The Market for Reserves and the Policy Rate
The overnight policy rate is set in the market for reserves. Reserve demand slopes down but flattens into a floor at the interest the central bank pays on reserves, since no bank lends overnight below what it earns risk-free. Reserve supply is vertical at the amount the central bank provides. Open market operations shift supply and the interest-on-reserves rate shifts the floor, and together they pin the equilibrium rate.
Try it yourself
The overnight policy rate is set where reserve demandmeets the central bank’s vertical reserve supply. Demand is fenced above by the discount rate and floored just below the IORB rate. Slide supply left to move from the ample floor system into the scarce corridor.
Why it matters
Banks bid for overnight funds the way buyers bid for any good. They will not pay more than the rate at which they can borrow from the central bank and will not lend for less than the rate the central bank pays them on reserves, so those two administered rates fence the market rate in. Where supply lands inside that fence decides whether reserves are scarce or ample.
Worked examples
Reserves are ample and the demand curve already sits on its flat floor. The central bank makes a small open market purchase. What happens to the overnight rate?
Almost nothing. On the flat part of demand the rate already equals the interest paid on reserves, so adding more reserves slides the vertical supply line along the floor and leaves the rate pinned at that floor. In an ample-reserves regime the central bank steers the rate by moving the floor, not by fine-tuning the quantity.
Reserves are scarce, so supply meets demand on the downward-sloping part. The central bank sells securities. What happens to the rate?
The vertical supply line shifts left, moving up the downward slope of demand, so the overnight rate rises. In a scarce-reserves regime small quantity changes move the rate, which is the classic open market operations channel.
Common mistakes
- ✗Reserve demand keeps falling forever as the rate drops. It flattens at the interest-on-reserves rate, because below that a bank would rather just hold reserves than lend.
- ✗Open market operations always move the policy rate. In an ample-reserves regime the rate sits on the flat floor, so adding or draining reserves barely moves it and the floor rate does the work.
- ✗Reserve supply responds to the market rate like an ordinary supply curve. It is set by the central bank, so it is effectively vertical at the chosen quantity.
Revision bullets
- •Policy rate is set where reserve supply meets reserve demand
- •Demand flattens at the interest-on-reserves floor, supply is vertical
- •Scarce reserves: quantity moves the rate. Ample reserves: the floor moves the rate
Quick check
In an ample-reserves regime, the central bank steers the overnight rate mainly by
The reserve demand curve flattens out at low rates because
Connected topics
Sources
- Mishkin (2018), Ch. 16Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.The market for reserves, the supply and demand for reserves, how the policy tools set the equilibrium overnight rate, and scarce- versus ample-reserves frameworks with interest on reserves as the floor.