Authors: Antoine Martin, James McAndrews, and David Skeie
The amount of reserves held by the U.S. banking system rose from under $50 billion in mid-2008 to over $1.5 trillion by mid-2011. Some economists argue that such a large quantity of bank reserves could lead to overly expansive bank lending as the economy recovers, regardless of the Federal Reserve’s interest rate policy. In contrast, we show that the size of bank reserves has no effect on bank lending in a frictionless model of the current banking system, in which interest is paid on reserves and there are no binding reserve requirements. We also examine the potential for balance sheet cost frictions to distort banks’ lending decisions. We find that large reserve balances do not lead to excessive bank credit and may instead be contractionary.