Declining Required Reserves, Funds Rate Volatility, and Open Market Operations

Abstract

The standard view of the monetary transmission mechanism rests on the central bank's ability to manipulate the overnight interest rate by controlling reserve supply. In the 1990s, there was a significant decline in level of reserve balances in the U.S. accompanied at first by an increase in the funds rate volatility. However, following this initial rise, volatility declined. In this paper, we find evidence of a structural break in volatility. We then estimate a tobit model of the major types of temporary open market operations and conclude that there have been changes in the Desk's reaction function that played a major role in controlling volatility.

Keywords: Required reserves, open market operations, trading Desk

JEL Classification: E0, E4, E5