Interest on Reserves: A Fourth Tool
of Monetary Policy
Shawn Osell
Department of Business and Economics
University of Wisconsin – Superior
sosell1@uwsuper.edu
1


QE1: September, 2008.
IORs: implemented on October, 2008
(Emergency Economic Stabilization Act)


QE2: November 2010 - June, 2011. $60B
of T-bills
Operation Twist
(decrease long term interest rates)

QE3: Announced Sept, 2012. $40B/month
of MBS**
2
M2; 1960 – 2012
http://research.stlouisfed.org/
3
4
What is the money multiplier?
(m)
 The maximum change in the money supply
due to an initial change in the excess
reserves banks hold
What is the money multiplier equal to?
 m = 1 / required reserve ratio ≡ 1/r
i.e. 1/10% = 1/(1/10) = 10
  M1 =initial ER x m
i.e. $90 X 10 = $900.
5
Bank
TR (Deposits)
RR
ER  loans
(or bonds)
M1
Cumulative
ΔM1
A
$100 from O.M.O.
$0
$100
$100
$0
B
$100
$10
$90
$100
$0
C
90
9
81
190
90
D
81
8.10
72.9
271
171
E
72.9
7.29
65.61
343.9
243.9
F
65.61
⁞
⁞
Total:
⁞
⁞
$1,000
$900
6
Can the multiplier be smaller than indicated?
The simple money multiplier assumes that:
1.* banks want to lend out all of their ER’s
2. borrowers’ want to borrow all of a bank’s ER’s
3. All loans are deposited back into the banking
system.
7
8
Interest on
Required
Reserves
Interest on
Excess
Reserves
Effective
Federal
Reserve Rate
Target Federal
Funds Rate
Date Value
2008-10-22 1.40
Date Value
2008-10-15 0.75
2008-10-22 0.75
2008-10-29 0.65
2008-11-05 0.65
2008-11-12 1.00
2008-11-19 1.00
2008-11-26 1.00
2008-12-03 1.00
2008-12-10 1.00
2008-12-17 0.25
2008-12-24 0.25
Date
Value
2008-10-01 0.97
Date 12/16/2008
2
2.5
Effective Fed Funds Rate and Interest on Reserves
1.5
2008-11-05 1.11
2008-11-19 1.00
1
2008-12-03 1.00
.5
2008-12-17 0.89
2008-12-31 0.25
2009-01-14 0.25
2008-11-01 0.39
2008-12-01 0.16
0
2009-01-01 0.15
To present 0.25
jan2008
jan2009
jan2010
2008 - 2012
jan2011
jan2012
0.25
.07 - .20
0 - .25
Interest rate on ERs
Effective Federal Funds Rate
9
0
5
10
15
20
Excess Reserves
jan1960
jan1970
jan1980
jan1990
January 1960 -April 2008
jan2000
jan2010
10
0
500
1000
Billions of Dollars
1500
Excess Reserves
jan1960
jan1970
jan1980
jan1990
jan2000
jan2010
jan2000
jan2010
1960 - 2012
Excess Reserves
2000
0
1000
percent change
3000
percent change
jan1960
jan1970
jan1980
jan1990
1960 - 2012
11
0
500
1000
1500
Excess Reserves
jan2008
jan2009
jan2010
2008 - 2012
jan2011
jan2012
12
Consequences of too much easy credit during
the 2000s
 Current economy
 Europe
 Future uncertainty
i.e. presidential election.
 Low interest rates are not profitable for
lenders – no incentive to lend.
 How much impact do/can IORs have?

