The Demand for Excess Reserves

Abstract

This paper provides an estimate of the demand for reserves in the United States. It finds that 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 reserves coming in response to lower required reserve balances and higher clearing volume. Some implications for monetary policy are discussed. The demand for 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 reserves, to determine the amount of reserves to supply through open market operations. This shift in the role of 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 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 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 reserves demanded should vary inversely with short-term interest rates, which are the opportunity cost of holding reserves, assuming that reserves pay no interest. The second proposition is that since reserves are providing a buffer against uncertainty about reserve balances, demand should increase with uncertainty. The textbook model of 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, reserves 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 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