Has the interest rate paid on central bank balances been a floor for market interest rates?
Because deposit balances held at central banks are risk free and dominate all other investments in terms of liquidity, any institution that can hold balances at a central bank should be willing to lend those balances only if the interest rate earned in the market is at least as high as the rate the institution would receive from the central bank. This proposition forms the basis for the expectation that the interest rate paid on reserves should be a floor for market rates. As we learned in the autumn of 2008, however, this expectation can fail if some institutions trading in the relevant money market do not have access to interest on deposits at the central bank.2 In such cases, the effectiveness of the central bank interest rate as a floor for short-term money market rates depends on the ability and willingness of institutions with access to borrow from institutions without access and on the competitive pressures to arbitrage any differences between the rates available at the central
