Reserve Requirement Changes and Money Market Responses

Abstract

Financial economists view reserve requirements as being important to financial markets. But, they have not always agreed on how reserve requirements impact financial markets. Conventional thinking would suggest that higher reserve requirements will result in lower rates paid on deposits, either because reserve requirements are a tax borne by depositors, or because depository institutions are viewed by depositors as safer and therefore worthy of a smaller default risk premium. In this paper, the impact of reserve requirement changes on money market rates and default spreads is examined following two announced policy changes in the 1990s. The evidence provided in this paper is inconsistent with the conventional view. We find that the TED narrowed on two announced reductions in reserve requirements in the 1990s. The evidence also indicates that the level of Treasury bill and Eurodollar Futures rates generally increased following the announcement. This is the opposite of the result expected if these events represented a relaxation of monetary policy. The paper also provides evidence on the value of the dollar in foreign exchange markets at the time of these policy announcements. Little evidence of a significant effect on the dollar against major currencies is uncovered. This evidence is consistent with these changes as not being significant monetary policy events.