Ihrig et al. (2015) review the implementation of monetary policy in the US prior to and after the Financial Crisis of 2008-2009. In describing the Fed's approach prior to the crisis, based on open market operations (OMO) to fine-tune the supply of reserves, they include a supply-demand graph that shows that the demand initially exhibits a flat profile; then increases as the Federal Funds Rate (FFR) decreases, until reaching a lower 0% bound (see figure below).

To justify why the Fed was able to influence the level of the FFR using OMO, they write (my emphasis):

A key feature of the supply and demand framework for reserves prior to the financial crisis is that the supply curve intersected the demand curve on the downward-sloping portion of the demand curve. This meant that the Fed was able to achieve the FOMC’s desired target level for the federal funds rate by using OMOs to adjust the supply of reserve balances.

However they do not provide any rationale for this statement. Is there any literature or justification for this feature? It is critical because, per their explanation, effectivity of Fed policy prior to 2008 relied on this holding.

Banks’ demand for and the Fed’s supply of reserve balances


Jane Ihrig, Ellen Meade, and Gretchen Weinbach (2015). "Monetary Policy 101: A Primer on the Fed's Changing Approach to Policy Implementation", Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System.


1 Answer 1


The reason for this is that prior 2009 the interest rate on reserves was not zero and Fed kept reserves scarce.

The top of the demand curve is censored by the discount rate, which is an effective ceiling for the FFR because banks would not borrow funds at a higher rate than that.

The demand curve slopes downward because when the cost of borrowing decreases, banks are willing to borrow more funds to increase their holdings of reserves.

The demand is flat again at zero because at that rate the reserves are effectively free so demand for them is infinite.

Consequently any time reserves are kept scarce (but not to the point of shortage) and FFR is above zero but below discount window rate you will have some equilibrium on downward sloping portion of demand curve.

As a reference you can use this Federal Reserve own explainer.

  • $\begingroup$ Thank you. I take from your answer the importance of reserve scarcity (as do the authors). I guess their sentence is a bit awkward, what they simply mean is that reserves were scarce enough (in part due to policy implementation) that supply fluctuated around a level to which demand was sensitive to. $\endgroup$ Jan 10 at 17:21
  • $\begingroup$ @DaneelOlivaw that is the same thing since supply and price have to be jointly codetermined to avoid shortage or surplus $\endgroup$
    – 1muflon1
    Jan 10 at 17:53

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