Free Reserves, Vault Cash, and the Portfolio Behavior of Banks

Abstract

is paper presents the results of a statis1tical test of Friedman's hypothesis (Friedman 1961) that the Federal Reserve's decision to count vault cash as reserves would increase the demand for free reserves. In addition, the results are interpreted in the light of the two main theories of portfolio management: the liquidity theory of Edgeworth (1888) and the risk theory of Markowitz (1952) and Tobin (1958). To test Friedman's hypothesis, member banks were divided into three categories: New York City banks, other reserve city banks, and country banks. Demand functions for free reserves were estimated for each bank class, with dummy variables being used to reflect the hypothesized shift in demand. The tests show that Friedman's hypothesis appears true for both classes of reserve city banks but is definitely false for country banks. These results reconcile both of the previously published empirical studies. Georgio Basevi (1963) confirmed Friedman's hypothesis by estimating the demand function for free reserves of all member banks together; and J. C. Rothwell (1962), using survey techniques, found little support for the hypothesis among country banks. It is argued that the different marginal responses of reserve city and country banks may be explained by assuming that country banks are motivated by risk considerations, while reserve city banks are motivated by liquidity considerations.