The Role of the Federal Funds Market: Note

There are at least three views of the role of the federal funds market. Probably the most widely held view is that it is an offset to monetary policy expanding and contracting in response to tightening and easing by the monetary authority (see [1] for a thorough treatment). That is, its dominant function is as a substitute for borrowing from the Federal Reserve. According to this view, we should expect variations in federal funds borrowing to be negatively associated with variations in bank reserves. An alternative view is that federal funds borrowing is a means by which increases in bank reserves are effectively distributed throughout the banking system. The Fed accommodates shifts in credit demands by limiting movements in the federal funds rate. According to this accommodation rationale, variations in federal funds borrowing would be positively associated with variations in bank reserves. A third empirical proposition is implicit in the intermediation among intermediaries role of the federal funds market. Federal funds borrowing and lending take place because the distribution of lending opportunities differs from the distribution of bank deposits. In this financial function the role of short-run changes in reserves is diminished. Indeed, we would anticipate no relationship between changes in bank reserves and the federal funds market.