Welfare Implications of Reserve Regimes
Draft: (coming soon)
We develop a general equilibrium model to quantify the welfare costs of alternative reserve regimes. Banks in our model face stochastic deposit flows requiring settlement through reserves, creating a precautionary demand shaped by frictions in the over-the-counter interbank market. We establish a novel irrelevance theorem, providing conditions under which interbank frictions and reserve quantities have no welfare implications. With frictions, however, banks’ liquidity management materially affects credit provision and welfare. Quantitatively, we find that increasing inflation to 10% while holding the real discount window rate constant generates welfare costs of 0.8% of consumption—comparable to Lucas (2000) despite our model excluding currency. The model reproduces the post-2008 tripling of reserve holdings and predicts that raising the real return on reserves initially reduces output as reserves crowd out productive loans, with this effect reversing only after deposit demand becomes satiated. Our results demonstrate that the welfare implications of returning to scarce reserves depend critically on implementation details.