The mechanicsofagracefulexit:Interestonreservesand segmentationinthefederalfundsmarket

To combatthefinancialcrisisthatintensifiedinthefallof2008,theFederalReserveinjected a substantialamountofliquidityintothebankingsystem.Theresultingincreaseinreserve balancesexerteddownwardpricepressureinthefederalfundsmarket,andtheeffective federalfundsratebegantodeviatefromthetargetratesetbytheFederalOpenMarket Committee.Inresponse,theFederalReservereviseditsoperationalframeworkfor implementingmonetarypolicyandbegantopayinterestonreservebalancesinanattempt to provideafloorforthefederalfundsrate.Nevertheless,followingthepolicychange,the effectivefederalfundsrateremainedbelownotonlythetargetbutalsotheratepaidon reservebalances.Wedevelopamodeltoexplainthisphenomenonandusedatafromthe federalfundsmarkettoevaluateitempirically.Inturn,weshowhowsuccessfultheFederal Reservemaybeinraisingthefederalfundsrateeveninanenvironmentwithsubstantial reservebalances.