First, the deposit rate is set equal to the target rate, instead of below it. In other words, in this system the central bank targets the floor of the channel, rather than some point in the interior. Second, the reserve supply is chosen so that it intersects the flat part of the demand curve generated by the deposit rate (Exhibit 3), rather than intersecting the downward-sloping part of the curve. Supply and demand will then cross exactly at the target rate, as desired.
“The key feature of this system is immediately apparent in the exhibit: the equilibrium interest rate no longer depends on the exact quantity of reserve balances supplied. Any quantity that is large enough to fall on the flat portion of the demand curve will implement the target rate…”
I haven’t thus far offered explanations for why these changes might be desirable, and how they relate to the broader context of monetary policy generally. More on that tomorrow.
By David Altig, senior vice president and director of research at the Federal Reserve Bank of Atlanta
