Abstract
Financial innovations have reduced banks' reserve holdings significantly. Some argue the Fed's ability to set interest rates might eventually be compromised as a result. This concern 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 circulating, or the relative size of the Fed's operations, is also unrelated to its influence on other 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.
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