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Declining required reserves and the volatility of the federal funds rate

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Abstract

Low required reserve balances in 1991 led to a sharp increase in the volatility of the federal funds rate, but similarly low balances in 1996 did not. This paper develops and simulates a microeconomic model of the funds market that explains these facts. We show that reductions in reserve balances increase the volatility of the federal funds rate, but that this relationship changes over time in response to observable changes in bank behavior. The model predicts that a continued decline in required reserves could increase funds-rate volatility significantly.

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  • James A. Clouse & Douglas W. Elmendorf, 1997. "Declining required reserves and the volatility of the federal funds rate," Finance and Economics Discussion Series 1997-30, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgfe:1997-30
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    Cited by:

    1. Lee, Jim, 2002. "Federal funds rate target changes and interest rate volatility," Journal of Economics and Business, Elsevier, vol. 54(2), pages 159-191.
    2. Craig H. Furfine, 1998. "Interbank payments and the daily federal funds rate," Finance and Economics Discussion Series 1998-31, Board of Governors of the Federal Reserve System (U.S.).
    3. Eduardo Jallath-Coria & Tridas Mukhopadhyay & Amir Yaron, 2002. "How Well Do Banks Manage Their Reserves?," NBER Working Papers 9388, National Bureau of Economic Research, Inc.
    4. Michael Woodford, 2001. "Monetary policy in the information economy," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 297-370.
    5. Paul Bennett & Stavros Peristiani, 2002. "Are U.S. reserve requirements still binding?," Economic Policy Review, Federal Reserve Bank of New York, vol. 8(May), pages 53-68.
    6. Sánchez-Fung, José R., 2008. "The day-to-day interbank market, volatility, and central bank intervention in a developing economy," MPRA Paper 15648, University Library of Munich, Germany.
    7. James P. Dow, 2001. "The Demand for Excess Reserves," Southern Economic Journal, John Wiley & Sons, vol. 67(3), pages 685-700, January.
    8. Cover, James P. & VanHoose, David D., 2000. "Political pressures and the choice of the optimal monetary policy instrument," Journal of Economics and Business, Elsevier, vol. 52(4), pages 325-341.
    9. Judson, Ruth A. & Klee, Elizabeth, 2010. "Whither the liquidity effect: The impact of Federal Reserve open market operations in recent years," Journal of Macroeconomics, Elsevier, vol. 32(3), pages 713-731, September.
    10. Carpenter, Seth & Demiralp, Selva, 2006. "The Liquidity Effect in the Federal Funds Market: Evidence from Daily Open Market Operations," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(4), pages 901-920, June.
    11. Bartolini, Leonardo & Bertola, Giuseppe & Prati, Alessandro, 2001. "Banks' reserve management, transaction costs, and the timing of Federal Reserve intervention," Journal of Banking & Finance, Elsevier, vol. 25(7), pages 1287-1317, July.
    12. Prati, Alessandro & Bartolini, Leonardo & Bertola, Giuseppe, 2003. "The overnight interbank market: Evidence from the G-7 and the Euro zone," Journal of Banking & Finance, Elsevier, vol. 27(10), pages 2045-2083, October.
    13. Michael Woodford, 2002. "Financial market efficiency and the effectiveness of monetary policy," Economic Policy Review, Federal Reserve Bank of New York, vol. 8(May), pages 85-94.
    14. Dow, James Jr., 2001. "The Recent Behavior of Adjustment Credit at the Discount Window," Journal of Macroeconomics, Elsevier, vol. 23(2), pages 199-211, April.
    15. Nautz, Dieter & Schmidt, Sandra, 2009. "Monetary policy implementation and the federal funds rate," Journal of Banking & Finance, Elsevier, vol. 33(7), pages 1274-1284, July.
    16. Craig H. Furfine, 2004. "Standing facilities and interbank borrowing: evidence from the Federal Reserve’s new discount window," Working Paper Series WP-04-01, Federal Reserve Bank of Chicago.
    17. Ahmed S. Baig & Drew B. Winters, 2021. "Month-End Regularities in the Overnight Bank Funding Markets," JRFM, MDPI, vol. 14(5), pages 1-16, May.
    18. Jeffrey M. Wrase, 1998. "Is the Fed being swept out of (monetary) control?," Business Review, Federal Reserve Bank of Philadelphia, issue Nov, pages 3-12.
    19. Furfine, Craig H., 2000. "Interbank payments and the daily federal funds rate," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 535-553, October.
    20. Athanasios Orphanides, 2001. "Expectations, open market operations, and changes in the federal funds rate (commentary)," Review, Federal Reserve Bank of St. Louis, vol. 83(Jul), pages 33-58.
    21. Kopecky, Kenneth J. & VanHoose, David, 2004. "Bank capital requirements and the monetary transmission mechanism," Journal of Macroeconomics, Elsevier, vol. 26(3), pages 443-464, September.
    22. Demiralp, Selva & Farley, Dennis, 2005. "Declining required reserves, funds rate volatility, and open market operations," Journal of Banking & Finance, Elsevier, vol. 29(5), pages 1131-1152, May.
    23. Yueh-Yun C. O'Brien, 2007. "Reserve requirement systems in OECD countries," Finance and Economics Discussion Series 2007-54, Board of Governors of the Federal Reserve System (U.S.).

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    Keywords

    Bank reserves; Federal funds rate;

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