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Excess Reserves and Monetary Policy Normalization

Listed author(s):
  • Benjamin Lester

    (Federal Reserve Bank of Philadelphia)

  • Roc Armenter

    (Federal Reserve Bank of Philadelphia)

We provide a framework to understand the factors affecting current short-term interest rates in the federal funds market given the presence of excess reserves and liquidity facilities. The key ingredients of our model are as follows. There is a central bank that operates two facilities: one pays interest on excess reserves to qualified depository institutions (DIs), and another provides a positive rate of return for overnight reverse repurchase agreements. The latter (ON RRP) rate is lower than the former (IOER) rate, but is available to financial institutions with excess cash that do not qualify as DIs. Hence, there is an arbitrage opportunity: DIs should be willing to borrow cash at a rate below the IOER rate and pocket the difference. However, there are two potential frictions in this inter-bank market. First, we assume that the market is not perfectly competitive, but rather characterized by search frictions in order to capture the ``over-the-counter'' nature of the fed funds market. The second key friction in our model is that DIs incur balance sheet costs when they accept deposits from lenders; these costs capture both the direct costs of a DI expanding its balance sheet, like FDIC fees, as well as the indirect costs associated with requirements on capital and leverage ratios.

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File URL: https://economicdynamics.org/meetpapers/2015/paper_586.pdf
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Paper provided by Society for Economic Dynamics in its series 2015 Meeting Papers with number 586.

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Date of creation: 2015
Handle: RePEc:red:sed015:586
Contact details of provider: Postal:
Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

Web page: http://www.EconomicDynamics.org/
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  1. Gara Afonso & Ricardo Lagos, 2015. "Trade Dynamics in the Market for Federal Funds," Econometrica, Econometric Society, vol. 83, pages 263-313, January.
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  17. repec:fip:fednsp:900 is not listed on IDEAS
  18. Leonardo Bartolini & Spence Hilton & Alessandro Prati, 2008. "Money Market Integration," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(1), pages 193-213, February.
  19. Moen, Espen R, 1997. "Competitive Search Equilibrium," Journal of Political Economy, University of Chicago Press, vol. 105(2), pages 385-411, April.
  20. Bech, Morten L. & Klee, Elizabeth, 2011. "The mechanics of a graceful exit: Interest on reserves and segmentation in the federal funds market," Journal of Monetary Economics, Elsevier, vol. 58(5), pages 415-431.
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