Some Myths About Interest on Reserves

There are two myths that I see repeated about interest on reserves that I would like to address:

1. “Of course the banking system is holding more reserves. They have no choice. The quantity of reserves is set by the Federal Reserve.”

That last sentence is correct. However, the relevant question is why banks are holding these reserves as excess reserves rather than as required reserves.

The typical way that we teach students about open market operations is as follows. Suppose that each component of the bank’s balance sheet is consistent with profit-maximization given a binding reserve requirement. The central bank conducts open market operations by buying bonds from the bank and crediting the reserve account of the bank. The bank now finds itself holding excess reserves. If the central bank is not paying interest on reserves, this is costly for the bank since it is now holding more reserves than it would prefer. As a result, the bank would lend out these excess reserves. What follows is the process of multiple deposit creation. When this process concludes, the quantity of reserves in the system will not have changed, but since the reserve requirement is binding, no bank will be holding excess reserves. Each bank is holding the required amount of reserves.

To say that banks are holding excess reserves because they have no other choice is therefore incorrect. While it is true that banks must hold the quantity of reserves determined by the Federal Reserve, their decision-making will determine whether they hold these reserves as excess reserves or required reserves. If banks are holding excess reserves, this implies that there is no operative mechanism of deposit creation. We might want to ask ourselves why this is the case.

On this point, Dutkowsky and VanHoose have written an excellent paper that looks at the profit-maximizing behavior of banks. Their model provides for the possibility of three different equilibria: (1) an interior solution in which banks hold excess reserves and participated in the wholesale loan market, (2) an equilibrium in which banks participate in the wholesale loan (fed funds) market, but do not hold excess reserves, and (3) an equilibrium in which banks hold excess reserves, but do not participate in the wholesale loan (fed funds) market.

What they show is the equilibria that we end up in depends critically on the relationship between the interest rate on excess reserves and the fed funds rate. In particular, they show that the interior solution equilibrium is operable under very narrow restrictions on the relationship between rates. In other words, we tend to either be in an equilibrium in which there are no excess reserves OR in an equilibrium in which there is no wholesale lending. While it is slightly more complicated than this, a general rule-of-thumb from my reading of the paper is that if the interest rate on reserves is higher than the fed funds rate, then this results in an equilibrium in which banks hold excess reserves and do not participate in the wholesale loan market.

The interest rate on reserves has been higher than the fed funds rate since 2009. Dutkowsky and VanHoose show a corresponding precipitous decline in interbank lending that has taken place in the period since.

Why is this important?

Typically banks are not willing to hold excess reserves because doing so is costly. In fact, if the required reserves constraint is binding, then banks will never want to hold excess reserves because they do not even want to hold the required amount. However, if banks are willing to hold excess reserves, then this process of multiple deposit creation will not be operable — or at least not to the extent that it would be traditionally.

This leads me to the second myth about interest on reserves.

2. “Interest on reserves gives the central bank flexibility to provide liquidity without sacrificing its ability to conduct monetary policy.”

The idea behind this statement is that when the central bank pays interest on reserves, banks are willing to hold more reserves which helps to better facilitate payments and provide liquidity to the banking system. At the same time, or so the argument goes, the interest rate on reserves becomes the relevant policy interest rate. As a result, by paying interest on reserves, the central bank can increase the amount of reserves in the system, streamline the payment process, provide liquidity, and still conduct monetary policy as it normally does.

This argument, however, presumes that the monetary policy works solely through the short term interest rate. However, monetarists like Friedman and Schwartz and Brunner and Meltzer, argued that monetary policy worked through open market operations by adjusting the relative supply of assets. This change in the composition of assets required changes in relative prices since assets are not all perfect substitutes. The process of relative price adjustment continues until everyone is satisfied with their new portfolio. For example, consider Friedman and Schwartz’s description of the monetary transmission mechanism in their paper “Money and Business Cycles”:

Let us now suppose that an unexpected rise to a new level occurs in the rate of change in the money stock, and it remains there indefinitely…To be definite, therefore, let us suppose it comes from an increased rate of open market purchases by a central bank.

