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The paper benefited from comments by Warren Coats, Stefan Ingves, Mario Mesquita, V. Sundararajan, Delisle Worrell, and participants in an internal MAE seminar. It also benefited from the research assistance of Kiran Sastry.
Velocity is calculated as the ratio of nominal GDP to base money. Money multipliers are calculated as the ratio of broad money to base money.
Some of the countries that are presently very close to targeting zero reserves include Australia, Belgium, Canada, Mexico, the U.K., and Sweden.
Note that, although wholesale payment systems have undergone important changes, the retail sector has been relatively slow to adopt new technologies. For example, the far-sweeping reforms and changes which many people predicted in the 1960’s and 1970’s did not take place. See Flannery (1996).
This is often feasible when the total number of banks is small and the electronic payments clearing between banks is well-developed. The payment instructions are processed centrally at each bank and sent to other banks usually in the form of batch transfers several times each day. Banks establish bilateral credit lines to one another to cover intraday shortfalls in liquidity. Intraday credits may or may not be collaterized.
In 1998, average daily transactions reached US$1.2 trillion while net end-of-day settlements amounted to only US$7 billion, i.e., a ratio of 171. See Richards (1995).
In the extreme case of continuous settlement, net clearing systems become gross systems.
This is the case, for example, of Argentine clearinghouses.
The stock of treasury securities held by banks in the U.S. at the end of 1973 was 91 billion U.S. dollars, compared to central bank reserves of 38 billion U.S. dollars, a ratio slightly over 2:1. Comparable figures for 1998 were 790 billion U.S. dollars and 65 billion U.S. dollars, respectively, i.e., a ratio of 12:1.
When banks must meet their settlement obligations by the end of the day, the demand for settlement balances is typically very insensitive to changes in the overnight rate over its typical range of variation, which implies that the overnight rate can become more volatile when reserve requirements are not binding. Recent experiences seem to confirm this prediction. For example, the volatility of the Federal funds rate rose sharply at the end of 1990 around the time of the Federal Reserve’s cut of reserve requirements.
In countries with unsound banking systems and weak bank supervision, the use of reserve requirements has also been advocated on prudential grounds, i.e., to ensure that banks hold a minimum liquidity that can be used to avoid undermining the payments system when a bank becomes illiquid or bankrupt. In some cases, the use of unremunerated reserve requirements has also been advocated as an additional source of seignorage revenue. However, if the aim of reserve requirements is strictly to generate quasi-fiscal revenue, a better targeted—hence more efficient—alternative would consist in directly taxing banks in proportion to their liabilities, without freezing their deposits. The seignorage issue, which is relevant to a central bank which no longer issues monetary liabilities—hence loses its seignorage on currency emission—is briefly addressed in Section III-C.
Under an averaging system, the demand for reserves becomes very elastic around the level of the rate expected to prevail in the immediate future.
These theoretical predictions are confirmed by a number of empirical studies. Poole (1968) investigates the U.S. Federal funds market and finds that, “the standard deviation of the Federal funds rate increases day by day over the [reserve averaging period].” Spindt and Hoffmeister (1988) also find evidence that the variance of the overnight rate is higher towards the end of each business day and is highest near the end of settlement days. See also Borio (1997) and Sellon and Weiner (1996, 1997).
Countries which currently do not have reserve requirements in place are Belgium, Kuwait, Norway, Switzerland, and the United Kingdom (see Fry et al., 1999). Canada and Mexico have introduced zero reserve requirement regimes.
There exists a wealth of papers analyzing a bank’s reserve management problem under payments uncertainty. Prominent among these are Orr and Mellon (1961), Poole (1968), Baltensperger (1974), Baltensperger and Milde (1976), and Stanhouse (1986). A dynamic treatment of the problem is presented in Ravalo (1995). Baltensperger (1974, p. 205) argues that, “in many instances the degree of ‘knowledge’ or ‘certainty’ about reserve changes is, to a certain extent, subject to the control of the decision maker. One of the main functions of precautionary reserves is, therefore, to save on planning and information costs.”
The literature has very little to say about such strategic issues affecting bank behavior, how they relate to the demand for reserves, and how payment system developments fit into the picture.
The model developed in this section is in the tradition of the models of demand for bank reserves under payments uncertainty that were first proposed by Poole (1968).
Note that the central bank’s discount rate can be lower than the money market rate, as in the case of the U.S., when there are significant non-pecuniary costs to accessing the discount window. For more on the use of Federal funds versus the discount window as a borrowing source, see Ho and Saunders (1985) and Smirlock and Yawitz (1985).
When excess reserves are not remunerated, symmetry leads to the familiar result that the central bank’s lending rate must equal twice the money market rate.
