Authors: Todd Keister, Antoine Martin, and James McAndrews
Many central banks implement monetary policy in a way that maintains a tight link between the stock of money and the short-term interest rate. In particular, their implementation procedures require that the supply of reserve balances be set precisely in order to implement the target interest rate. Because bank reserves play other key roles in the economy, this link can create tensions with other important objectives, especially in times of acute market stress. This article considers an alternative approach to monetary policy implementation -- known as a “floor system”-- that can reduce or even eliminate these tensions. The authors explain how this approach, in which the central bank pays interest on reserves at the target interest rate, “divorces” the supply of money from the conduct of monetary policy. The quantity of bank reserves can then be set according to the payment or liquidity needs of financial markets. By removing the opportunity cost of holding reserves, the floor system also encourages the efficient allocation of resources in the economy.