Corridors and Floors in Monetary Policy - Liberty Street Economics (2023)

Todd Keister

As part of its prudent planning for future developments, the Federal Open Market Committee (FOMC) has discussed strategies for normalizing the conduct of monetary policy, when appropriate, as the economy strengthens. One issue, raised in April 2011, is whether the longer-run framework for implementing monetary policy will be a corridor-type system or a floor-type system. What do these terms mean, and how do they relate to monetary policy? In this post, I describe the key differences between these two approaches to implementing monetary policy and some of the advantages offered by each.


The Federal Reserve conducts monetary policy by choosing a target for the federal funds rate, which is the average, market-determined interest rate at which banks and certain other institutions lend funds to each other on an overnight basis. The Federal Reserve has several tools that it can use to influence conditions in the federal funds market and thereby steer the market interest rate toward the chosen target. The terms “corridor” and “floor” refer to different procedures for combining the various tools to achieve this objective.

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Two important tools are the discount rate and the interest-on-reserves rate. The discount rate is the interest rate at which the Federal Reserve is willing to lend funds, against collateral, to banks in good standing. This rate tends to create an upper bound, or ceiling, for the market interest rate by giving banks an option to borrow funds outside of the market. The discount rate is currently 0.75 percent. The interest-on-reserves rate represents what banks earn on the funds deposited in their accounts at the Federal Reserve. This rate tends to create a lower bound, or floor, for the market interest rate on interbank loans by removing any incentive for banks to lend funds at a lower rate. The interest-on-reserves rate is currently 0.25 percent.

The Demand for Reserve Balances
The “funds” being lent in the fed funds market are balances that banks and other institutions hold on deposit at the Federal Reserve. (These balances are sometimes called federal funds.) Banks hold these balances for a variety of reasons: to meet reserve requirements, to make payments to other banks, and as part of their general pool of liquid assets. Banks’ demand for these balances can be represented graphically as depicted in the figure below. The vertical axis in the figure measures the market interest rate on overnight fed funds loans, and the horizontal axis measures the total quantity of reserve balances.

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To understand the shape of the demand curve in this figure, suppose first that the supply of reserve balances is very small. In this case, some banks will have difficulty meeting their reserve requirement. As these banks try to borrow funds, the market interest rate will be pushed up toward the ceiling created by the discount rate. (The market rate may actually rise above the discount rate, as depicted in the figure; I return to this issue at the end of the post.)

Once the supply of balances becomes large enough that all banks expect to meet their requirements, the demand curve falls off sharply. At this point, the value of reserve balances is determined largely by banks’ desire to be able to make payments out of their account as needed without the risk of falling below their requirement. This part of the curve is labeled the inelastic region in the figure; the term “inelastic” here means that the quantity of balances banks demand is relatively insensitive to changes in the interest rate.

As the supply of balances increases further, the demand curve flattens out into an elastic region where the demand for balances is much more sensitive to changes in the interest rate. In this region, banks have sufficient balances to meet their reserve requirements comfortably while satisfying all payments needs. The value of reserve balances in this region comes largely from the fact that these balances are a perfectly liquid, interest-bearing asset that banks can hold as part of their general liquidity pools. The interest-on-reserves rate that banks earn by holding these balances is, therefore, the relevant reference point for the market interest rate.

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The Supply of Reserve Balances
The Federal Reserve’s third key tool for influencing market interest rates is changing the total supply of reserve balances through open market operations—that is, buying securities in the market to increase balances or selling securities to decrease balances. A change in the supply of balances moves the market to a different point on the demand curve in the figure above, which then brings about a corresponding change in the market interest rate.

Corridors and Floors
Once the FOMC determines a target interest rate, the Federal Reserve has different ways of using the tools described above to implement this decision. A corridor-style system is depicted in the left panel of the figure below: The discount rate is set above the target interest rate and the interest-on-reserves rate is set below it. These two rates form a “corridor” that will contain the market interest rate; the target rate is often (but not always) set in the middle of this corridor. Open market operations are then used as needed to change the supply of reserve balances so that the market interest rate is as close as possible to the target. Notice in particular that this approach relies on setting the supply of balances so that it falls in the inelastic region of the demand curve.

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The right panel of the figure depicts a floor-type system. In this approach, the interest-on-reserves rate is set very close or equal to the target rate. The open market desk again supplies reserve balances as needed to steer the market interest rate to the target. In this case, the appropriate supply of balances falls in the elastic region of the demand curve and the market rate is close to the floor created by the interest-on-reserves rate.

