Shawn Osell Department of Business and Economics University of Wisconsin – Superior

1. Interest on Reserves: A Fourth Tool of Monetary Policy Shawn Osell Department of Business and Economics University of Wisconsin – Superior sosell1@uwsuper.edu

2. Interest on Reserves (IORs), Quantitative Easing (QE), Excess Reserves (ERs), and the money supply • QE1: September, 2008. • IORs: implemented on October, 2008 (Emergency Economic Stabilization Act) • QE2: November 2010 - June, 2011. $60B of T-bills • Operation Twist (decrease long term interest rates) • QE3: Announced Sept, 2012. $40B/month of MBS**

3. M2; 1960 – 2012 http://research.stlouisfed.org/

4. M2; 2006 – 2012

5. Where does money come from? -- What we learn about the money multiplier and money supply creation What is the money multiplier? (m) • The maximum change in the money supply due to an initial change in the excess reserves banks hold What is the money multiplier equal to? • m = 1 / required reserve ratio ≡ 1/r i.e. 1/10% = 1/(1/10) = 10 •  M1 =initial ER x m i.e. $90 X 10 = $900.

6. Money Creation via the Banking System - A Lecture from a macroeconomics course

7. Three Caveats regarding the money multiplier Can the multiplier be smaller than indicated? The simple money multiplier assumes that: 1.* banks want to lend out all of their ER’s 2. borrowers’ want to borrow all of a bank’s ER’s 3. All loans are deposited back into the banking system.

8. Reserve Market and IOR Theory

9. Federal Funds Rate and Interest on Reserves

10. Excess Reserves (Bil.) 1960-2008

11. Excess Reserves; 1960 - 2012

12. Excess Reserves; 2008 - Present

13. Why are banks not lending their Excess Reserves? • Consequences of too much easy credit during the 2000s • Current economy • Europe • Future uncertainty i.e. presidential election. • Low interest rates are not profitable for lenders – no incentive to lend. • How much impact do/can IORs have? *** The opportunity cost of lending or buying liquid assets has decreased.

14. Is there a relationship between Excess Reserves and interest on reserves? Causation vs. Correlation

15. Excess reserves and Required Reserves as a Percentage of Total Reserves

16. Include the Currency Ratio and Excess Reserve Ratio into the Money Multiplier Excess Reserve ratio = e = ER/D; where D = Checkable Deposits. Public can & does hold currency which slows the money creation process. Public preference for currency is measured by Currency ratio = c = C/D Currency has become a larger part of M1 than checkable deposits  C > D. Where is all the currency?: i.e. Overseas, Drug Trade. m = 1 + c   r + e + c

17. Money Creation with More Players Now, how well can the Fed control the money supply, M1? MB X m = M1 (MBn + DL) X 1 + c = M1 r + e + c The Federal Reserve controls: MBn, r = req. reserve ratio Financial Intermediaries control: e = ER ratio, and DLs = (note: Discount Loans are a right), The public controls: c = Currency Ratio.

18. MB * m = M1  m = M1/MB

19. Currency ratio and excess ratioa comparison before and after QE1

20. Supply of reserves:Borrowed and Non-Borrowed reserves

21. Banking and Excess reserves Bank Loans and ER ratio after QE1 Regression on loans after QE1

22. Concluding statements • IORs benefit Financial Intermediaries by lowering the opportunity cost of holding Excess Reserves and the Implicit tax on Required Reserves • Effective/additional Monetary Policy tool • Disincentive for lending • Loss of funds for US Treasury • Can/will be used to moderate future inflation