The Demand for Excess Reserves

Southern Economic Journal, Jan, 2001 by James P. Dow, Jr.

James P. Dow, Jr. [*]

This paper provides an estimate of the demand for excess reserves in the United States. It finds that excess reserves are negatively related to the Federal funds rate and positively related to transactions deposits. It also finds that clearing needs significantly affect the demand for reserves with increases in excess reserves coming in response to lower required reserve balances and higher clearing volume. Some implications for monetary policy are discussed.

1. Introduction

The demand for excess reserves is at the center of a number of issues in monetary economics. While at one time it was featured primarily in the calculation of money multipliers, more recently it has figured in Federal Reserve policy through its connection to the targeting of the Federal funds rate. Each week, the open market desk is obligated to forecast the demand for reserves, including the demand for excess reserves, to determine the amount of reserves to supply through open market operations. This shift in the role of excess reserves is reflected worldwide; a number of countries have abandoned reserve requirements altogether, and the entire connection between monetary policy and the economy is through the demand for "excess" reserves. This paper looks at recent data on excess reserves in the United States to determine the sensitivity of demand to changes in interest rates and other variables affecting the willingness to hold reserves.

The standard approach to modeling the demand for excess reserves is to treat it as part of a bank's liquidity management decision. Banks want to hold reserves to avoid overdraft or reserve deficiency penalties on their account at the central bank when facing uncertain flows of funds. This general model of the precautionary demand for reserves was given by Poole (1968). Two basic propositions fall out of this approach. The first is that the quantity of excess reserves demanded should vary inversely with short-term interest rates, which are the opportunity cost of holding reserves, assuming that excess reserves pay no interest. The second proposition is that since excess reserves are providing a buffer against uncertainty about reserve balances, demand should increase with uncertainty. The textbook model of excess reserve demand assumes that this uncertainty increases proportionately with the level of transactions deposits. This paper finds support for both of these propositions. In recent years, excess reserv es have increased with the growth in transactions deposits and were negatively related to interest rates, decreasing roughly $120 million for each percentage-point increase in the Federal funds rate.

The role of excess reserves in monetary policy depends on the particular operational strategy adopted by the central bank. The approach in the United States shifted in 1982, when the Federal Reserve moved to a borrowed reserve target from a policy of targeting the growth of nonborrowed reserves in response to the high variability of the Federal funds rate over the preceding years. [1] While some emphasis was still given to the monetary and reserve aggregates after that time, the implementation of policy effectively followed an interest rate targeting rule, although announcements of the intended Federal funds rate did not begin until 1994. The declared operating strategy of the open market desk ("the desk" henceforth) was to supply the amount of reserves demanded by banks less the borrowing target, relying on the fact that the demand for borrowing from the discount window was a relatively stable function of the difference between the intended Federal funds rate and the discount rate. This policy effectively t argeted the overnight interest rate since the only way to get the targeted amount of borrowing was by maintaining the appropriate spread between the Federal funds rate and the discount rate. The demand for excess reserves was believed to be relatively inelastic, and little attention was given to its response to changes in the intended Federal funds rate (e.g., Sellon and Seibert 1982).

By the 1990s, the stable borrowing relationship had fallen apart (Clouse 1994), so interest rate targeting would have to rely on something else for interest elasticity in the Federal funds market. Because excess reserves pay no interest, banks are likely to economize on them when market interest rates increase, which might provide the necessary elasticity. Given a downward-sloping demand for reserves, setting the supply of reserves each day would fix that day's interest rate in the Federal funds market. Of course, required reserves may also be sensitive to changes in the interest rate; an increase in opportunity cost may cause a shift out of non-interest-bearing deposits, producing a corresponding decline in required reserves. However, this is likely to be a slow process and thus difficult to use as the basis for short-term interest rate targeting. It is the demand for excess reserves that provides the short-term interest rate elasticity relied on by the desk.