What is the Saturated Level of Reserves?

The above figure portrays the market for Reserves. On the vertical axis is the real price of reserves, which is not the nominal interest rate paid by the central bank, but the relative opportunity cost of investing in reserves instead of alternatives. The real price of reserves can be defined as the difference between the expected risk-adjusted real return on alternative assets minus that on reserves.

The blue line is the demand curve of reserves, which portrays the inverse relation between the quantity demanded of reserves and the opportunity cost of holding reserves.

The demand for reserves starts as a vertical line at the level v^r. This is the pre-QE level of reserve supply, where banks mostly hold reserves at the level required by the central banks, i.e. the level of excess is essentially zero.

An important feature of the reserve market is that while a lower price for reserves rises demand, it is only up to a certain level, which is v^s in the figure. This is the so-called saturated level of reserve in the reserves market.

Please note that the downward slope of the demand curve also reflects the service that reserves may provide in the form of liquidity. The scarcity of liquidity leads to a premium being priced onto the reserve, which is essentially the real price of reserves. The smaller the premium is, the larger the demand for reserves. Nonetheless, there is some point at which banks have all the liquidity they want, and this is v^s in the figure. From this point onwards, the opportunity cost of holding reserves (i.e. the liquidity premium) disappears and banks are indifferent towards holding more reserves. The demand curve beyond this point becomes close to horizontal and the reserves market is said to be saturated. This is where most advanced economies are in after rounds of QE injections.

References: “Funding Quantitative Easing to Target Inflation” by Ricardo Reis

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Cloud Yip

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