Although the initial sellers of the securities purchased by the central bank were willing sellers, this does not mean that they want to hold the proceeds in money indefinitely. The bank offered them a good price, so they sold; they added to their money balances as a temporary step in rearranging their portfolios. If the seller was a commercial bank, it now has larger reserves than it has regarded before as sufficient and will seek to expand its investments and its loans at a greater rate than before. If the seller was not a commercial bank, he is not likely even temporarily to want to hold the proceeds in currency but will deposit them in a commercial bank, thereby, in our fractional reserve system, adding to the bank’s reserves relative to its deposits. In either case, therefore, in our system, commercial banks become more liquid. In the second case, in addition, the nonbank sellers has a higher ratio of money in his portfolio that he has had hitherto.

Both the nonbank seller and commercial banks will therefore seek to readjust their portfolios, the only difference being that the commercial banks will in the process create more money, thereby transmitting the increase in high-powered money to the total money stock…

They go on to explain that this portfolio reallocation will result in changes in relative prices and ultimately economic activity until equilibrium is restored.

Similarly, Ben Bernanke has described the monetary transmission mechanism as follows:

I see the evidence as most favorable to the view that such purchases work primarily through the so-called portfolio balance channel, which holds that once short-term interest rates have reached zero, the Federal Reserve’s purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public.

Specifically, the Fed’s strategy relies on the presumption that different financial assets are not perfect substitutes in investors’ portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets. Thus, our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration. For example, some investors who sold MBS to the Fed may have replaced them in their portfolios with longer-term, high-quality corporate bonds, depressing the yields on those assets as well.

The logic of the portfolio balance channel implies that the degree of accommodation delivered by the Federal Reserve’s securities purchase program is determined primarily by the quantity and mix of securities the central bank holds or is anticipated to hold at a point in time (the “stock view”), rather than by the current pace of new purchases (the “flow view”). In support of the stock view, the cessation of the Federal Reserve’s purchases of agency securities at the end of the first quarter of this year seems to have had only negligible effects on longer-term rates and spreads.

Implicit in these discussion is that there isn’t one particular asset price that matters for transmitted monetary policy. Rather, what matters are the relative quantities of the assets and the relative price adjustment necessary to get to an equilibrium in which everyone is satisfied with their portfolio.

If Bernanke and the monetarists are correct, then the change in the Federal Reserve’s operating procedures should give one pause about the ability of monetary policy to continue unaffected in a world of interest on reserves. Dutkowsky and VanHoose’s model suggests that open market operations should largely be irrelevant because we are currently in an equilibrium in which the interest rate on reserves is higher than the fed funds rate. As a result, banks are likely to hold excess reserves rather than engage in portfolio reallocation. Thus, one must rely on “the” short term nominal interest rate, in this case the interest rate on reserves, to influence economic activity. Whether or not this mechanism is sufficient depends on the sensitivity of macroeconomic variables to the short term interest rate. The empirical evidence suggests that the responsiveness of things like investment to interest rates is actually quite weak. As a result, there is some reason for concern about the ability of monetary policy to work as it normally does.

2 responses to “Some Myths About Interest on Reserves

  1. David Chester


    Our present complicated system for taxation is unfair and has many faults. The biggest problem is to arrange it on a socially just basis. Many companies employ their workers in various ways and pay them diversely. Since these companies are registered in different countries for a number of categories, the determination the criterion for a just tax system becomes impossible, particularly if based on a fair measure of human work-activity. So why try when there is a better means available, which is really a true and socially just method?

