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posted on 26 December 2015

Required Reserves Are An Implicit Tax On Banks, Says Fed

by Dirk Ehnts, Econoblog101

I have often talked to people who think that required reserves "work". They believe that an increase in the ratio of required reserves (to deposits) will stop borrowing - or rather lending. That is not what seems to be happening, as lots of available evidence shows. Among others, there is a paper by Finn Körner and myself on Chinese monetary policy.

We find that even though the required reserve ratio is varied over time, an increase does not mean that the quantity of bank loans stop growing. There is hence no easy way to connect required reserves to the quantity of bank loans. Instead, it is quite well-known that required reserves are a tax on the banking sector, since they used to get no interest for holding these reserves in a special account at the Fed. The US central bank now does pay an interest rate on required reserves. The Fed also writes on its website:

The interest rate on required reserves (IORR rate) is determined by the Board and is intended to eliminate effectively the implicit tax that reserve requirements used to impose on depository institutions.

So, both theoretically and empirically there are sound arguments against using the required reserve ratio as a tool to influence the quantity of credit. Nevertheless, you can still use it as a tool to drain excess reserves and put a floor to your short-term interest rate. After all, nobody in the money market will be willing to lend at a rate below the deposit rate that is paid on both required and excess reserves.

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