Interest on Reserves, Settlement, and the Effectiveness of Monetary Policy

Abstract

Over the last several years, the Federal Reserve has conducted a series of large scale asset purchases. The effectiveness of these purchases is dependent on the monetary transmission mechanism. Former Federal Reserve chairman Ben Bernanke argued that large scale assets purchase are effective because they induce portfolio reallocations that ultimately lead to changes in economic activity. Despite these claims, a large fraction of the expansion of the monetary base is held as excess reserves by commercial banks. Concurrent with the large scale asset purchases, the Federal Reserve began paying interest on reserves and enacted changes in its Payment System Risk policy. This paper demonstrates that these policy changes have had statistically and economically significant effects on the demand for reserves and imply that the effectiveness of conventional monetary policy has likely been significantly weakened.