    Adam Smith (“Wealth of Nations”, 1776 REF. 1) says that land is one of the 3 factors of production (the other 2 being labor and durable capital goods). The usefulness of land is in the price that tenants pay as rent, for access rights to the particular site in question. Land is often considered as being a form of capital, since it is traded similarly to other durable capital goods items. However it is not actually man-made, so rightly it does not fall within this category. The land was originally a gift of nature (if not of God) for which all people should be free to share in its use. But its site-value greatly depends on location and is related to the community density in that region, as well as the natural resources such as rivers, minerals, animals or plants of specific use or beauty, when or after it is possible to reach them. Consequently, most of the land value is created by man within his society and therefore its advantage should logically and ethically be returned to the community for its general use, as explained by Martin Adams (in “LAND”, 2015, REF 2.).

    However, due to our existing laws, land is owned and formally registered and its value is traded, even though it can’t be moved to another place, like other kinds of capital goods. This right of ownership gives the landlord a big advantage over the rest of the community because he determines how it may be used, or if it is to be held out of use, until the city grows and the site becomes more valuable. Thus speculation in land values is encouraged by the law, in treating a site of land as personal or private property—as if it were an item of capital goods, although it is not (Prof. Mason Gaffney and Fred Harrison: “The Corruption of Economics”, 2005 REF. 3).

    Regarding taxation and local community spending, the municipal taxes we pay are partly used for improving the infrastructure. This means that the land becomes more useful and valuable without the landlord doing anything—he/she will always benefit from our present tax regime. This also applies when the status of unused land is upgraded and it becomes fit for community development. Then when this news is leaked, after landlords and banks corruptly pay for this information, speculation in land values is rife. There are many advantages if the land values were taxed instead of the many different kinds of production-based activities such as earnings, purchases, capital gains, home and foreign company investments, etc., (with all their regulations, complications and loop-holes). The only people due to lose from this are the “army” of tax collectors employed by the government, as well as those who exploit the growing values of the land over the past years. Here “mere” land ownership confers a financial benefit, without the owner doing a scrap of work. Consequently, for a truly socially just kind of taxation to apply there can only be one method–Land-Value Taxation.

    Consider how land becomes valuable. New settlers in a region begin to specialize and this improves their efficiency in producing specific goods. The central land is the most valuable due to easy availability and least transport needed. This distribution in land values is created by the community and (after an initial start), not by the natural resources. As the city expands, speculators in land values will deliberately hold potentially useful sites out of use, until planning and development have permitted their values to grow. Meanwhile there is fierce competition for access to the most suitable sites for housing, agriculture and manufacturing industries. The limited availability of useful land means that the high rents paid by tenants make their residence more costly and the provision of goods and services more expensive. It also creates unemployment, causing wages to be lowered by the monopolists, who control the big producing organizations, and whose land was already obtained when it was cheap. Consequently this basic structure of our current macroeconomics system, works to limit opportunity and to create poverty, see above reference.

    The most basic cause of our continuing poverty is the lack of properly paid work and the reason for this is the lack of opportunity of access to the land on which the work must be done. The useful land is monopolized by a landlord who either holds it out of use (for speculation in its rising value), or charges the tenant heavily for its right of access. In the case when the landlord is also the producer, he/she has a monopolistic control of the land and of the produce too, and can charge more for this access right than what an entrepreneur, who seeks greater opportunity, normally would be able to afford.

    A wise and sensible government would recognize that this problem derives from lack of opportunity to work and earn. It can be solved by the use of a tax system which encourages the proper use of land and which stops penalizing everything and everybody else. Such a tax system was proposed 136 years ago by Henry George, a (North) American economist, but somehow most macro-economists seem never to have heard of him, in common with a whole lot of other experts. (I would guess that they don’t want to know, which is worse!) In “Progress and Poverty” 1879, REF. 4, Henry George proposed a single tax on land values without other kinds of tax on produce, services, capital gains etc. This regime of land value tax (LVT) has 17 features which benefit almost everyone in the economy, except for landlords, tax-men and banks, who/which do nothing productive and find that land dominance has its own reward.

