Ample reserves regime | AP Macroeconomics | Khan Academy

What we're going to do in this video is talk about some interesting things that have happened since 2008. In particular, we're going to talk about what an ample reserves regime is but even more importantly what its actual implications are and how you can analyze it with a graph like this.

So let's just make sure we have our bearings first. The horizontal axis right over here is reserve balances, and then the vertical axis here is interest rates. So for the first part of this discussion, let's ignore everything that we see in gray over here. That's what we're going to talk about when we talk about the ample reserves regime. Let's say we're talking about a period pre-2008, and in that situation, you could imagine the more reserve balances you have, the lower the demand is for reserve balances.

Because if more banks are sitting on reserves, well then they don’t need to go into the market and borrow reserves as much. What you would naturally expect is, as reserve balances increase, demand goes down. Of course, the actual interest that people would need to pay in order to get reserves if they're running low would go down.

So for example, let's ignore this red line here. Let's imagine a pre-2008 scenario where the actual reserves, the supply of reserves, looks like this. Of course, the Federal Reserve can determine this by printing money, increasing its balance sheet, or contracting its balance sheet. They can do that as they see fit. So in this situation right over here, these are the total reserves that are in the system that the Federal Reserve can decide, and you have now a market rate for overnight reserves.

So if a bank is running low, let’s say they had a lot of withdrawals, they need to meet their reserve requirements back then. Well then, they would go into the quote money market and they would borrow some of that money from a bank that has excess reserves. Now you might be wondering, why does this curve, this blue curve, flatten out as you go further and further to the left? Why doesn’t it do something like this? If the reserve balances are lower and lower, you’d think people would charge higher and higher interest rates to lend reserves overnight.

Well, what puts a cap on this is the discount window, this primary credit rate. This is the rate that a bank in good standing, a strong bank, can access. You also have a secondary credit rate for slightly weaker banks; that would be a higher rate. But this is essentially what banks can go to the Federal Reserve and borrow directly from the Federal Reserve at the discount window. So that discount window rate right over here essentially puts a cap on the overnight borrowing rate, a cap on the rate that a bank would have to pay in order to borrow reserves.

And so that’s why you see the curve essentially gets limited by that. But now let’s think about what happened in 2008. To understand that, I always get a kick out of looking at the total assets of the Federal Reserve. This is essentially the Federal Reserve's balance sheet. You can view this as how much base money they have put into circulation.

And I know these numbers are hard to read, so let me write it down for you out here. That is 2008. In this, the rightmost point, we are about 34% of the way through 2023. Now you see something interesting happening. Essentially, a little bit midway through 2008, the balance sheet increases significantly. We go from roughly one trillion of base money to $2 trillion of base money.

So essentially, what the Federal Reserve was doing, they were taking this vertical line and they were pushing it far to the right over here. Now you might think, historically, why were they doing that? Well, some of you might remember we had banks failing; it had a financial crisis. They wanted to shore up not just the banking system but also the economy. So the Federal Reserve just started printing money, and it put us into a new territory, a territory of ample reserves. That’s why it's called an ample reserves regime.

Now there’s an interesting question though. If you go to a situation of ample reserves, and that’s essentially the situation that we could imagine right over here. If you just had your traditional demand curve here, this curve would have just kept going down and down and down. Essentially, there’s so much reserves in the system that the demand would go so low that if a bank had excess reserves, it would pretty much get little to no interest on those reserves.

Now that’s a tough situation in and of itself because some of those banks needed that interest on reserves. Once again, they were all in a tough situation. You also want a situation where banks could probably attract some depositors by hopefully giving some interest to the depositors themselves. That also would strengthen the banking system.

So that’s when, in this ample reserves regime, the Federal Reserve did something else. They said, “Okay banks, it is no longer the case that the only way that you could get interest on your reserves is by lending it to other banks. We’re going to allow you to take those reserves and deposit them with us, with the Federal Reserve, and we will give you interest on those reserves.” That’s what this “I” is; interest on reserves.

So if you are a banking institution, this essentially set up a floor on the interest that you would get on your reserves. Now the question you might be wondering is, why doesn’t this blue line then just flatten out right over there? In some more simplified diagrams, you will actually see that. But it turns out that banks are not the only participants in the money market.

You have other people who are potentially lending reserves to banks, and they don’t have access to depositing their reserves with the Federal Reserve. So that’s not a floor on them. The Federal Reserve introduced another rate. I won’t go into the details of what RRP stands for. These are essentially repurchase agreements. This is essentially the Federal Reserve giving interest to non-banking institutions on reserves that they place with the actual Federal Reserve.

So this places a hard floor because even those folks would never want to lend below this because they could get that much interest with the Federal Reserve. Now the next question you might be wondering is, “All right, if we are out here in this ample reserves regime, traditionally the Federal Reserve could change the federal funds rate, the target rate, by moving this red line to the left and the right.”

If you’re in a non-ample reserves regime, if you move this red line to the left, well what’s going to happen? You’re going to essentially increase the overnight borrowing rate, and that would constrict the economy. If you move it to the right, you’re going to decrease the overnight borrowing rate, and that would stimulate the economy.

If you’re out here on the right side, if you move this vertical red line to the right or the left, it’s not going to change the overnight borrowing rate because you’re essentially going to be hugging this pretty flat blue line. And things have gotten even more ample since 2008. We went from roughly one trillion to two trillion, and then out here we’re getting approaching eight trillion.

You might say, “Well, what happened right over here?” Well, that was the COVID pandemic, where once again the Federal Reserve really wanted to stimulate the economy, and they did that by printing a ton of money. So in the scenario that we’ve been in for a while now, we are deep into an ample reserves regime. If we were in ample reserves in 2008, we’re that much further right now in the 2020s.

So how does the Federal Reserve actually control interest rates now? Well, what they can do is they can control these floors, or you could say this floor right over here. If they want to increase interest rates, they just increase the interest on reserves they give. If they do that, then the curve will look something like this, and then the overnight borrowing rate will be higher. Of course, that would be restrictive for the economy, and if they want to loosen, they can likewise lower the interest on reserves.