It is worth emphasizing that both approaches are consistent with the view, expressed by the FOMC in June 2011, that the quantity of reserve balances should be kept to the “smallest levels that would be consistent with the efficient implementatio
n of monetary policy.” While the level of balances would be larger under a floor-type system, in each case this level is set precisely to meet banks’ demand for balances at the target interest rate.

Comparing Systems
Each of these approaches offers some advantages. Central banks have much more experience with corridor-type systems, in part because it is possible to operate one without paying interest on reserves. Notice that, in the left panel of the figure above, the approach would be largely unchanged if the interest-on-reserves rate were set to zero. A floor-type system, in contrast, requires that the interest-on-reserves rate be close to the FOMC’s target. Prior to October 2008, the Federal Reserve did not pay interest on reserve balances and operated a corridor-type system with the interest-on-reserves rate set to zero.

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While a floor-type system is less familiar, it helps promote the efficient functioning of the financial system by allowing banks to earn the market rate of interest on all of their reserve balances. In a corridor-type system, the interest-on-reserves rate is lower than the market interest rate. Banks thus have an incentive to invest time and effort trying to economize on the quantity of balances they hold by lending extra funds to other banks or by purchasing other assets. However, all of the balances created by the Federal Reserve must be held by someone, so these efforts by individual banks to avoid holding balances simply cancel out. A floor-type system removes the incentive for banks to undertake such efforts. It also supplies banks with a larger quantity of this perfectly safe, liquid asset. A more detailed discussion of these efficiency concerns, and other differences between corridor-type and floor-type systems, can be found in two Federal Reserve publications, “Divorcing Money from Monetary Policy” and “Understanding Monetary Policy Implementation.”

Leaky Ceilings and Soggy Floors
One final note: The terms “ceiling” and “floor” are somewhat misleading in that the discount rate and the interest-on-reserves rate do not create firm bounds for the market interest rate. For example, banks may choose to borrow in the market at a rate higher than the discount rate because they fear that borrowing from the Federal Reserve could be interpreted as a sign of weakness (see some theory, discussion, and evidence of this “stigma” effect). On the other side of the corridor, some lenders in the federal funds market are not eligible to earn interest on reserves and hence may be willing to lend in the market at lower rates. The government-sponsored enterprises Fannie Mae, Freddie Mac, and the Federal Home Loan Banks fall into this category. The effective federal funds rate has, in fact, been lower than the interest-on-reserves rate for much of the recent period. A discussion of these and related issues can be found in the Federal Reserve publication “Monetary Policy under a Corridor Operating Framework.”

Disclaimer
The views expressed in this post are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of NewYork or the Federal Reserve System. Any errors or omissions are the responsibility of the author.

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FAQs

What is Corridor in monetary policy? ›

The Corridor in monetary policy of the RBI refers to the area between the reverse repo rate and the MSF rate. Reverse repo rate will be the lowest of the policy rates whereas Marginal Standing Facility is something like an upper ceiling with a higher rate than the repo rate.

What are the 4 main tools used to implement monetary policy? ›

Central banks have four main monetary policy tools: the reserve requirement, open market operations, the discount rate, and interest on reserves. 1 Most central banks also have a lot more tools at their disposal.

What is Corridor system? ›

Under a corridor system, central banks maneuver the market interest rate for. overnight interbank loans by operating bilateral overnight standing facilities. A central. bank's lending facility allows banks to borrow overnight against collateral at a rate.

What is a corridor in finance? ›

A corridor or channel is a set part of a graph in a trading terminal which indicates the range in which the price of a trading instrument is fluctuating on the Forex market. The lower limit of the channel is the support and the upper is the resistance.

What is floor system in monetary policy? ›

In a floor system the key policy rate is equal to the central bank's deposit rate. Then the central bank must provide the banking system with so much liquidity that the overnight rate approaches the central bank's deposit rate.

What is an example of a corridor? ›

An example of a corridor is a hotel hallway. An example of a corridor is a passageway to the sea from a land-locked country. An example of a corridor is the northeast rail corridor which connects New Jersey and New York. A thickly populated strip of land connecting two or more urban areas.

What are the 5 instruments of monetary policy? ›

Currently, OMO is the major instrument of monetary policy at the CBN. Other supporting instruments are discount window operations, moral suasion, forex sales and the standing facility introduced in December 2006.

What are the 3 types of monetary policy? ›

The Fed has traditionally used three tools to conduct monetary policy: reserve requirements, the discount rate, and open market operations.

