What Quantity of Reserves Is Sufficient?

Abstract

What quantity of reserves should the Fed supply in order to support effective monetary policy implementation and an efficient interbank payment system? To answer this question, I construct a model linking interbank intraday payment timing with monetary policy implementation. A low supply of reserves causes banks to delay payments to each other and strategically hoard reserves. This in turn disincentivizes banks from providing liquidity to short-term funding markets, driving up the spreads between overnight risk-free market rates and the central bank deposit rate. As reserve balances get sufficiently low, even small reductions in reserves can have large impacts on these spreads, as in September 2019. My fitted model captures the funding rate spikes of September 16-18, 2019 as an out-of-sample event.

Yilin (David) Yang

Assistant Professor in Finance

Assistant Professor in Finance at the City University of Hong Kong.