The Interest Elasticity of Excess Reserves Held at the Federal Reserve

Abstract

This paper identifies the interest elasticity of excess reserves held at the Federal Reserve in order to critically analyze the Federal Reserve’s plan to exit the extreme level of monetary policy accommodation used to combat the Great Recession. An econometric model is developed and estimates are drawn from a time-series data set ranging from 2007 to 2010. Particular attention is given to the Federal Reserve’s new ability to pay interest on reserves and how this tool will affect the Federal Reserve’s exit strategy and the interest elasticity of excess reserves. Results indicate that the semi-elasticity of excess reserves is -0.34. Furthermore, expectations of future interest rates have the most substantial effect on the level of excess reserves. These results imply that the Federal Reserve will not be able to implement the channel-corridor system in the United States banking system to exit the current extreme level of monetary accommodation.