What are the 3 objectives of monetary policy? ›

The three objectives are: The stability of the currency of Australia. The maintenance of full employment in Australia. The economic prosperity and welfare of the people of Australia.

Why is it called corridor? ›

Etymology. Borrowed from French corridor, from Italian corridore (“long passage”) (= corridoio), from correre (“to run”).

What is the purpose of corridor planning? ›

Corridor Planning is a multimodal transportation planning approach that recognizes that transportation needs are based on the complex geographic, demographic, economic, and social characteristics of communities.

What are some characteristics of corridor? ›

The definition of a corridor includes infrastructure, economy, space and environment, and a large number of stakeholders are involved in the planning and decision-making process [16][17] [18] .

What is floor and examples? ›

The definition of floor is the bottom surface of a room, the bottom of something, or a level in a building. An example of a floor is the bottom surface of a kitchen. An example of a floor is the lowest price that will be charged. An example of a floor is the level in a building; the fifth floor. noun.

What are the three main functions of a floor? ›

The floor has three main functions in relation to our actions (Fig. 25). It directs us from one place to another, it delimits a space from its surroundings, and it supports us by providing a firm footing.

What is floor and its function? ›

' A floor typically provides: Structural support for the contents of the room, its occupants, and the weight of the floor itself. Resistance to the passage of moisture, heat and sound. A surface finish which may contribute to the look, feel and acoustics of a space.

What are the types of corridors? ›

Corridors can be made in two distinct areas—either water or land. Water corridors are called riparian ribbons and usually come in the form of rivers and streams. Land corridors come on a scale as large as wooded strips connecting larger woodland areas.

What is a corridor on a street? ›

Copy. Sidewalk Corridor means a passageway typically located within the public Right- of-Way between the curb or roadway edge and the property line. The Sidewalk Corridor contains four distinct zones: The Curb Zone, the Furnishings Zone, the Through Pedestrian Zone, and the Frontage Zone.

What is a corridor called? ›

hall, hallway. an interior passage or corridor onto which rooms open. concourse. a wide hallway in a building where people can walk. type of: passageway.

Who are the 6 members of monetary policy? ›

The thirty sixth meeting of the Monetary Policy Committee (MPC), constituted under section 45ZB of the Reserve Bank of India Act, 1934, was held during June 6 to 8, 2022.
...
Minutes of the Monetary Policy Committee Meeting, June 6 to 8, 2022.
MemberVote
Dr. Shashanka BhideYes
Dr. Ashima GoyalYes
Prof. Jayanth R. VarmaYes
Dr. Rajiv RanjanYes
2 more rows
22 Jun 2022

What are the major types of monetary policy? ›

There are two forms of monetary policy, i.e., the contractionary and expansionary policy.

What are the six basic goals of monetary policy? ›

Six basic goals are continually mentioned by personnel at the Federal Reserve and other central banks when they discuss the objectives of monetary policy: (1) high employment, (2) economic growth, (3) price stability, (4) interest-rate stability, (5) stability of financial markets, and (6) stability in foreign exchange ...

What are the 2 types of monetary policy? ›

Types of monetary policy

There are two main kinds of monetary policy: contractionary and expansionary.

What are the four channels of monetary policy transmission? ›

(3) Other channels of monetary policy transmission include asset price channels, credit channels, bank lending channels and balance sheet channels.

What are examples of monetary policies? ›

The three key actions by the Fed to expand the economy include a decreased discount rate, buying government securities, and a lowered reserve ratio. Quantitative easing is another monetary policy tool used by central banks.

What is the main function of monetary policy? ›

A key role of central banks is to conduct monetary policy to achieve price stability (low and stable inflation) and to help manage economic fluctuations.

What is the most important goal of monetary policy? ›

The objective of monetary policy is to preserve the value of money by keeping inflation low, stable and predictable.

What are the factors of monetary policy? ›

Four factors affect the effectiveness of monetary policy, three of which are exogenous, fiscal dominance, dollarization and global risks; one is endogenous, monetary policy framework that integrates strategy, tactics and governance of monetary policy.

What are public corridors? ›

Public corridor means a corridor that provides access to exit from more than one suite. (See Appendix A.) Public way means a sidewalk, street, highway, square or other open space to which the public has access, as of right or by invitation, expressed or implied.

Who invented the corridor? ›

In 1597 John Thorpe is the first recorded architect to replace multiple connected rooms with rooms along a corridor each accessed by a separate door.

