[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

Chapter 32
THE FEDERAL
RESERVE AND
INTEREST RATES
∂
In the previous chapter, we assigned a key role to the Federal Reserve’s response
to inflation in the model of short-run fluctuations. The downward slope of the
aggregate demand–inflation curve reflected the Fed’s policy reaction as inflation
varied. What we did not discuss, though, was exactly how the Federal Reserve
is able to move interest rates. Chapter 28 did examine the three basic tools of the
Federal Reserve—open market operations, the discount rate, and reserve requirements—but
there the focus was on how these are used to influence bank reserves
and the money supply. The objective in this chapter is to explain how the Fed uses
its tools to implement monetary policy by influencing market interest rates.
The Federal Funds Market
At meetings of its policymaking committee, the Federal Open Market Committee
(FOMC), the Fed establishes a target interest rate. The FOMC focuses on the
federal funds rate; and to understand what this key interest rate is and how the
Fed is able to affect the economy, we need to understand the workings of a very
important financial market, the federal funds market.
We usually think of banks lending to consumers wishing to buy cars or homes,
or to firms seeking to build factories or stores or to finance their inventories. But
banks also lend to each other. Often, a bank’s need is very short-term; AmericaBank
might borrow from NationalBank and repay the loan just one day later. Banks borrow
and lend funds overnight in the federal funds market, and the interest rate on these
loans is the federal funds rate. Before examining this market in detail, we will first
look at the details of what the Fed does every business day to influence the level of
reserves and the federal funds rate.
715