Paying Interest on Reserve Balances: It's More Significant Than You Think

By Fullwiler, Scott T. | Journal of Economic Issues, June 2005 | Go to article overview

Paying Interest on Reserve Balances: It's More Significant Than You Think


Fullwiler, Scott T., Journal of Economic Issues


It has long been recognized that uncompensated reserve balances act like a tax on banks and that banks as a result expend scarce resources to avoid holding them. The Fed itself has historically supported legislation to enable it to pay interest on reserve balances (e.g., Kohn 2003), as have economists (e.g., Goodfriend 2002), both for reasons of economic efficiency and to improve the implementation of monetary policy. The traditional argument against interest payment has been that it would reduce the Fed's earnings that are subsequently turned over to the Treasury (Feinman 1993b; Abernathy 2003). The purpose of this paper is to demonstrate the implications of paying interest on reserve balances on the daily operations of both the Fed and the Treasury. While the arguments here--for different reasons--generally are in favor of enabling the Fed to pay interest on reserve balances, more important than the actual payment of such interest is the perspective gained when considering in detail the operations of both in an environment where reserve balances earn interest.

The Accommodative Nature of the Fed's Operations and Interest Payment on Reserve Balances

In the federal funds market, banks borrow and lend reserve balances held in reserve accounts at the Fed; most of the trades are accomplished either through pre-existing lines of credit or arranged via brokers. The Fed uses open market operations, overdrafts (provided automatically whenever a bank's reserve account moves into negative balance), and overnight loans to ensure the quantity of reserve balances circulating is such that the federal funds rate remains as close as possible to the FOMC's target rate. Since reserve balances are liabilities on the Fed's balance sheet, banks in the aggregate have no effect upon their quantity; by definition, only changes in the Fed's balance sheet can alter the quantity of reserve balances. (1)

The Fed's necessary accommodation of the demand for reserve balances is obvious when one considers daily operations in the absence of reserve requirements. Without reserve requirements, banks hold non-interest-bearing reserve balances only to settle payments such as checks drawn on customer accounts or Fedwire funds transfers for direct payments to other banks or the Treasury, or as settlement of netted clearinghouse transactions. In order to avoid the Fed's overdraft charges (discussed in Fullwiler 2003), banks desire to hold sufficient reserve balances to settle their net payment commitments for the day. A bank holding less than this amount would attempt to borrow more reserve balances, while one holding more would attempt to lend the excess. In the aggregate, too many or too few reserve balances circulating leads to wide swings in the federal funds rate since such lending/borrowing among banks does not affect the aggregate quantity of reserve balances. Too few balances could also threaten the smooth functioning of the payments system, which the Fed is charged in the Federal Reserve Act with protecting. Larger quantities of reserve balances do not "fund" more money creation since there is no operative constraint on bank lending beyond the existence of willing, creditworthy borrowers. In other words, loans create deposits while reserve balances only settle payments (Moore 1988; Wray 1998, 2003-4; Fullwiler 2003).

Adding reserve requirements is simply one way to reduce potential volatility in the federal funds rate. First, reserve requirements require banks to hold more reserve balances and thereby reduce the likelihood of overnight overdrafts. Second, because reserve requirements are met on average across a lengthy maintenance period, deficiencies or surpluses on most days can be offset later in the maintenance period. Together these provide "room for error" for the Fed as it attempts to correctly forecast the demand for reserve balances at the target rate (Fullwiler 2003). However, reserve balances still do not "fund" money creation and are still necessarily supplied endogenously to accommodate banks' demand for them--albeit as a daily average across the maintenance period. …

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

Paying Interest on Reserve Balances: It's More Significant Than You Think
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Full screen

matching results for page

Cited passage

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited passage

Welcome to the new Questia Reader

The Questia Reader has been updated to provide you with an even better online reading experience.  It is now 100% Responsive, which means you can read our books and articles on any sized device you wish.  All of your favorite tools like notes, highlights, and citations are still here, but the way you select text has been updated to be easier to use, especially on touchscreen devices.  Here's how:

1. Click or tap the first word you want to select.
2. Click or tap the last word you want to select.

OK, got it!

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.