THE EFFECT OF AN ACTIVE MARKET IN FEDERAL FUNDS ON THE TRANSMISSION OF MONETARY POLICY*

Abstract

THE FEDERAL-FUNDS MARKET is a medium used by commercial bankers in the United States for the short-term transfer of reserve balances among themselves; it is used both to eliminate reserve excesses and deficiencies and to generate additional lendable funds at particular banks. Part One of this study analyzes these functions to determine the possible economic consequences of the market. Part Two considers the context in which the market operates; a model of the financial sector of the economy is developed and is used to test a set of hypotheses based on the background obtained in Part One. The importance of the federal-funds market derives primarily from its role in the transmission of monetary-policy actions through the banking system. Because the market affects the liquidity of the system, because the interest rate charged for loans of federal funds affects the general level of short-term interest rates, and because changes in the volume of transactions in the market may affect the ability of a given volume of reserves to support bank credit, the actions taken by commercial bankers in their own interest could have important implications for the public interest. Earlier work on this problem divides into two distinct schools of thought. These may be identified as the lubrication and schools. The former holds that the federal-funds market may be expected to enhance the effectiveness of monetarypolicy actions by lubricating the mechanism by which policy actions are transmitted through the economy. The second school considers the market to be a potential offset to the monetary policy through its supposedly perverse effects on the velocity of the reserve base. To resolve this controversy, the present study attacks the issue in two ways: through the construction of a theoretical model of the market mechanism, which is seen to be part of a broader market for borrowed reserves on the one hand and part of a market for secondary reserve investments on the other; and through the use of an econometric model of the macroeconomic functions to which the federal-funds market may be related. The two schools of thought are summarized in a null hypothesis, that the market does not act to reduce the effectiveness of monetary policy. Finally, computer simulation of the macro-model is used to test the validity of this hypothesis. Two principal conclusions emerge from this study. The first is that monetary policy is indeed enhanced by the behavior of the federal-funds market, at least when policy decisions are effected through the use of open-market operations. There is some evidence that the effectiveness of the discount rate as a credit-control device may be slightly diminished by the existence of the funds market, but this finding does not appear of major significance. Marginal shifts in demands for cash balances are found to be an ineffective means of offsetting the effects of Federal Reserve policy. The second conclusion is that the federal-funds market serves an important function in the economy. It is important to the commercial banker, for it has become