*** The opportunity cost of lending or buying liquid assets has decreased.
13
Excess Reserves amount and interest rate paid
ERs are in Billions of dollars
.6
.4
.2
0
0
500
1000
Interest rate on ERs
.8
1500
1
Excess Reserves of Depository Institutions
Interest rate on ERs
jan2008
jan2009
jan2010
month, year
jan2011
jan2012
Source: St. Louis FRB
14
ERs and RRs as a percent of TRs
1
.8
.6
.4
.2
0
jan1960
jan1970
jan1980
jan1990
jan2000
jan2010
1960 - 2008
ER as percent ot TR
RR as percent ot TR
1
.8
.6
.4
.2
0
jan2008
jan2009
jan2010
2008 - 2012
ER as percent ot TR
jan2011
jan2012
RR as percent ot TR
15
Excess Reserve ratio = e = ER/D;
where D = Checkable Deposits.
Public can & does hold currency which slows the money creation
process.
Public preference for currency is measured by Currency ratio = c = C/D
Currency has become a larger part of M1 than checkable deposits
 C > D.
Where is all the currency?: i.e. Overseas, Drug Trade.
m= 1+c
r+e+c
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Now, how well can the Fed control the money supply, M1?
MB
X
m
= M1
(MBn + DL) X
1+c
= M1
r+e+c
The Federal Reserve controls: MBn, r = req. reserve ratio
Financial Intermediaries control: e = ER ratio,
and DLs = (note: Discount Loans are a right),
The public controls: c = Currency Ratio.
17
M1 money multiplier
4
3000
M1 money supply and the monetary base
jan1960
2
0
0
1
1000
M1 mm
2000
3
M1 Money Stock
Monetary Base
jan1970
jan1980
jan1990
years 1960 - 2012
jan2000
jan2010
jan1960
jan2000
jan2010
M1 Money Stock
Monetary Base
0
jan1960
2000
1500
1000
500
Billions of dollars
1000
2500
M1 Money Stock
Monetary Base
jan1980
jan1990
years 1960 - 2012
M1 money supply and the monetary base
3000
1500
M1 money supply and the monetary base
jan1970
jan1970
jan1980
jan1990
years 1960 - 2008
jan2000
jan2010
jan2008
jan2009
jan2010
years 2008 - 2012
jan2011
jan2012
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Variable
Obs.
Mean
Std. Dev.
Min
Max
3
Currency and ER ratios
2
Currency Ratio
1
Jan. 1960 – Aug. 2008
ER (Bil.)
584
.8232414
.9451131
.12
19.015
ER ratio
584
.0030797
.0025858
.000558
.0511982
0
e/DD and c/DD
Excess Reserve ratio
jan1960
jan1970
jan1980
jan1990
years 1960 - 2012
jan2000
jan2010
1
2
Sept. 2008 – May, 2012
ER (Bil.)
45
1,091.961
368.0216
59.482
1,618.129
ER ratio
45
2.034559
.470678
.1650902
19
0
e/DD and c/DD
3
Currency and ER ratios
jan2008
jan2009
jan2010
years 2008 - 2012
Excess Reserve ratio
jan2011
Currency Ratio
jan2012
19
Borrowed and Non-Borrowed Reserves
1000
-500
0
500
Billions of Dollars
1500
of Depository Institutions
jan1960
jan1970
jan1980
jan1990
jan2000
jan2010
Month, Year
Non-borrowed Reserves of Depository Institutions
Borrowed Reserves of Depository Institutions
Borrowed and Non-Borrowed Reserves
1000
0
500
-500
Billions of Dollars
1500
of Depository Institutions
jan2008
jan2009
jan2010
2008 - 2012
jan2011
jan2012
Non-borrowed Reserves of Depository Institutions
Borrowed Reserves of Depository Institutions
20
Coef.
t
3
Constant
7625.366*
41.8*
2
Regression on loans after
QE1
ER ratio
- 294.78*
- 6.66*
1
Bank Loans and ER ratio after
QE1
C ratio
- 83.57
- 1.09
Total Loans and Leases of Banks and ER ratio
Loans are in Billions of dollars
0
6600
6800
7000
ER/Deposit ratio
7200
7400
Total Loans and Leases of Commercial Banks
ER/Deposit ratio
jul2008
jul2009
jul2010
month, year
jul2011
jul2012
Adj.-R = .49
Source: BoG and St. Louis FRB
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IORs benefit Financial Intermediaries by
lowering the opportunity cost of holding
Excess Reserves and the Implicit tax on
Required Reserves
 Effective/additional Monetary Policy tool
 Disincentive for lending
 Loss of funds for US Treasury
 Can/will be used to moderate future inflation

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