- 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. These procedures require the central bank to set the supply of reserve balances precisely in order to implement the target interest rate.
- Because reserves play other important roles in the economy, the link can create tensions with other objectives of central banks. For example:
- The imbalance between the intraday need for reserves for payment purposes and the overnight demand leads central banks to provide low-cost intraday loans of reserves to participants in their payments systems, exposing central banks to credit risk and potential moral hazard problems.
- The link between money and monetary policy prevents central banks from increasing the supply of reserves to promote market liquidity in times of financial stress without compromising their monetary policy objectives.
- The link also relies on banks facing an opportunity cost of holding excess reserves, which leads them to expend effort to avoid holding these reserves and thereby makes the monetary system less efficient.
- Keister, Martin, and McAndrews consider an alternative approach to monetary policy implementation—a “floor system”—that can eliminate these tensions by “divorcing” the central bank’s quantity of reserves from its interest rate target.
- By paying interest on reserve balances at its target interest rate, a central bank can increase the supply of reserves without driving market interest rates below the target.
- The authors explain that a floor system allows a central bank to set the supply of reserve balances according to the payment or liquidity needs of financial markets. By removing the opportunity cost of holding reserves, the system also encourages the efficient allocation of resources in the economy.
- A version of the floor system was recently adopted by the Reserve Bank of New Zealand; this option for monetary policy implementation will be available to the Federal Reserve beginning in 2011.