A bank’s final reserve balance, therefore, may be either higher or lower than the quantity of reserves it chooses to hold in the interbank market. This uncertainty makes it difficult for a bank to satisfy its requirement exactly and generates a ‘precautionary’ demand for reserves.
“First, note that if the market interest rate were above the penalty rate, there would be an arbitrage opportunity: banks could borrow reserves at the (lower) penalty rate and lend them at the (higher) market interest rate… As a result, the demand curve is flat . . . at the level of the penalty rate for sufficiently small levels of reserve balances…
“If the market interest rate were exactly zero, however, there would be no opportunity cost of holding reserves. In this limiting case, there is no cost at all to a bank of holding additional reserves above the fully insured amount. The demand curve is therefore flat along the horizontal axis after this point.”
Then, on to the system that became effective in the United States on October 6.
“Many central banks use what is known as a symmetric channel (or corridor) system for monetary policy implementation. Such systems are used, for example, by the European Central Bank (ECB) and by the central banks of Australia, Canada, England, and (until spring 2006) New Zealand. The key features of a symmetric channel system are standing central bank facilities that lend to and accept deposits from commercial banks…
“The new feature in Exhibit 2 is that the demand curve does not decrease all the way to the horizontal axis, but instead becomes flat at the deposit rate. In other words, the deposit rate forms a floor below which the demand curve will not fall.”
Finally, what of the world as it is today?
“Starting from the symmetric channel system presented in Exhibit 2, suppose that the central bank makes two modifications.
