Remuneration of Required Reserves at an Average Rate

Abstract

In this chapter, we change the current rate model presented in the previous chapter by assuming that reserves are remunerated at the average of the repo rates l₁ and l₂ at the end of the second period instead of at the current repo rate l_t at the end of each period. We will show that under this different assumption concerning the remuneration of required reserves, interest rate changes do influence the banks’ optimal liquidity management. If the central bank cuts (raises) the repo rate, banks will postpone (frontload) holdings of required reserves which implies that also on aggregate reserves will be provided unevenly. This again implies that aggregate central bank borrowing will deviate from the benchmark, i.e. underbidding (overbidding) will occur. Furthermore, we will show that banks are not only affected differently by a monetary policy impulse in form of a change in reserve requirements but also by a monetary policy impulse in form of a change in the repo rate. Moreover, it will turn out that the interbank market rate is smoothed in the sense that it will slightly decrease (increase) even before the central bank actually cuts (raises) the repo rate.