extracted from econbrowser on
January 23, 2011
Prior to the fall of 2008, the focus of monetary policy was to choose a target for the fed funds rate, which is the interest rate banks charge each other for overnight loans of Federal Reserve deposits. In normal times, this rate was extremely sensitive to the quantity of those deposits created by the Fed, enabling the Fed to achieve its target for the fed funds rate with relatively modest additions or withdrawals of reserves. But by the end of 2008, the Fed had driven the fed funds rate essentially to zero and began paying interest on reserves. Since then, banks have been content to hold an arbitrarily large amount of excess reserves, and the overnight rate has been as low as it could go. In other words, the traditional tools of monetary policy have become completely irrelevant in the current setting.
The Fed has therefore been trying to find other ways to stimulate the economy by buying longer term assets. Hess Chung and colleagues expressed the idea this way:
A primary objective of large-scale asset purchases is to put additional downward pressure on longer-term yields at a time when short-term interest rates have already fallen to their effective lower bound. Because of spillover effects on other financial markets, such a reduction in longer-term yields should lead to more accommodative financial conditions overall, thereby helping to stimulate real activity and to check undesirable disinflationary pressures through a variety of channels, including reduced borrowing costs, higher stock valuations, and a lower foreign exchange value of the dollar. In many ways, this transmission mechanism is similar to the standard one involved in conventional monetary policy, which primarily operates through the influence on long-term yields of changes to the current and expected future path of the federal funds rate.
Although the transmission mechanism may be similar to conventional monetary policy, the implementation is quite different. To make a significant change in the supply of Federal Reserve deposits, in normal times the Fed only needed to buy or sell a few billion dollars worth of T-bills. But to make a significant change in the market's available supply of long-term Treasury securities, the purchase needs to be in the hundreds of billions of dollars, and even then, there are debates as to whether there would be any noticeable effects. Hence the interest in empirical studies of exactly what the effect of such operations appears to be.
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