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Equal treatment under the Fed: Interest on reserves, the federal funds rate, and the ‘Third Regime’ of bank behavior

Donald Dutkowsky () and David D. VanHoose

Journal of Economics and Business, 2020, vol. 107, issue C

Abstract: Since the latter part of 2018, the federal funds rate has been equal to or nearly equal to the interest rate on excess reserves (IOER). Correspondingly, the Fed has expressed a desire for increased interbank lending within its target range for the federal funds rate. This paper examines these developments within a model of bank behavior. We argue that the resulting spread between the federal funds rate and IOER during this time led banks to switch to a third regime, different from the zero-excess-reserves regime of pre-October 2008 or the zero-wholesale-loan regime of post-October 2008 up to the period described above. Comparative-statics results from general-equilibrium solutions show that within this third regime, in which banks choose positive quantities of excess reserves and wholesale loans, banks exhibit the strongest response in retail lending to changes in the federal funds rate and the IOER. This regime, though, also has the weakest response in retail lending to a quantitative easing-type policy. Extending the model to the interbank loan market reveals that in the interior solution regime, even when faced with large increases in exogenous loan demand, banks borrow from the interbank loan market only under restrictive conditions. Taken with previous findings, we argue that monetary policy can include the Fed choosing the federal funds rate-IOER spread to determine the regime within which it desires for banks to operate. In this regard, we offer a sketch of how the Fed can utilize monetary policy strategically to stabilize the macroeconomy during the next recession.

Keywords: Interest on reserves; Federal funds rate; Bank credit; Monetary policy (search for similar items in EconPapers)
JEL-codes: E58 G21 (search for similar items in EconPapers)
Date: 2020
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DOI: 10.1016/j.jeconbus.2019.105860

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