes an inverted L-shape. The shape of the supply curve is explained by the differences in the discount rate and the federal fund rate. In the graph, it can be noted that the supply curve is horizontal and then it has a sharp turn to the vertical shape. The shape arises from the fact that if the federal fund rate exceeds the discount rate, then the banks demand for the loans offered by the Fed will rise sharply because of the clear difference in the interest rate. Besides, it creates an opportunity for arbitrage (Wright and Quadrini 1). This implies that banks will borrow at the cheapest discount rate and sell to other banks at the federal fund rate and make a profit. At this point the supply curve is perfectly elastic. The other section, the supply curve is perfectly inelastic. In this section, the level of supply of reserves in the open market operations is determined by the Fed (Hetzel 47). Therefore, this supply does not depend on the federal fund rate. This explains the inelastic section of the supply curve.
The law of demand applies in the case of federal funds. The law holds that there is an inverse relationship between the quantity demanded and price, holding other factors that affect demand constant. Therefore, a decrease in interest rate will result in an increase in the quantity of reserve demanded. The reserve is a summation of required and excess reserve. In the demand curve presented above, a decline in the federal funds rate makes the opportunity cost of keeping the excess reserves declines. This results in a rise in demand for the service. The equilibrium point is attained at the intersection of the supply curve and the demand curve. The point is shown using an arrow in the diagram above. The point gives the optimal quantity of reserve and the federal fund rate. The equilibrium interest rate is i2 while the equilibrium quantity of reserve is Rn. Once the equilibrium is attained, the section of the downward sloping demand curve that extend beyond the equilibrium is irrelevant and can be ignored because the supply is not changing (Wright and Quadrini 1). The shape of demand curve can now take the horizontal shape. This explains why the demand curve of the Fed market is downward slopping and then takes the horizontal shape.
Monetary policy tools
There are a number of monetary policy tools that can be used by the Fed. The two that will be discussed in this section are the federal fund rate and the reserve requirements. In the recent years, the Fed prefers to use the federal fund rate over reserves. If the Fed decides to use the reserve requirements, then a decline in the reserve requirement will cause an inward shift of the demand curve. This will cause a drop in the federal fund rate. In the recent days, this tool is not effective because banks have the ability to circumvent the mandatory reserve and this limits the ability of fed to execute monetary policy using this tool. Further, the activities carried out by banks during liquidity management have the potential of shifting the demand curves for reserves either inward or outwards (Mishkin 10). This results in a change of the expectation of net deposit inflows. In order to use the banks’ reserve requirement as a monetary policy tool, the Fed has to plan for these shifts. This has a lot of risks because the Fed is prone to missing the target. In some scenario, the Fed estimates are on target while in others they are off target by a big margin and it reduces the effectiveness if the reserve requirement as a monetary tool. These challenges explain why the Fed targets the federal fund rate as a monetary policy tool (Mankiw 481).
Hetzel, Robert. The Monetary Policy of the Federal Reserve: A History, New York: Cambridge University Press, 2008. Print.
Mankiw, Gregory. Principles of Macroeconomics, USA: Cengage Learning, 2008. Print.
Mishkin, Frederic. Monetary Policy Strategy. Cambridge, MA: MIT Press, 2007. Print.
Wright, Robert and Vincenzo Quadrini. Money and Banking: The Federal Funds Market and Reserves. 2014. Web.