Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Monetary Policy without Reserve Requirements: Analytical Issues

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Monetary Policy without Reserve Requirements: Analytical Issues

Article excerpt

Reserve requirements have traditionally been viewed as a key instrument of monetary policy. Indeed, textbook discussions of monetary policy typically center on the role of reserve requirements in determining the size of the money multiplier and the magnitude of bank credit expansion. In recent years, however, there has been a significant decline in the use of reserve requirements in the United States and in other industrialized countries. Many countries have made substantial cuts in the level of reserve requirements, and some countries have eliminated reserve requirements altogether.

The diminished role of reserve requirements stems from several developments. One factor is a change in the way that central banks implement monetary policy. Over the past decade, many central banks have shifted their emphasis from short-run control of reserves to control over short-term interest rates. While reserve requirements are essential to a reserves strategy, they play a less important role in an interest-rate strategy. A second reason for reduced reliance on reserve requirements is the view that such requirements serve as a tax on depository institutions that puts them at a competitive disadvantage relative to other financial institutions. And third, even where reserve requirements have not been reduced formally, their effectiveness has been reduced by financial innovations. For example, the spread of deposit "sweep accounts" in the United States over the past two years has reduced the level of required reserve balances to its lowest level in 30 years.

The declining use of reserve requirements has important implications for monetary policy. First, in the absence of a binding level of reserve requirements, the demand for central bank balances is no longer determined by the public's demand for transactions deposits and term deposits but, instead, depends on depository institutions' need to hold balances for clearing and settlement purposes. This means that there is a direct connection between the payments system and monetary policy and implies that institutional changes in the payments system, such as new clearing and settlement methods, may require corresponding changes in monetary policy operating procedures. Second, the absence of binding reserve requirements may lead to increased volatility of short-term interest rates and impair the ability of central banks to implement monetary policy. If so, central banks may have to adapt operating procedures to contain this volatility.

This article, the first of two, examines the implications for monetary policy of the declining use of reserve requirements. The first section discusses the historical role of reserve requirements and documents their recent decline in the United States and other industrialized countries. The second section shows how a reduction in reserve requirements can lead to an environment in which monetary policy issues and payments system issues are directly linked. The third section discusses how a reduction in reserve requirements potentially increases the volatility of short-term interest rates. The companion article, to be published in a future issue of the Review, looks at three countries that have eliminated reserve requirements-Canada, the United Kingdom, and New Zealand-and asks whether adaptations to monetary policy procedures in those countries could be extended to the United States.

I. THE DECLINING USE OF RESERVE REQUIREMENTS

While reserve requirements have been a part of banking systems for many years, their role has evolved due to changes in the financial system and monetary policy operating procedures. Once viewed as essential in controlling the creation of money and credit and providing financial stability, reserve requirements have come to be seen as a useful supplement to other instruments. As the rationale for reserve requirements has weakened, their use has diminished. In recent years, many central banks have reduced reserve requirements, and, in some countries, reserve requirements have been eliminated. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.