Tunnels and Reserves in Monetary Policy Implementation

Abstract

In recent years, some central banks have implemented monetary policy without reserve requirements by using a ceiling and floor for overnight interest rates established by central bank lending and deposit facilities. This paper analyzes a theoretical model of such a "tunnel" system and the benefits of adding reserve requirements to it. However, reserve requirements may involve social costs owing to the reserve avoidance activities of banks. The paper also presents a modified model with no reserve avoidance, where banks optimally choose to hold voluntary reserve requirements. The paper highlights the importance for central banks to consider such models in light of idiosyncratic features of their own institutional environment, which may importantly condition the advisability of any particular approach.

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