CFA Level I · CFA Level I Exam · Monetary Policy
A central bank wants to raise short-term market interest rates in a country where banks hold large excess reserves and the central bank pays interest on reserves. Which tool is most likely the most effective way to establish a floor under the overnight rate?
Raising the interest rate paid on reserves is most effective. Banks with ample excess reserves will not lend at less than what the central bank pays them, so this rate acts as a floor for overnight rates. The other two actions add liquidity and lower rates.
- ARaising the interest rate paid on reservesCorrect
- BLowering the statutory reserve requirement
- CPurchasing government bonds in the open market
Explanation
With abundant excess reserves, banks will not lend overnight below the rate the central bank pays on reserves, so raising that rate lifts the floor under the overnight rate. Lowering reserve requirements and buying bonds would add liquidity and push rates down, which is the opposite effect.
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