Central Bank Reserves and the Balance Sheet of Banks

We introduce a tractable model of the two-tier monetary system with heterogeneous agents and incomplete markets. We use this model to characterize the dynamics of bank lending under general fiscal and monetary policy and derive the welfare optimal level of Central Bank reserves and the optimal interest rate on reserves. We also identify a new risk channel of monetary policy. In the model, banks have a dual role as loan providers and money creators, and cannot fully diversify credit risk. Central Bank reserves are used to settle interbank claims and serve as a safe asset, thereby buffering risks for banks. We show how the Central Bank and the Treasury can implement any desired allocation by setting interest rates, issuing a particular amount of reserves, and imposing taxes, and show that uncoordinated policy responses to shocks by the Central Bank alone may cause sub-optimal outcomes and significant instability.