The existence of a liquidity effect has been on the research agenda for some time and experienced a strong revival in the 1990’s. While not always conclusive, the evidence is generally in favor of the existence of a liquidity effect, that is, additional reserves do lower the interbank interest rate. Empirical results were not satisfying until researchers distinguished between non-borrowed and borrowed reserves and accounted for the endogeneity of borrowed reserves. For key papers in this area, see Leeper and Gordon (1994), Chari, Christiano, and Eichenbaum (1995), and Hamilton (1997).
The model presented here is a gross simplification of reality and can be extended in many ways. In particular, transaction costs, non-pecuniary costs to accessing the central bank’s lending window, limits on access, or non-linear schedules for borrowing from this window can be introduced, as in Poole (1968), Baltensperger (1974), Baltensperger and Milde (1976), and Stanhouse (1986). However, these more complete analyses do not yield substantially more insight.
For example, the Swiss central bank uses a deactivated discount window facility to provide guidance on interest rates. For details, see Borio (1997).
A settlement system with such characteristics has been recently introduced in Malaysia.
For example, in the context of an attack on the currency, central banks may wish to communicate that while they are ready to let short-term rates rise sharply, they view this increase as strictly transitory (i.e., interest rates should return to their “normal” level in the near future).
See in particular the path-breaking analysis in Woodford (1997), which shows that in a model where money vanishes a stable local equilibrium continues to exist for the rate of inflation even when money balances are zero.
While central banks can continue to manage treasury accounts even if they do not issue their own money (these two functions are totally unrelated), the trend is towards the treasuries taking increasing responsibility for managing their liquidity in accounts with commercial banks.
Notice that the debate as to whether central banks should conduct their monetary operations on the liability side or asset side of their balance sheet (i.e., leaving the system structurally long or structurally short) can be reinterpreted in the context of a moneyless economy as a preference for leaving banks usually dependent on the end-of-day borrowing facility. However, the potential benefit of leaving the market short on a routine basis is essentially an empirical issue which, to our knowledge, remains to be fully substantiated.
Such lender of last resort support can only be justified when banks are unable to borrow in the interbank market due to widespread “market failure.” This may occur in particular in the case of a systemic crisis when, due to asymmetric information and a large systemic increase in credit risk, the interbank market becomes fragmented or breaks down altogether. See Holmstrom and Tirole (1998).
This is similar in spirit to what Timberlake (1984) refers to as a Treasury open-market operation.
The central bank can then deposit the “proceeds” of the treasury bill issues in a frozen remunerated account on the liability side of its balance sheet. Arrangements of this type have been introduced in several central banks, including in Mexico.
On the “fiscal” theory of the price level, see Woodford (1997). An early analysis of underlying linkages between fiscal and monetary theories can be found in Sargent and Wallace (1981). See Ize (1987) for a related interpretation of exchange rate theory.
However, the scope for inflating away the domestic debt in a non monetary economy is limited by the level of nominal interest rates. Thus, if nominal interest rates are initially very close to zero (as in the current Japanese “liquidity trap”), liquidating the public debt through negative real interest rates could become altogether impractical or impossible. In an open economy, a more effective liquidation of public debt can be obtained through a demand shift to foreign securities, away from domestic securities, which leads to price increases through an exchange rate depreciation. See Ize (1987).
While this discussion goes beyond the scope of this paper, it is worth noticing that even governments that do not face systematic financing requirements may find it advantageous to develop a treasury bill market, either to cover short-term cashflow imbalances or to facilitate intergenerational wealth transfers.
The interest rate instability results from the fact that with very limited settlement balances it becomes easy for clearinghouse participants to “corner” the market, i.e., to borrow intra-day and leave the money market short. When such activities occur towards the end of the trading day, it becomes difficult for foreign interest rate arbitraging to undo such activities on a timely basis, even with a fully open economy. In Hong Kong, for example, speculators were able during 1998 to manipulate stock prices by forcing money market rates to rise, which led the monetary authorities to intervene directly in the stock market to stabilize it.
One possible solution consists in expanding the definition of the monetary base to include other (fully backed) central bank liabilities with banks (such as required reserves or central bank bills) that can be used flexibly to obtain settlement balances at a repo rate set by the central bank. Thus, the Hong Kong monetary authorities have recently broadened the definition of the monetary base to include (fully backed) central bank bills that banks can use for daily settlements through automatic repo operations with the central bank at a predetermined rate. Another solution could follow the route suggested earlier in this paper of a two-stage settlement process which obliges clearinghouse participants with long end-of-day positions to lend these resources to the monetary authority so that they can be on-lent to participants that are short, at central bank-determined interest rates.
Indeed, in the limiting case of a currency board with zero base money, the absurd conclusion could be reached that zero international reserves backing is needed to make it credible.