July 9, 2007

Richmond Fed's Economic Quarterly Examines Interest Payment on Banks' Reserves as an Alternative to Daylight Credit

Richmond, VA

Interest on Reserves and Daylight Credit by Huberto M. Ennis and John A. Weinberg

Congress passed a law last year that allows the Federal Reserve to pay interest on balances held by depository institutions at the central bank. The implications for the demand for reserves, and by extension, monetary policy, may be significant. At present, banks face opportunity costs for holding reserves overnight at the Fed, since their funds might be able to earn interest if deployed elsewhere. During the daytime, banks weigh the tradeoff of holding as few reserves as possible with the costs of obtaining intraday credit from the Fed to meet their payment obligations. By 2011, when the new law takes effect, the incentives for these choices will be different. Since effective monetary policy may depend on predictable demand for reserves, understanding how these new incentives alter banks' decisions about reserve holdings may be useful. Richmond Fed economists Huberto Ennis and John Weinberg build a model of the demand for reserves by banks and study the potential consequences of paying interest on reserves.

You can find the full text of this article and others in the latest issue of Economic Quarterly at the Bank's Web site.

Also in the Spring 2007 issue:

  • How Accurate Are Real-Time Estimates of Output Trends and Gaps? by Mark W. Watson
  • The Economics of Sovereign Defaults by Juan Carlos Hatchondo, Leonardo Martinez, and Horacio Sapriza
  • Banks and Liquidity Creation: A Simple Exposition of the Diamond-Dybvig Model  by Douglas W. Diamond

The Economic Quarterly is a free publication containing economic analysis pertinent to Federal Reserve monetary and banking policy. For free copies or more information, contact the Federal Reserve Bank of Richmond's Public Affairs office at 804.697.7982.

The Richmond Fed serves the Fifth Federal Reserve District, which includes the District of Columbia, Maryland, North Carolina, South Carolina, Virginia and most of West Virginia. As part of the nation's central bank, we're one of 12 regional Reserve Banks that work together with the Federal Reserve's Board of Governors to strengthen the economy and our communities. We manage the nation's money supply to keep inflation low and help the economy grow. We also supervise and regulate financial institutions to help safeguard our nation's financial system and protect the integrity and efficiency of our payments system.


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