The Demand for Reserves by Commercial Banks

Abstract

Relatively little effort has been devoted so far to lay the microeconomic foundations of the behavior of commercial banks. The omission is unjustifsed in view of the role of commercial banks in the money creation process. The present enquiry constitutes an attempt to further the understanding of the behavior of commercial banks with respect to their demand for reserves. The assumptions of the model to be developed below differ from those of other stochastic models of bank behavior (see [4, 7, 10, 11, 12] ) in that the bank is supposed to interfere with the fluctuations in the amount of its reserves whenever the latter deviates from limits set by the bank, but not as long as the amount of reserves remains within those limits. The appropriateness of this strategy when earning assets cannot be acquired and sold costlessly has been recognized by Baltensperger [2] and Frost [6], yet they failed to analyze the bank's behavior irl a dynamic framework, as does the present model.1 Furthermore, most previous models came in one way or another to the conclusion that, if the penalty the bank has to pay in the case of reserve deficits is smaller than the rate of interest earned on loans, no reserves will be held by the bank. This prediction has never been borne out by the observed behavior of commercial banks. The model developed here does not postulate any specific relationship between the