Frictions in the Interbank Market and the Demand for Reserves: Lessons from the Financial Crisis

Many central banks around the world have adopted a framework for implementing monetary policy that involves targeting a value for the overnight rate on unsecured loans of reserves between banks. The financial crisis wrecked havoc in this market and central banks responded, in part, by flooding the system with reserves, driving rates lower. We extend the canonical model of implementation of monetary policy within a corridor system to include credit risk and transactions cost. We empirically test how well this model can describe the demand for reserves dynamics during the crisis and find that both frictions played important roles. JEL classification: E43, E52 and E58