Wednesday, July 29, 2009

Are Excess Reserves a Sign of Ineffective Fed Policy?

From a friend and classmate of mine in grad school, Todd Keister, comes this interesting paper (via the WSJ Real-Time Economics Blog):

Excess Reserves: Todd Keister and James McAndrews at the New York Fed offer a great explanation for why there are more excess reserves at the Fed. “The quantity of reserves in the U.S. banking system has risen dramatically since September 2008. Some commentators have expressed concern that this pattern indicates that the Federal Reserve’s liquidity facilities have been ineffective in promoting the flow of credit to firms and households. Others have argued that the high level of reserves will be inflationary. We explain, through a series of examples, why banks are currently holding so many reserves. The examples show how the quantity of bank reserves is determined by the size of the Federal Reserve’s policy initiatives and in no way reflects the initiatives’ effects on bank lending. We also argue that a large increase in bank reserves need not be inflationary, because the payment of
interest on reserves allows the Federal Reserve to adjust short-term interest rates independently of the level of reserves.”

By the way, Todd, as a Teaching Assistant, taught me just about everything I know about graduate level macroeconomics. His ability to explain both the technical aspects of the models and their intuition far surpassed the professor's. He is one of the smartest guys I know, and he works for the Fed. This is not unique - the Fed is in excellent hands and employs an astonishing number of exceptionally smart and independent economists.

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