With the debate started by Krugman and Interfluidity on floors, base money, and monetary policy (and more), it might be useful with a primer on the difference between corridors and floors in monetary policy.
Fortunately, the NY Fed’s Liberty Street blog wrote such a post back in April last year.
Here’re the essentials:
Once the FOMC determines a target interest rate, the Federal Reserve has different ways of using the tools described above to implement this decision. A corridor-style system is depicted in the left panel of the figure below: The discount rate is set above the target interest rate and the interest-on-reserves rate is set below it. These two rates form a “corridor” that will contain the market interest rate; the target rate is often (but not always) set in the middle of this corridor. Open market operations are then used as needed to change the supply of reserve balances so that the market interest rate is as close as possible to the target. Notice in particular that this approach relies on setting the supply of balances so that it falls in the inelastic region of the demand curve.
The right panel of the figure depicts a floor-type system. In this approach, the interest-on-reserves rate is set very close or equal to the target rate. The open market desk again supplies reserve balances as needed to steer the market interest rate to the target. In this case, the appropriate supply of balances falls in the elastic region of the demand curve and the market rate is close to the floor created by the interest-on-reserves rate.
It is worth emphasizing that both approaches are consistent with the view, expressed by the FOMC in June 2011, that the quantity of reserve balances should be kept to the “smallest levels that would be consistent with the efficient implementation of monetary policy.” While the level of balances would be larger under a floor-type system, in each case this level is set precisely to meet banks’ demand for balances at the target interest rate.
Comparing Systems
Each of these approaches offers some advantages. Central banks have much more experience with corridor-type systems, in part because it is possible to operate one without paying interest on reserves. Notice that, in the left panel of the figure above, the approach would be largely unchanged if the interest-on-reserves rate were set to zero. A floor-type system, in contrast, requires that the interest-on-reserves rate be close to the FOMC’s target. Prior to October 2008, the Federal Reserve did not pay interest on reserve balances and operated a corridor-type system with the interest-on-reserves rate set to zero.While a floor-type system is less familiar, it helps promote the efficient functioning of the financial system by allowing banks to earn the market rate of interest on all of their reserve balances. In a corridor-type system, the interest-on-reserves rate is lower than the market interest rate. Banks thus have an incentive to invest time and effort trying to economize on the quantity of balances they hold by lending extra funds to other banks or by purchasing other assets. However, all of the balances created by the Federal Reserve must be held by someone, so these efforts by individual banks to avoid holding balances simply cancel out. A floor-type system removes the incentive for banks to undertake such efforts. It also supplies banks with a larger quantity of this perfectly safe, liquid asset. A more detailed discussion of these efficiency concerns, and other differences between corridor-type and floor-type systems, can be found in two Federal Reserve publications, “Divorcing Money from Monetary Policy” and “Understanding Monetary Policy Implementation.”
Hat tip to Stacy.
