Why Hold Reserves?
By Bryan Caplan
Suppose you see an individual, a bank, or a corporation sitting on a big pile of money. What should you conclude?
Theory #1: The actor has nothing good to spend it on. The individual is satiated, at least relative to existing products. The bank doesn’t expect any more loans to be profitable. The corporation doesn’t think that additional production would be profitable.
Theory #2: The actor wants a buffer. The individual, bank, or corporation is worried about the world’s vicisitudes, and sees the money as an insurance policy.
Note: The two theories make opposite predictions about the effect of exogenous income shocks. According to Theory #1, winning the lottery or losing a lawsuit won’t change actors’ behavior (unless the lawsuit is big enough to wipe out the whole money pile). According to Theory #2, in contrast, winning the lottery or losing a lawsuit matters. Indeed, it might lead the actor to drastically change his behavior in order to reestablish a buffer or take advantage of bypassed opportunities.
Theory #1 is often popular, but all the evidence I’ve heard of supports Theory #2. The most infamous example: In 1936-7, the Federal Reserve acted on Theory #1 by doubling reserve requirements in the face of excess reserves. Banks’ behavior, however, clearly fit Theory #2. Banks increased their “excess” reserves to restore their buffer.
Wages are the largest component of costs thus sticky wages keep costs high and profits low… suppose that the problem is that firms can’t get capital to
expand–perhaps because the banking system is not working well–then
what matters for firm expansion is free cash flow. But sticky wages
keep firm costs high, reducing free cash flow and inhibiting expansion.
Tyler responds, “[H]igh cash reserves are one reason why I don’t think Alex’s nominal wage stickiness story explains current unemployment.”
My defense of Alex: The cash flow mechanism doesn’t assume cash-poor firms. It just assumes Theory #2: Firms hold cash because they want a buffer, not because there’s nothing good to buy. And if past experience is any guide, Theory #2 is correct.