The Optimum Quantity of Central Bank Reserves

Jonathan Witmer

Staff Working Papers from Bank of Canada

Abstract: This paper analyzes the optimal quantity of central bank reserves in an economy where reserves and other financial assets provide liquidity benefits. Using a static model, I derive a constrained Friedman rule that characterizes the socially optimal level of reserves, demonstrating that this quantity is neither necessarily large nor small but depends on the marginal benefits of reserves relative to alternative safe assets. The model highlights how the supply of government and private-sector liquid assets influences demand for reserves and the size of a central bank balance sheet. I calibrate and estimate the model to determine the optimal amount of central bank holdings in the United States. I extend the analysis to account for shadow banking, where non-bank intermediaries create short-term liquid assets but generate monitoring costs and externalities. The presence of shadow banking alters the optimal balance of reserves and other assets, potentially constraining optimal balance sheet policy. The results offer new insights into the debate over the size of central bank balance sheets and the interaction between public and private liquidity provision.

Keywords: Monetary policy implementation; Financial institutions; Financial markets; Financial system regulation and policies (search for similar items in EconPapers)
JEL-codes: E41 E42 E58 G21 G28 (search for similar items in EconPapers)
Pages: 30 pages
Date: 2025-05
New Economics Papers: this item is included in nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:bca:bocawp:25-15

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