Voluntary Reserve Targets

Abstract

We study monetary policy implementation through an operating regime involving voluntary reserve targets (VRTs). Operating regimes based on reserve requirements may lead to a collapse in interbank trade, as they have since the financial crisis. We show that, no matter the abundance of reserves, VRTs encourage market activity and support the central bank's control over interest rates. We consider (i) the impact of anticipated and unanticipated liquidity injections by the central bank on market outcomes and (ii) a comparison with the implementation framework currently adopted by the Federal Reserve. Overall, a VRT framework may provide several advantages over other frameworks.

A Simple Model of Voluntary Reserve Targets with Tolerance Bands

“…We describe a model of VRT with a perfectly competitive interbank market in the style of Poole (1968), first presenting a simplified version of the analysis in Baughman and Carapella (2020), and then applying the model to study tolerance bands. In the model, banks' choice of targets is endogenous, and so are interest rates in the interbank market.…”

“…This must be done carefully, however. If banks anticipate that the central bank will respond to their targets, they may strategically alter targets, creating instability discussed in section 5 of Baughman and Carapella (2020). Hence, in order to preserve the rate control promised by Proposition 1, a central bank should condition its operations not on targets, per se, but instead on information about the aggregate state, $$\omega$$— for example, information on so‐called autonomous factors, like payments to or from the Treasury.…”

“…Taken together, the set of tools employed comprise a central bank's framework for monetary policy implementation. Building a simplified version of the model in Baughman and Carapella (2020), this note describes a framework based on voluntary reserve targets (VRT). Relative to Baughman and Carapella, this paper provides insight into the interaction between the interbank interest rate and banks' targets, and considers a technique designed to limit rate variability.…”

“…Here, complementary to Baughman and Carapella (2020), we consider in detail the effect of target setting on the market rate. We provide a simple argument that, given an appropriate remuneration function, optimal target setting itself helps to guide market rates.…”

“…Specifically, targets can serve as the basis for two methods to limit rate variability-tolerance bands and reserve averaging-both of which depend on binding requirements. 2 Here, complementary to Baughman and Carapella (2020), we consider in detail the effect of target setting on the market rate. 3 We provide a simple argument that, given an appropriate remuneration function, optimal target setting itself helps to guide market rates.…”