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FRM Part II · FRM Exam Part II · Monetary and Fiscal Policy: Safeguarding Stability and Trust

A central bank wants to raise short-term market interest rates in an economy where banks hold abundant reserves because of earlier large-scale asset purchases. Which conventional policy tool is most directly used to steer overnight rates in this setting?

Raising the interest rate paid on reserves is the conventional tool, because with abundant reserves banks will not lend below the rate the central bank pays them. This sets a floor under overnight rates and transmits the tightening to the wider money market.

  1. ARaising the interest rate paid on reserves held at the central bankCorrect
  2. BRaising the statutory income tax rate on banks
  3. CImposing a cap on government bond issuance
  4. DIncreasing the central bank's holdings of long-term bonds

Explanation

In an abundant-reserves (floor) system, the rate paid on reserves sets a floor for overnight rates, since banks will not lend below what the central bank pays. Buying long-term bonds would ease, not tighten, conditions and is an unconventional tool. Tax and issuance caps are not monetary instruments.

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