Setting Interest Rates in the Modern Money Era

Abstract

Financial innovations have reduced banks’ reserve holdings. Some argue the Fed’s ability to set interest rates might be compromised. This concerns arises from a misunderstanding of Fed operations. Regardless of the quantity of reserve balances, the Fed can always set its federal funds rate target. The quantity of reserve balances or the relative size of the Fed’s operations are also unrelated to its influence on interest rates. That banks must settle their customers’ tax liabilities using reserve balances is sufficient for the Fed’s interest rate target to influence other interest rates.