Excess reserves and economic activity

This paper examines endogenous excess reserve holdings in the banking sector of an otherwise standard DSGE environment. Excess reserves act as an extensive margin of bank lending that is inactive in traditional limited participation models where banks hold minimal reserves by assumption. The results suggest that this extensive margin of bank lending can dampen and even overturn the standard liquidity effect of monetary contractions. When the liquidity effect is overturned, a monetary contraction results in an increase in output. In addition, the model predicts that changes in the interest rate paid on reserves can deliver large, short-run responses.