Abstract
Low required reserve balances in 1991 led to a sharp increase in the volatility of the
federal funds rate, but similarly low balances in 1996 did not.  This paper develops and simulates
a microeconomic model of the funds market that explains these facts.  We show that reductions
in reserve balances increase the volatility of the federal funds rate, but that this relationship
changes over time in response to observable changes in bank behavior.  The model predicts that
a continued decline in required reserves could increase funds-rate volatility significantly.

1. Introduction
In late 1990, the Federal Reserve reduced reserve requirements on nonpersonal time
deposits and Eurocurrency liabilities from three percent to zero.  Banks can satisfy reserve
requirements by holding vault cash and balances at the Federal Reserve.  Because the cut in
requirements had little effect on banks' desired vault cash, it had a large effect on required
reserve balances, as seen in Figure 1.   Accompanying this decline in reserve balances was a 1
dramatic increase in the volatility of the interest rate that banks pay each other to borrow reserve
balances, namely the federal funds rate.  Figure 2 shows that the standard deviation of the daily
difference betwee英语论文网 【http://www.51lunwen.org】n the actual funds rate and the Federal Open Market Committee's intended rate
surged to about 80 basis points in early 1991, or nearly four times the level that prevailed prior
to the cut in reserve requirements.  Later that year, required reserve balances were boosted by
rapid growth of transactions deposits and other factors, and funds-rate volatility subsided.  Since
early 1994, however, required reserve balances have fallen significantly, reaching their 1991
trough in early 1996.  This decline can be attributed primarily to the emergence of so-called
"retail sweep programs," in which banks shift deposits from reservable accounts (like NOW
accounts)  to  non-reservable  ones  (like  money  market  deposit  accounts)  without  impairing
depositors' access to the funds.   Yet, despite the large drop in required balances, Figure 2 shows 2
that funds-rate volatility increased only slightly, and remained well below its level of early 1991.
Why was the low level of required reserve balances in 1991 accompanied by a sharp