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Market Operations under the Three-Tier System- Explanation Using the Reserve Demand Curve Model -

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  • Takuto Arao

    (Bank of Japan)

Abstract

In Japan's money markets, negative interest rate transactions prevail under the three-tier system applied to the financial institutions' current accounts held at the Bank of Japan. This paper explains the mechanism of short-term interest rate formation under the three-tier system and the concept of market operations using a simple reserve demand curve model. Under the three-tier system, in which current deposits are divided into three tiers and different interest rates are applied to each tier, financial institutions have an incentive to conduct money market transactions for arbitrage purposes depending on to which tier their outstanding current account balances fill up prior to money market transactions. The Bank realizes negative interest rates consistent with yield curve control by taking steps so that the "hypothetical policy-rate balance (the policy-rate balance that remains assuming that arbitrage transactions have taken place in full), " is maintained at a certain level. The shape of the reserve demand curve is considered to be downward sloping around the boundaries of each tier due to the uncertainties over future course of current account balances. The shape and position of the reserve demand curve will change depending on the degree of the uncertainties and other factors such as the use of Special Operations in Response to COVID-19 and various loan support programs. Short-term interest rates also change when arbitrage transactions are not conducted in full due to market friction. It can be interpreted that the Bank influences on short-term interest rates by changing the reserve demand curve and the reserve supply curve through setting the Benchmark Ratio and carrying out market operations based on the information about these factors.

Suggested Citation

  • Takuto Arao, 2022. "Market Operations under the Three-Tier System- Explanation Using the Reserve Demand Curve Model -," Bank of Japan Research Papers 22-05-27, Bank of Japan.
    • Handle: RePEc:boj:bojron:ron220527a
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    References listed on IDEAS

    as
    1. William Poole, 1968. "Commercial Bank Reserve Management In A Stochastic Model: Implications For Monetary Policy," Journal of Finance, American Finance Association, vol. 23(5), pages 769-791, December.
    2. Whitesell, William, 2006. "Interest rate corridors and reserves," Journal of Monetary Economics, Elsevier, vol. 53(6), pages 1177-1195, September.
    3. Alessandro Secchi, 2019. "A two-tier system for remunerating banks’ excess liquidity in the euro area: aims and possible side effects," Questioni di Economia e Finanza (Occasional Papers) 534, Bank of Italy, Economic Research and International Relations Area.
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