Question

Explain the Channel/corridor system for setting interest rates

Answer 1

Answer- The terms “corridor” and “floor” refer to different procedures for combining the various tools to achieve this objective.

A Corridor-style system in which 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 not always set in the middle of this corridor.

This approach relies on setting the supply of balances so that it falls in the inelastic region of the demand curve.

Each of these approach also offers some advantages like central banks have much more experience with corridor-type systems, in part because it is possible to operate one without paying interest on reserves.

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.

In a corridor-type system, the interest-on-reserves rate is lower than the market interest rate. Thus bank 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.

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