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The Federal Reserve's operating procedure, nonborrowed reserves, borrowed reserves and the liquidity effect

  • Daniel L. Thornton

Recently, there has been considerable interest in identifying the exogenous policy actions of the Fed and a number of identification methods have been proposed. This paper deals with one of these, namely, using nonborrowed reserves in a recursive structural vector autoregression(VAR). A number of researchers [Christiano, Eichenbaum and Evans (1994ab, 1996, 1997), Evans and Marshall(1997), Strongin(1995), Pagan and Robertson(1995) and Brunner(1994)] find evidence of a statistically significant liquidity effect using nonborrowed reserves in a VAR. The success in finding the liquidity effect with nonborrowed reserves in the VAR is attributed to innovations to nonborrowed reserves reflecting supply shocks while innovations to total reserves primarily reflect shocks to demand. The purpose of this paper is to demonstrate that the opposite is true. Evidence of the liquidity effect in recursive structural VARs depends critically on the existence of a negative covariance between the federal funds rate and nonborrowed reserves. Under a variety of operating objectives, the Trading Desk of the Federal Reserve Bank of New York has offset changes in bank-initiated discount window borrowing when implementing the Federal Open Market Committee's policy directive. This practice has created a negative contemporaneous covariance between nonborrowed reserves and the funds rate that has been incorrectly attributed to the liquidity effect. Once the Desk's practice is accounted for, there is no evidence of a statistically significant liquidity effect.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 1998-009.

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Date of creation: 1998
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Publication status: Published in Journal of Banking and Finance, September 2001, 25(9), pp. 1717-39
Handle: RePEc:fip:fedlwp:1998-009
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  35. Jon Faust, 1998. "The robustness of identified VAR conclusions about money," International Finance Discussion Papers 610, Board of Governors of the Federal Reserve System (U.S.).
  36. Daniel L. Thornton, 1988. "The borrowed-reserves operating procedures: theory and evidence," Review, Federal Reserve Bank of St. Louis, issue Jan, pages 30-54.
  37. Spindt, Paul A. & Tarhan, Vefa, 1987. "The Federal Reserve's new operating procedures : A post mortem," Journal of Monetary Economics, Elsevier, vol. 19(1), pages 107-123, January.
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