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Interest on Reserves, Settlement, and the Effectiveness of Monetary Policy

19 Pages Posted: 1 Dec 2016 Last revised: 25 May 2017

Joshua R. Hendrickson

University of Mississippi

Date Written: November 29, 2016


Over the last several years, the Federal Reserve has conducted a series of large scale asset purchases. The effectiveness of these purchases is dependent on the monetary transmission mechanism. Former Federal Reserve chairman Ben Bernanke argued that large scale asset purchases are effective because they induce portfolio reallocations that ultimately lead to changes in economic activity. Despite these claims, a large fraction of the expansion of the monetary base is held as excess reserves by commercial banks. Concurrent with the large scale asset purchases, the Federal Reserve began paying interest on reserves and enacted changes in its Payment System Risk policy. In this paper, I estimate the effect of the payment of interest on reserves (as well as other payment policy changes) on the demand for daylight overdrafts through Fedwire. Since Fedwire provides overdrafts at a fixed price, any fluctuation in the quantity of overdrafts is a change in demand. A reduction in overdrafts corresponds with an increase in the demand for reserves. I show that the payment of interest on reserves has had a negative and statistically significant effect on daylight overdrafts. Furthermore, I interpret these results in light of recent theoretical work. I argue that by paying an interest rate on excess reserves that is higher than comparable short term rates, the Federal Reserve likely hindered the portfolio reallocation channel outlined by Bernanke. Thus, the payment of interest on reserves increased payment processing efficiency, potentially at the expense of limiting the ability of monetary policy to influence economic activity.

Keywords: monetary policy, interest on reserves, daylight overdrafts, settlement

JEL Classification: E52, E58

Suggested Citation

Hendrickson, Joshua R., Interest on Reserves, Settlement, and the Effectiveness of Monetary Policy (November 29, 2016). Journal of Macroeconomics, Forthcoming. Available at SSRN:

Joshua R. Hendrickson (Contact Author)

University of Mississippi ( email )

Oxford, MS 38677
United States

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