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More on Reserve Requirements

Will be busy this weekend but wanted to quickly respond to a comment by J.P. Koning on my previous post on reserve requirements indicating that Canada does not have such requirements.

I previously argued that a reserve requirement replaces a gold standard as a constraint on credit creation.  I believe this is correct but I don’t mean to imply that it is the only way credit creation can be prevented from going to infinity.  I realize I sort of said that but I was thinking in terms of a simplified model.  The important assumption was that people hold no currency and that all base money takes the form of bank reserves.  This of course is not the case in reality, it just made the model simpler.

Even when this is the case, it is possible for a reserve requirement to be non-binding.  This was the case in my characterization of a “liquidity trap.”  The only potentially problematic implication of this simplified model is that, when the reserve constraint is not binding, the expansion of credit is demand constrained in the sense that the interest rate will be driven down to zero (or the rate of IOR) and credit would expand only to the level that would be supported by the willingness to hold loans at that rate.

In reality, discount rates in Canada have not been zero since they dropped their reserve requirement, though they have been low (maximum of 4.25%) and reserve ratios have been low (usually around 3 or 4%) but not infinitesimal.  But this can be explained by relaxing the (false) assumption that all base money must be reserves and imagining that banks face some risk of becoming illiquid.  If they are concerned about this, they will demand some level of reserves which will most likely be inversely related to the interest rate since the more reserves they hold, the bigger the buffer against illiquidity but the higher the interest rate, the more revenue they must give up on the margin for additional protection.

This is another way of saying, they will have an upward sloping supply of loans.  And for the record, I acknowledged this in the comments of my original market-for-loans post when I said:

A more accurate supply curve would be a monotonically increasing curve above and to the left of the one I drew which is very flat and close to the level of IOR for low quantities and approaches infinity as the quantity approaches the maximum possible quantity but gets pretty close to that quantity for moderately high interest rates. It doesn’t change the essential point I am trying to make.

So I assumed a supply curve that looks like this.

loans market normal

A more realistic supply curve with a reserve requirement would be this.

Loanable goods market IV

And with no reserve requirement, it would look like this.

Loanable goods market V

So I suspect that, when the reserve requirement is (nearly) binding, removing it would lower interest rates and reserve ratios but everything should still work.  Of course, modeling this would require a different supply function from the one I assumed previously.  But the main implications should be basically the same.  This does put “liquidity traps in a slightly different light since we can’t just say that it’s because demand hits zero (or IOR) before you hit the reserve requirement.  But the nature of it is not much different since the rising supply is due to the liquidity risk, it should be a function of reserve ratios (holding other things equal) so when the base increases, it should stretch this curve to the right making supply higher for any given interest rate and so it is easy to imagine it being very close to zero/IOR for a long way out and this causing reserve ratios to be relatively high and rates to be close to zero/IOR.

So my approach is probably the result of good old-fashioned American myopia, I will try to broaden my horizons.  But I think the basic framework I am working with holds up in light of this wrinkle.  I do wonder what the reasoning for Canada dropping the requirement was though.  It would seem to me that this would make monetary policy a bit less precise since they would have to estimate the slope of the supply curve out at the end (they probably don’t think about it this way but somehow or another, there is an extra degree of freedom if reserve ratios are fluctuating with monetary policy).  But monetary policy is one area where it’s difficult to criticize our neighbors to the north since they have had somewhat less difficulty with it than we have lately.

 

 

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