Measuring the Liquidity Effect

This paper measures the effect on the federal funds rate of an open-market operation. The paper deals with simultaneous-equations bias by developing a proxy for the errors the Federal Reserve makes in forecasting the extent to which Treasury operations will add or drain reserves available to private banks. These errors induce fluctuations in bank reserves which have measurable consequences for the federal funds rate. The paper estimates that a reduction in nonborrowed reserves of $30 million, if sustained for an entire fourteen-day reserve maintenance period, will cause the federal funds rate to rise by ten basis points. Copyright 1997 by American Economic Association.