The overnight reserve repo rate ON RRP is a supplementary mo

The overnight reserve repo rate (ON RRP) is a supplementary monetary policy tool of the Federal Reserve. Explain how this tool can set a floor under the market federal fund reserves.

Solution

Overnight reverse repo agreement (ON RRP) is an agreement through which Federal reserve sells government securities to counterparties and agrees to buy back the same securities the following day. These type of agreements are money market instruments using which Federal reserve can regulate the money supply in country. Federal reseverve determines the maximum rate which is offered to counterparty in overnight reverse repo agreement through an auction process. This rate is called as ON RRP rate and it sets floor under the market federal fund reserves. This is because a counterparty will not enter into overnight reverse repurchase agreement with a party (other than Federal reserve) offering rate lower than ON RRP rate. In this way ON RRP is a supplementary monetary policy tool to control overnight short term rates.