Bryan Caplan  

Best Banking: Animal Analogy Ever

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Arcane banking regulations matter, but it's hard to communicate anything about them to a broader audience.  Alex Tabarrok rises to the occasion with an elegant analogy:
When no interest was paid on reserves banks tried to hold as few as possible.  But during the day the banks needed reserves - of which there were only $40 billion or so - to fund trillions of dollars worth of intraday payments.  As a result, there was typically a daily shortage of reserves which the Fed made up for by extending hundreds of billions of dollars worth of daylight credit.  Thus, in essence, the banks used to inhale credit during the day - puffing up like a bullfrog - only to exhale at night. 
Alex is the only economist I know of who has highlighted the connection between the Fed's new policy of paying interest on reserves, and the apparent evidence of a liquidity trap.  Yet another reason why the world should listen to him.

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COMMENTS (2 to date)
Jeff Hummel writes:

Bryan: I must point out that I have been warning at Liberty & Power about the payment of interest on bank reserves and its potential effects on monetary policy since the middle of October. See my posts Interest on Bank Reserves and the Recent Crisis and Recent Fed Machinations.

R. Pointer writes:

When I read that last night, I was shocked. These are economists running the Fed right? Is it all bull---- what they teach in Grad school about incentives? Or are the only incentives that matter the central bankers'?

Lastly, how do they unravel this? They have grabbed the lion's mane. They will never have the incentive to let go.

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