A Micro Model of the Federal Funds Market

Abstract

This paper demonstrates that valuable insights into the determination of Federal funds rates can be gained through modeling the micro-decisions of market participants. Fed fund demand functions are derived for different bank valuation functions and several implications are discussed. Specifically, it is: (i) possible to rationalize the observation that large banks are net purchasers and small banks net sellers of Fed funds; (ii) to explain the positive spread of Fed funds rates over other short-term money market rates; and (iii) to link the size of this spread to the Federal Reserve's underlying monetary policy strategy.