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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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  1. Daniel L. Thornton, 1988. "The borrowed-reserves operating procedures: theory and evidence," Review, Federal Reserve Bank of St. Louis, issue Jan, pages 30-54.
  2. Charles L. Evans & David A. Marshall, 1997. "Monetary policy and the term structure of nominal interest rates: evidence and theory," Working Paper Series, Macroeconomic Issues WP-97-10, Federal Reserve Bank of Chicago.
  3. 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.).
  4. Hoover, Kevin D. & Perez, Stephen J., 1994. "Post hoc ergo propter once more an evaluation of 'does monetary policy matter?' in the spirit of James Tobin," Journal of Monetary Economics, Elsevier, vol. 34(1), pages 47-74, August.
  5. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 1994. "The effects of monetary policy shocks: evidence from the flow of funds," Proceedings, Federal Reserve Bank of Dallas, issue Apr.
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  9. David B. Gordon & Eric M. Leeper, 1992. "The dynamic impacts of monetary policy: an exercise in tentative identification," Working Paper 92-13, Federal Reserve Bank of Atlanta.
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  11. Pagan, A.R. & Robertson, J.C., 1994. "Resolving the Liquidity Effect," Papers 277, Australian National University - Department of Economics.
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  15. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 1997. "Modeling money," Working Paper Series, Macroeconomic Issues WP-97-17, Federal Reserve Bank of Chicago.
  16. Carr, Jack & Darby, Michael R. & Thornton, Daniel L., 1985. "Monetary anticipations and the demand for money: Reply to MacKinnon and Milbourne," Journal of Monetary Economics, Elsevier, vol. 16(2), pages 251-257, September.
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  20. Pagan, A.R. & Robertson, J.C., 1995. "Structural Models of the Liquidity Effect," Papers 283, Australian National University - Department of Economics.
  21. Leeper, Eric M. & Gordon, David B., 1992. "In search of the liquidity effect," Journal of Monetary Economics, Elsevier, vol. 29(3), pages 341-369, June.
  22. Peristiani, Stavros, 1991. "The Model Structure of Discount Window Borrowing," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 23(1), pages 13-34, February.
  23. Thornton, Daniel L & Batten, Dallas S, 1985. "Lag-Length Selection and Tests of Granger Causality between Money and Income," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 17(2), pages 164-78, May.
  24. 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.
  25. Coleman, Wilbur John, II & Gilles, Christian & Labadie, Pamela A, 1996. "A Model of the Federal Funds Market," Economic Theory, Springer, vol. 7(2), pages 337-57, February.
  26. James A. Clouse, 1994. "Recent developments in discount window policy," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), issue Nov, pages 965-977.
  27. R. Alton Gilbert & Michael E. Trebing, 1981. "The FOMC in 1980: a year of reserve targeting," Review, Federal Reserve Bank of St. Louis, issue Aug, pages 2-22.
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  31. Johansen, Soren, 1988. "Statistical analysis of cointegration vectors," Journal of Economic Dynamics and Control, Elsevier, vol. 12(2-3), pages 231-254.
  32. Sims, Christopher A, 1998. "Comment on Glenn Rudebusch's "Do Measures of Monetary Policy in a VAR Make Sense?"," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(4), pages 933-41, November.
  33. Cochrane, John H, 1989. "The Return of the Liquidity Effect: A Study of the Short-run Relation between Money Growth and Interest Rates," Journal of Business & Economic Statistics, American Statistical Association, vol. 7(1), pages 75-83, January.
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  35. Lawrence J. Christiano, 1996. "Identification and the liquidity effect: a case study," Economic Perspectives, Federal Reserve Bank of Chicago, issue May, pages 2-13.
  36. Allan D. Brunner, 1994. "The federal funds rate and the implementation of monetary policy: estimating the Federal Reserve's reaction function," International Finance Discussion Papers 466, Board of Governors of the Federal Reserve System (U.S.).
  37. Cagan, Phillip & Gandolfi, Arthur, 1969. "The Lag in Monetary Policy as Implied by the Time Pattern of Monetary Effects on Interest Rates," American Economic Review, American Economic Association, vol. 59(2), pages 277-84, May.
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  39. Lawrence J. Christiano, 1995. "Resolving the liquidity effect: commentary," Proceedings, Federal Reserve Bank of St. Louis, issue May, pages 55-62.
  40. Daniel L. Thornton, 1988. "The effect of monetary policy on short-term interest rates," Review, Federal Reserve Bank of St. Louis, issue May, pages 53-72.
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