    17 Aspects of LVT Affecting Government, Land Owners, Communities and Ethics

    Four Aspects for Better Government:
    1. LVT, adds to the national income as do other taxation systems, but it should replace them.
    2. The cost of collecting the LVT is less than for all other production-related taxes, since tax avoidance becomes impossible–the various sites are visible to all, and their ownership is public knowledge.
    3. Consumers pay less for their purchases due to lower production costs (see below). This creates greater satisfaction with the management of national affairs.
    4. The speculation in and withholding of unused land is eliminated, see item 7 and the national economy stabilizes. It no longer experiences the 18 year business boom/bust cycle, due to periodic speculation in land values (see below).

    Six Aspects Affecting Land Owners:
    5. LVT is progressive–owners of the most potentially productive sites pay the most tax. Urban sites provide the most usefulness and resulting tax. Big rural sites have less value and can be farmed appropriately to their ability to provide useful produce.
    6. The land owner pays his LVT regardless of how his site is used. A large proportion of the present ground-rent from tenants becomes the LVT, with the result that land has less sales-value but a significant “rental”-value (even when it is not used).
    7. LVT stops speculation in land prices because the withholding of land from proper use is not worthwhile.
    8. The introduction of LVT initially reduces the sales price of sites, even though their rental value can still grow over a longer term. As more sites become available, the competition for them is less fierce.
    9. With LVT, land owners are unable to pass the tax on to their tenants as rent hikes, due to the reduced competition for access to the additional sites that come into use.
    10. With LVT, land prices will initially drop. Speculators in land values will want to foreclose on their mortgages and withdraw their money for reinvestment. Therefore LVT should be introduced gradually, to allow these speculators sufficient time to transfer their money to company-shares etc., and simultaneously to meet the increased demand for produce (see below, items 12 and 13).

    Three Aspects Regarding Improved Communities:
    11. With LVT, there is an incentive to use land for production or residence, rather than it being unused.
    12. With LVT, greater working opportunities exist due to cheaper land and a greater number of available sites. Consumer goods become cheaper too, because entrepreneurs have less difficulty in starting-up their businesses and because they pay less ground-rent–demand grows, unemployment decreases.
    13. Investment money is withdrawn from land and placed in durable capital goods. This means more advances in technology and cheaper goods too.

    Four Aspects About Kinder Ethics:
    14. The collection of taxes from productive effort and commerce is socially unjust. LVT replaces this national extortion by gathering the surplus rental income, which comes without any exertion from the land owner or by the banks– LVT is a natural system of national income-gathering.
    15. The previous bribery and corruption for gaining privileged information about land cease. Before, this was due to the leaking of news of municipal plans for housing and industrial development, causing shock-waves in local land prices (and municipal workers’ and lawyers’ bank balances).
    16. The improved use of the more central land of cities reduces the environmental damage due to a) unused sites being dumping-grounds, and b) the smaller amount of fossil-fuel use, when traveling between home and workplace.
    17. Because the LVT eliminates the advantage that landlords currently hold over our society, LVT provides a greater equality of opportunity to earn a living. Entrepreneurs can operate in a natural way– to provide more jobs because their production costs are reduced. Then untaxed earnings will correspond to the value that the labor puts into the product or service. Consequently, after LVT has been properly and fully introduced as a single tax, it will eliminate poverty and improve business ethics.

    1. Adam Smith: “The Wealth of Nations”, 1776.
    2. Martin Adams: “LAND– A New Paradigm for a Thriving World”, North Atlantic Books, California, 2015.
    3. Mason Gaffney and Fred Harrison: “The Corruption of Economics”, Shepheard-Walyn, London, 2005.
    4. Henry George: “Progress and Poverty” 1897, reprinted by Schalkenbach Foundation, NY, 1978.

    We should tax LAND and not LABOR; tax TAKINGS not MAKINGS!

  2. Pingback: Some Myths About Interest on Reserves – Daily Economic Buzz

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