What are three synonyms for corridor? ›

synonyms for corridor
  • aisle.
  • foyer.
  • hall.
  • lobby.
  • passage.
  • passageway.
  • entranceway.
  • ingress.

What are two benefits of corridors? ›

Habitat corridors allow movement between isolated populations, promoting increased genetic diversity. They provide food and shelter for a variety of wildlife and help with juvenile dispersal and seasonal migrations.

Which is an advantage of a corridor? ›

Corridors can aid dispersal of species and gene flow between populations, and allow recolonisation due to disturbance. This means that they help in the persistence of species in the landscape (Baudry and Merriam, 1987).

What are strategic corridors? ›

The Strategic Corridors are transport systems that facilitate sustainable, They underpin the territorial organisation (rural and urban) through reliable networks and services that create jobs and support value chains that can benefit industries in both Africa and Europe.

What is a corridor analysis? ›

Generally, the goals of a Corridor Study seek to: Involve the community in developing a long-term vision for that corridor. Define policies and actions that will guide how the corridor should be maintained or changed in the future. Identify future land uses in an overall communitywide context.

What are nodes and corridors? ›

Nodes are neighborhood hubs where people and nature meet. They are softer, greener, outdoor gathering spaces for recreation, resting, community events and improved habitat. They are destinations. Nodes are connected to one another by corridors.

What does Corridor Crew do? ›

Its second channel, Corridor Crew, consists of behind-the-scenes content, including the popular series VFX Artists React and VFX Artist Reveals, the latter of which is hosted by Wren Weichman. The channel has 5.84 million subscribers as of September 2022.

What does Digital corridor pay? ›

As of Oct 28, 2022, the average annual pay for a Corridor Digital in Atlanta is $65,422 a year. Just in case you need a simple salary calculator, that works out to be approximately $31.45 an hour. This is the equivalent of $1,258/week or $5,451/month.

What is interest corridor? ›

An interest rate corridor (IRC) is a system for guiding short-term market interest rates towards the central bank (CB) target/policy rate. It consists of a rate at which the CB lends to banks (typically an overnight lending rate) and a rate at which it takes deposits from them (deposit rate).

What does corridor project mean? ›

A corridor study is a planning project that defines the relationships between a roadway and its adjacent land.

What is liquidity corridor? ›

Liquidity adjustment facility (LAF), also known as the liquidity corridor, essentially indicates the difference between the repo rate and the reverse repo rate. It was introduced in year 2000 following recommendation of Narasimham Committee Report on Banking Reforms.

What are the 3 types of interest? ›

What are the Different Types of Interest? The three types of interest include simple (regular) interest, accrued interest, and compounding interest.

Can you explain how an interest rate corridor work? ›

Interest corridor puts a ceiling on the inter-bank rate. If demand for reserves falls sufficiently relative to supply, the interest rate is pushed down to the deposit facility rate floor. The surplus liquidity would then be placed in the deposit facility. The interest corridor puts a floor on the inter-bank rate.

What is the lower band of interest rate corridor? ›

The permanent liquidity facility rate of 5% is to be maintained as the upper limit of the interest rate corridor (IRC) and the lower band of IRC is decreased from 2% to 1%.

How many corridors are there? ›

There are 11 Industrial corridors in India. They are Delhi Mumbai Industrial Corridor (DMIC), Chennai Bengaluru Industrial Corridor (CBIC), Extension of CBIC to Kochi via Coimbatore, Amritsar Kolkata Industrial Corridor (AKIC), Hyderabad Nagpur Industrial Corridor (HNIC).

What is the corridor called? ›

hall, hallway. an interior passage or corridor onto which rooms open. concourse. a wide hallway in a building where people can walk. type of: passageway.

What is policy corridor width? ›

In view of persistent excess liquidity, it has been decided to widen the existing policy rate corridor from 50 bps to 65 bps.

What is the meaning of asymmetric corridor? ›

Asymmetric interest rate corridor The asymmetric interest rate corridor is a new tool developed by the CBRT to increase the flexibility of monetary policy. It provides the ability to make timely responses to external finance or risk sentiment shocks through active management of daily open market operations.

What is SDF flooring? ›

RBI Starts Normalisation On Liquidity; Introduces SDF As The Floor To Absorb Excess Funds. Governor Shaktikanta Das said the SDF will be at 3.75 per cent, 0.25 per cent below the repo rate and 0.50 per cent lower than the marginal standing facility (MSF) which helps the banks with funds when required. | RBI.

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