Understanding Monetary Policy Implementation

O ver the last two decades, central banks around the world have adopted a common approach to monetary policy that involves targeting the value of a short-term interest rate. In the United States, for example, the Federal Open Market Committee (FOMC) announces a rate that it wishes to prevail in the federal funds market, where commercial banks lend balances held at the Federal Reserve to each other overnight. Changes in this shortterm interest rate eventually translate into changes in other interest rates in the economy and thereby influence the overall level of prices and of real economic activity. Once a target interest rate is announced, the problem of implementation arises: How can a central bank ensure that the relevant market interest rate stays at or near the chosen target? The Federal Reserve has a variety of tools available to influence the behavior of the interest rate in the federal funds market (called the fed funds rate). In general, the Fed aims to adjust the total supply of reserve balances so that it equals demand at exactly the target rate of interest. This process necessarily involves some estimation, since the Fed does not know the exact demand for reserve balances, nor does it completely control the supply in the market. A critical issue in the implementation process, therefore, is the sensitivity of the market interest rate to unanticipated changes in supply and/or demand.