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The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.


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May 21, 2009


More on interest on reserves

Following my previous macroblog post on tools for managing the Federal Reserve’s balance sheet, I received a few questions, and I’m using today’s post to reply to these.

First, a question from Alexander Singer:
Wouldn't the reserves we are talking about fall as well as a result of banks actually lending money out to their customers?

The banking system cannot create or destroy reserves no matter how many loans they make as long as the borrowed funds are deposited. For example, if one bank takes a portion of its reserve balance and turns it into a loan, and those borrowed funds are deposited at a second bank, then that deposit is matched by an equivalent increase in the second bank’s reserve balance. The net effect on reserves is zero.

The Fed has created a substantial amount of reserves during the past year and a half. At the end of 2007 reserve balances at Federal Reserve stood at about $8 billion. Currently reserve balances are closer to $900 billion.

Will the broader money supply grow once lending increases? Yes, lending will generate bank deposits, and bank deposits (plus currency) equals money. But that won’t have any direct impact on total reserve balances within the banking system.

A second question comes from Tom:
With interest on reserves (IOR), why would a bank not want to keep its reserves at the existing level after the policy rate is increased? They are operating on a horizontal segment of their demand for reserves. I just don't see why raising the policy rate will be a problem with IOR. What am I missing?

Some economists have argued that paying interest on reserves will render the demand for reserves indeterminate (see, for example, the 1985 JME article by Neil Wallace and Tom Sargent). But proponents argue that pinning down the demand function is not crucial for an interest on reserves based monetary policy to be effective (see, for example, Goodfriend 2002). In Goodfriend’s view (which is based on the assumption that interest rate rules for monetary policy deliver coherent outcomes for inflation and output), there is great value in a central bank being able to pursue separate interest rate and bank reserve polices. Interest rate policy would be used to maintain overall macroeconomic stability, while bank reserve policy would be used to address financial market objectives. Linking the policy rate to the interest rate paid on reserve balances means that a change in the interest rate does not require changing the supply of reserves.

Why might this be useful? Here’s one hypothetical scenario: Suppose the Fed needed to keep bank reserves at a high level because of lingering demand for liquidity in financial markets that is not being provided by the private sector. Now, suppose the Fed also wanted to tighten monetary policy because of separate macroeconomic stability concerns. Interest on reserves provides a tool to meet both a financial stability objective (by helping the functioning of credit markets) and a macroeconomic stability objective (by influencing banks’ willingness to lend to private borrowers).

A bit more detail. Banks used to view reserves as a “hot potato.” Reserves are useful to banks in making settlements, etc., but banks did not want hold too many reserves because they were a nonearning asset. The Fed did not compensate banks for holding the reserves and so banks had better uses for their funds. The Fed was able to keep the market price for reserves (its policy instrument) positive by keeping the amount of reserves scarce. But today, reserves are far from being scarce, and the Fed keeps the market price for reserves positive by paying interest on reserve balances (albeit only 25 basis points).

Keister, Martin, and McAndrews (2008) called this new approach “Divorcing Money from Monetary Policy.” I think that is a bit strong, but it does amount to an amicable separation between reserves management and monetary policy. Textbook descriptions of money and banking emphasize an important role for reserve management in the implementation of monetary policy (daily open market operations, etc.). But clearly that is not the only possible operating approach.

By John Robertson, vice president in Research at the Atlanta Fed

May 21, 2009 in Monetary Policy | Permalink

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Comments

If I may be so bold, I have tried to explain QE in an intuitive way that may provide the answers to such questions (eg Alexander's question is covered in paragraph 11) at: http://reservedplace.blogspot.com/2009/04/easing-understanding.html

Posted by: RebelEconomist | May 24, 2009 at 10:45 AM

I have a question regarding your comment:
"The banking system cannot create or destroy reserves no matter how many loans they make as long as the borrowed funds are deposited. For example, if one bank takes a portion of its reserve balance and turns it into a loan, and those borrowed funds are deposited at a second bank, then that deposit is matched by an equivalent increase in the second bank’s reserve balance. The net effect on reserves is zero."

What happens if Bank A loans out money and the money makes its way into foreign hands via a currency swap, via purchasing something that is foreign owned, therefor Recipient A is now transferring his borrowed cash to a foreign owner, who may in turn not deposit it into a U.S. Bank and therefor the net net is not zero, but a reduction in Bank A's reserve balance. Your scenario works quite well in a cash based U.S. centric world yet does not hold any relevancy in a credit based foreign financed U.S. economy. The reason why the banking system is not releasing those reserves is because they will find their way outside of the U.S. domestic economy. Your net zero scenario is far too simplistic in theory it is correct but in practice, it is not relevant today. The velocity of money is zero and thus real growth is also zero.

Secondly where in your analysis is your accounting for all the future "interest" payments that $900bn in reserves are going to come from, even at a meager 1% per year we are talking about a net increase in the money supply to the tune of $9bn dollars per year just to account for interest payments, and I am being generous with the 1% calculation. So money supply must increase at a proportionate rate of interest relative to the available pool of outstanding currency or reserves. Unfortunately we have too much credit requiring interest as well which dwarfs the actual money supply outstanding. Which is our real problem.

Secondly your other point:
"Interest on reserves provides a tool to meet both a financial stability objective (by helping the functioning of credit markets) and a macroeconomic stability objective (by influencing banks’ willingness to lend to private borrowers)."

I agree with the first part as paying reserves does provide stability as it gives the banks incentives to hoard money and deposit it at the FED and keeps it out of speculative hands, which reigns in credit and thus dampens speculative bubbles, except the FED only resorts to the measure well after the bubble has been pricked, so in this current case, paying interest on reserves is a way to heal bank balance sheets via giving away risk free money and buying time. Yet at the current time, the banks are causing a deepening yet necessary correction in the overall marketplace in terms of debt deflation, however this is a very acute game of chicken as the FED punishes businesses and worsens the future outlook for jobs as a virtual hiring freeze ensues because all funding is cut off in order to buy banks time to heal their balance sheets, meanwhile mainstreet gets crushed and the self feeding reduction continues.

Your academic explanations are in theory correct but when applied come to far different conclusions when present macro economic forces are analyzed.

Perhaps you are better informed looking out the FED window and seeing exactly what has transpired. The FED has lost control and currently cannot figure out a way to stop interest rates from going where, in effect they really ought to go, and that is up. Which is fine for the banks but detrimental for everyone else. Main street does not have the luxury of roll over its debt, via the printing press, The U.S. is the only country I know of that can simultaneously raise its debt burden exponentially and lower the very rate by which it borrows it at. No other entity can make that claim. I don't think the U.S. can make that claim any longer either. The FED has sold us out. Great Job

Posted by: magne13 | May 27, 2009 at 01:31 AM

Can you recommend any good articles/papers that handle how to think about the monetary implications of the shadow banking system other than Gorton's recent paper. I am most interested in the deflationary implications of the collapse in the repo "deposits", i.e. really non-deposit monetary liabilities of the financial system Gorton discusses.

Posted by: rfarris | May 31, 2009 at 04:36 PM

Thank you very much for this very clear explanation

Posted by: Stuart Bevan | July 21, 2009 at 10:51 AM

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