The recent unrest in money markets, which briefly caused short-term interest rates to get out of the Federal Reserve’s control, won’t undermine the central bank’s ability to achieve its longer-term economic goals. That said, it does signal that something’s very wrong with the financial system.
To understand what’s going on, let’s return to a simple model. Suppose there’s only one big bank. It has a choice of what to do with most of its assets: It can keep them on deposit at the Fed, earning the interest rate that the central bank pays on excess reserves; or it can take more risk and earn more return by investing in securities or loans. In this world, all the assets earn the same “risk-adjusted” return, which the Fed effectively determines by setting the interest rates on excess reserves.
